In January, Neuberger Berman analyst Steven Eisman announced a new headline short position for his firm.
From his senior portfolio manager perch, Eisman (of "Big Short" fame) said he has made the bet that equity shares of bad-credit auto finance company Credit Acceptance Corp. (Nasdaq: CACC) will decline amid shrinking profitability, despite the company's $421 million in net income (or $23.47 a share) last year.
“This is not a short thinking that the company is going to suffer credit losses,” Eisman said in an
Eisman described the litany of legal and oversight issues faced by Southfield, Mich.-based Credit Acceptance Corp. (CAC), including an
(Credit Acceptance, one of the nation’s largest subprime auto lenders, has denied the allegations in the Massachusetts lawsuit, according to Bloomberg).
While he described the company's lending and collection tactics as "disgusting," Eisman said his motive is also driven by the shifting political winds in Washington, D.C. "With a new head of the Consumer Financial Protection Bureau going to take charge soon, I think there’s the potential here for this company to be regulated to a much lower level of profitability, at the very least.”
The subprime-auto finance industry and its lenders have withstood regulatory and legal scrutiny for years, partly by nimbly adapting their businesses to appease regulatory concerns, say ratings agency analysts. But, should executive director nominee Rohit Chopra be confirmed after
New standards possible
CAC and other subprime lenders may be under further pressure from the bureau if Chopra, an avowed consumer activist who currently serves on the Federal Trade Commission, takes the helm. Market watchers believe subprime lenders, despite the fact most have tightened their underwriting standards in recent years, could be faced with new rulemaking and legal enforcement that would force lenders to change some of their business practices in underwriting loans.
Most significantly, speculation centers on whether Chopra will impose ability-to-repay standards in subprime auto lending, similar to those the CFPB enforces in the housing industry through qualified-mortgage rules created out of Dodd-Frank.
“Subprime lenders could run into issues, either individually with the CFPB or [if the agency] attempts to do rulemaking for indirect auto lending that would have a financial impact on those companies,” said Edwin Groshans, a senior vice president at Heights Capital Markets. According to Bloomberg, Groshans has been cautioning investor clients about more robust federal regulation of subprime auto lenders, who have issued in excess of $24 billion in loan-backed securities in each of the past six years.
Joseph Cioffi, chair of the insolvency, creditors’ rights & financial products practice group at Davis & Gilbert, told Asset Securitization Report that “we might find going forward that there’s an even higher standard on what proper underwriting standards are in terms of borrowers’ ability to pay.”
In addition to ATR standards, analysts believe the CFPB under Chopra would also focus on fair-lending and debt-collection practices of subprime auto lenders, based on his background. Chopra previously served with the CFPB during the Obama years under former director Richard Cordray, helping to implement the bureau at launch as well as taking the lead on policing student leading as an assistant director. Chopra led the crackdown on abusive student lending by suing for-profit colleges including Corinthian Colleges and ITT Educational Services for coercing students into high-interest loans with a high probability default.
Groshans said it is likely Chopra will focus on expanding ability-to-repay underwriting rules to all categories of suprime lending (including payday loans), as well as look at whether problematic lending practices fall under “abusive” standards. While what constitutes “abusive” standards has not been established by statute or even case law, said Groshans, “[i]f you’re trying to build case law around the term ‘abusive,’ then an abusive practice would be extending a loan that you don’t expect the borrower to pay off while still making a good return on it,” Groshans said.
The lawsuit filed by Massachusetts AG Maura Healey claims CAC's tactics fall into that category. The company "made high-interest subprime auto loans to Massachusetts borrowers that the company knew borrowers would be unable to repay, in violation of state law," a press release announcing the lawsuit stated. "While the company profited, borrowers experienced ruined credit, lost vehicles or down payments, and were left with an average of approximately $9,000 of debt."
Rising risks for borrowers
Auto loans in recent years have become more expensive and burdensome for borrowers, in both the prime and subprime spaces. For subprime borrowers, the average listing price for used vehicles climbed to $21,558 last July, according to Edmunds. Higher sticker prices are forcing borrowers to take out longer-term loans of up to 84 months from some lenders.
Earlier this month, CAC closed on its second auto-loan securitization of the year with a pool of loans that had average length of 61 months and APRs of 22.2%. Four years ago, CAC's first ABS deal of 2017 saw borrowers in contracts averaging only 56 months.
But in subprime auto ABS pools in 2020, there are few signs of borrower trouble. Pools from issuers reporting data to the Securities and Exchange Commission (under Reg AB II reporting standards) showed outstanding performance in terms of delinquencies, according to a Feb. 18 auto ABS industry report issued by S&P Global ratings. Despite initial pressure on borrowers during the outbreak of COVID-19 last spring, S&P says the average rate of non-payment after 60 days was 4.08% on non-prime loan accounts last December – well below the 5.08% rate at year's end 2019 and representing a six-year low.
But analysts say the performance was buoyed by unprecedented government assistance for borrowers as well as generous forbearance and extension agreements from lenders. Cioffi said that subprime borrowers are at greater risk than prime borrowers of losing their (typically) lower-paying jobs, and the combination of longer loan maturities and high monthly payments creates “layered risk” that increases the chance borrowers’ will be unable to pay off those loans.
Subprime-loan extensions rose to 4.99% in December, the highest rate since June 2020 in the early stages of the pandemic response, S&P noted in its report last week. "Toward mid-2021, once stimulus and enhanced unemployment payments have been spent and allowable extension limits have been exhausted, losses are likely to rise and slightly exceed pre-pandemic levels," the report stated.
Impact on ABS
CAC is not the only lender and subprime ABS issuer that has been in the legal crosshairs from state and federal authorities. Santander Consumer USA Holdings reached an agreement last May with 34 state attorneys general providing $550 million in restitution and debt relief to borrowers that authorities said were underwritten for risky loans by Santander in alleged violation of state consumer protection laws dating back to 2015.
The Massachusetts attorney general's office has also reached settlements in recent years with Santander as well as Exeter Finance for originating what authorities claimed were "unfair, high-rate auto loans" for credit-challenged borrowers.
Earlier this month, the Federal Reserve
Investors in subprime-auto ABS have so far overlooked the state-level litigation, demonstrated by their willingness to continue accepting lower yields compared to earlier years.
Cioffi noted that subprime-auto ABS has remained attractive to investors because of its structural protections, but that could be affected if the CFPB were to push for more fundamental lending changes. Limits on the interest rates lenders can charge, for example, could result in less excess spread, encouraging lenders to buffer securitization trusts by adding more loans and potentially increasing deal costs and lowering investor returns.
Ultimately, though, that may end up being a positive development, said Cioffi, whose
“A strong regulatory environment in the long run should mean stronger quality loans in the securitization pools, if at some additional cost,” he said.
Bloomberg News contributed to this report.
