Most of us still vividly remember the housing bubble and its disastrous aftermath. The underwriting and repackaging of residential sub-prime mortgages helped drive the economy into a meltdown in 2008 and led to our worst recession since the Great Depression.
The Housing Bubble
But in case you need a refresher, let’s summarize. Beginning in the late 1990s, residential housing prices began to climb dramatically. By the mid-2000s, real estate speculation had reached feverish proportions. At that point, banks were writing home loans to just about anybody, qualified or not, on the assumption that ever-increasing property values would protect them in the event of defaults. But housing prices began to fall in 2006 and lenders began to sweat a bit.
Enter the evil geniuses of Wall Street, who saw a way to take maximum advantage of the sub-prime loan phenomenon. They did this by engaging in a bit of financial alchemy, taking ill-advised and risky sub-prime home loans, packaging groups of them into what they falsely represented to be high quality individual investments called mortgage-backed securities, and selling these securities to unwitting retail investors. This easy and profitable avenue for banks to pass their sub-prime loans on to others left them disinclined to engage in thorough due diligence before making loans. After all, they knew they could unload the loans immediately to issuers of the mortgage backed securities.
When the housing bubble burst, homeowners lost the houses they could no longer afford. And with defaults in the sub-prime mortgages that were to provide the income stream and principal protection for holders of interests in mortgage backed securities, many investors lost substantial portions of their life savings.
The Auto Loan Bubble
While we like to think we learn from our mistakes, it turns out all too often that we repeat them. There are warning signs that we could well see a return of the asset backed security debacle, but this time the driving engines (pun intended) are sub-prime auto loans instead of residential mortgages. Obviously, an “auto loan bubble” does not pose even a significant fraction of the systemic risk that was created by the vastly larger and more important sub-prime housing market, but securities created from sub-prime car loans pose a real threat to investors.
Subprime Auto Loans
Subprime auto loans have been and are being bundled into auto loan asset-backed securities (“ABS”) and sold to the public as solid, income-producing debt investments similar to corporate bonds. They’re marketed as secure products offering above-average interest. But while a bond may be backed by an issuing company’s income and assets, these auto loan ABS products are backed solely by a pool of auto loans. The loans are bundled and the rights to receive the payments generated by the loans are sold to investors. Those rights are divided into tranches (“tranche” being the French word for “slice.”).
As income flows from the loans, payments to investors are made in a manner analogous to a terraced waterfall: once the first level of tranche holders get paid, payments spill over to the second tranche, and then successively to each lower tranche in turn. Owners of the top tranche earn the least interest because their priority payment makes their holdings the least risky. With each successive tranche, the interest rate climbs as the risk of non-payment climbs. Owners of the bottom tranche, who are most at risk of non-payment in the event of inadequate returns from the loan pool, receive the highest rate of return.
The ABS issuer profits from this arrangement, in part, by skimming off a significant portion of the interest payments from the pooled loans before it pays the ABS investors. Here’s the way one major player in the creation of these products, GM Financial, summarizes its process:
- Each month, GM Financial’s customers make payments on their auto loans.
GM Financial receives a fixed amount of money: 1) loan principal and 2) the interest portion of the customer’s payment. These monthly payments are submitted directly to the ABS trust.
2. The ABS trust uses this monthly cash flow from GM Financial’s customers to repay the bond investors.
The investors receive a monthly payment: 1) principal (to repay the borrowed money) and 2) interest, or coupon, which is the interest rate paid on the bonds.
3. GM Financial earns (or receives) the net interest margin – which is the difference between the interest rate that our customers pay on their auto loans and the interest rate paid to the investors.
For example, the securitization named 2007-D-F has an average customer interest rate of 16.9 percent, but we are only required to pay the investors approximately 5.5 percent. Therefore, GM Financial will earn a 11.4 percent net interest margin (16.9 percent minus 5.5percent) on these loans before covering credit losses, operating expense and any fees associated with the securitization.
While the structure sounds like it should be pretty safe for investors there are problems underlying these investments, much like the problems that arose with mortgage-backed securities.
Issues with Asset Backed Securities (ABS)
First, and most important, the quality of these auto loan ABS products relies principally on the quality of the auto loans underlying them. A significant portion of the asset pools used to create these products are composed of subprime loans, and the proportion of the securities made up of “deep subprime” loans is increasing in a massive way. Morgan Stanley has stated: “In fact, since 2010, the share of Subprime Auto ABS [asset-backed securities] origination that has come from these deep subprime deals has increased from 5.1% to 32.5%.” Subprime loans are those made to people with low credit scores. While there is no standard definition for “subprime,” it often refers to people with credit scores lower than 640, and “deep subprime” refers to credit scores lower than 500. The lower the borrower’s credit score, the more likely the borrower is to default on a loan. Accordingly, subprime loans are inherently riskier than prime loans and deep subprime loans are riskier still.
Given the higher risk inherent in subprime loans, one would hope that borrowers are being forthright in their loan applications and that lenders are being thorough in their due diligence. Unfortunately, it appears that neither may be happening. Bloomberg reports that “as many as one in five auto-loan borrowers admitted in a survey that their applications for debt contained inaccuracies . . . meaning fraud could be more pervasive than lenders planned for. The “inaccuracies” are all too often “material misrepresentations.” Bloomberg has reported that “as many as 1 percent of U.S. car loan applications include some type of material misrepresentation . . . . Lenders’ losses from deception may double this year to $6 billion from 2015 . . . .”
Lenders At Fault As Well
Unfortunately, as borrowers’ inaccuracies or falsehoods increase, lenders are growing lax in their data verification. It was reported recently that Santander Consumer USA Holdings, Inc. – one of the largest subprime auto finance companies – verified income on a mere 8% of the borrowers whose loans it bundled into $1 billion of bonds. Santander agreed to pay nearly $26 million in settlements with Massachusetts and Delaware related to allegations that it facilitated unfair, high-rate auto loans for thousands of buyers. Naturally those loans were packaged into securities sold to investors. Santander is, however, not alone in its income verification procedures. Americredit, another large auto-loan company (and a unit of General Motors Financial Company), reportedly verifies only 64% of its prospective borrowers’ incomes.
Delinquency Rates Rising
The problems with the subprime loans, and the securities derived from them, are not purely hypothetical. Subprime borrowers are defaulting at ever-increasing rates. In fact, the delinquency rates for subprime auto loans are reaching crisis-level peaks. And many of those subprime borrowers who aren’t defaulting are tending to pay their loans more slowly. Borrowers with more cash than credit tend to pay their loans more quickly to avoid the high interest rate attached to the loans. The fact that they’re paying loans more slowly is thought to be a sign that borrowers are more strapped than they have been previously. Wells Fargo has reported that:
Borrowers are making fewer payments on loans bundled into bonds backed by sub-prime loans in 2015-16, compared with 2013 and 2014 bonds. Borrowers are also defaulting on a ‘record number’ of auto debt[s] . . . .
Santander Drive Auto Receivables Trust
One of the more popular auto loan-backed securities is the Santander Drive Auto Receivables Trust (“SDART”) product. The SDARTs offered bonds categorized into different classes – a number of A class bonds, followed by B, C, D, and E class bonds. The payoff time was to be longer for each successively higher class, leading to greater risk but higher interest rates for the lower classes. An analysis of the SDART offerings shows the cumulative effect of rising defaults and slower payoffs in underlying loans.
The third SDART offered in 2010 (SDART 2010-3) was issued in November 2010. The Class B bonds were expected to be paid in full by May 15, 2015. The Class C bonds were supposed to be paid in full by November 15, 2017. In fact, all classes (A through E) were actually paid in full by February 17, 2015 – before the B classes were expected to be retired. This pattern of early payoffs continued through 2012. The last SDART offered in 2012, SDART 2012-6, was issued in October 2012. Its class B bonds were supposed to be paid by May 15, 2017 and Class C bonds were supposed to be paid by March 15, 2018. In fact, all classes were paid in full by February 15, 2017, again before the Class B shares were expected to be retired.
Then, things changed. Beginning with the first SDART issued in 2013, the payouts started growing longer. Whereas the October 2012 offering had the Class B payout to be completed in May 2017, the January 2013 offering called for the Class B payout by January 2019. Stated differently, a product offered four months later pushed the payout seven months out. While all of the SDART products offered through the end of 2012 are fully paid and retired, all of the products offered thereafter have one or more classes of debt still outstanding.
It seems that the trend of slower borrower loan payments is having the direct effect of causing these products to run for progressively longer periods of time. While that means that those who own the various bond classes enjoy the interest return for a longer period of time, it also means that they’re subjected to the risk inherent in the product for a longer period as well. As auto loan default rates climb, it is possible that the ratings agencies will downgrade the riskier debt classes, making it more difficult to sell those instruments on the open market.
Increasing defaults will have a greater effect on these transactions going forward for another reason. Specifically, there is a glut of used cars on the market now, largely thanks to the supply of cars coming off completed leases. The higher supply of used cars serves to lower used car prices in general, which then serves to lower the recoveries from auto repossessions. Lower recoveries on auto loans only serves to further degrade the auto-loan backed security performance and values.
What Does This Mean for Retailers?
If the underlying loan slow payments and defaults are significant enough, it is possible that investors won’t receive the interest they expected to receive. The bond values will then decrease on the open market. Investors trying to unload the under-performing or non-performing bonds may only be able to sell them at a loss, if they’re able to sell them at all. If the underlying loan performance is bad enough, some of the bonds themselves could go into default, meaning that the principal sums due are never repaid. Investors face the possibility of losing some or all of the money invested in these supposedly safe bond or bond-like investments.
The bottom line is that auto loan ABS investments are not safe, secure, and better paying bonds or bond alternatives. They are subject to major losses and will become increasingly risky as car loan defaults continue to increase.
Auto-loan-backed securities are too risky
Auto-loan-backed securities, like the residential mortgage backed securities that preceded them, are complex products that are subject to a variety of risks. Just as lax loan standards helped drive the housing crisis, decreased auto loan standards could well drive a new crisis related to the securities derived from those loans. Whatever they are, auto-loan-backed securities are not simple bond products suitable for everyone’s retirement accounts. If you bought one of these products, and it is not performing as you expected, call Hugh Berkson at (216) 696-1422 or toll free at (866) 932-1295 for a free evaluation of your recovery options. You can also email us at email@example.com.
 Matt Turner, An increasing number of Americans have stopped paying their car loans, and Wall Street is starting to worry, available at: http://www.businessinsider.com/wall-street-is-worried-about-car-loans-2017-3/#fitch-deteriorating-credit-performance-will-be-more-acute-in-the-subprime-segment-1 .
 Matt Scully, AutoLoan Borrowers May Be Gaming Their Credit Scores, UBS Says (May 17, 2017), available at: https://www.bloomberg.com/news/articles/2017-05-17/auto-loan-borrowers-may-be-gaming-their-credit-scores-ubs-says .
 Matt Scully, Auto Loan Fraud Soars in a Parallel to the Housing Bubble (May 10, 2017), available at: https://www.bloomberg.com/news/articles/2017-05-10/auto-loan-fraud-is-soaring-in-a-parallel-to-the-housing-bubble .
 Analysis: Sloppy subrime car loans will deepen automakers’ woes (May 23, 2017), available at: http://www.crainscleveland.com/article/20170523/NEWS01/170529947/analysis-sloppy-subprime-car-loans-will-deepen-automakers-woes .
 Turner, An increasing number of Americans have stopped paying their car loans, and Wall Street is starting to worry.
 David Kily, Subprime Auto Loan Payments Slowing In Tandem With Rise In New Vehicle Prices (May 31, 2017), available at: https://www.forbes.com/sites/davidkiley5/2017/05/31/sub-prime-auto-loan-payback-and-delinquencies-rising-along-with-new-vehicle-prices/#61c6af459742 .
Hugh Berkson is a Securities Attorney with McCarthy, Lebit, Crystal & Liffman, Co. LPA. Hugh is rated AV® Preeminent™ by Martindale-Hubbell®.
He obtained a business degree in Finance from the University of Texas at Austin in 1989, and is a 1994 graduate of Case Western Reserve University School of Law, where he was a member of the Order of the Barristers and received both the American Jurisprudence Award, (National Mock Trial) in 1993 and the Jonathan M. Ault Mock Trial Prize for 1993-1994.