FT Alphaville " The return of auto subprime lending We were intrigued to discover on Wednesday that we are subscribed to something called the Moody's Auto Navigator report. When it showed up in our inbox Tuesday, we were intrigued further by what it said: The subprime auto lending market is exhibiting some characteristics last seen during the early- to mid-1990s, when overheated competition led to poor underwriting and drove unexpectedly high losses that put many smaller lenders out of business. Then, as now, investor capital flowed into the sector, lured by the profit potential from the ability to charge high loan rates while enjoying low funding costs. When the lending boom in the 1990s eventually went bust, the number of lenders contracted drastically, and subprime auto ABS investors suffered losses. If today's subprime auto lending market were to deteriorate as it did back then, investors could suffer comparable or greater losses, especially in the absence of monoline guarantors or other controlling parties available to minimize or absorb their losses. Over the last two years, the sector's profit potential has lured private equity investment into subprime auto lenders, many of which are relatively small, specialty finance companies that exhibit speculative characteristics and relatively high medium-term default probabilities. As a result, the subprime autoloan ABS market in the US is booming, with 2012 issuance on pace to exceed the robust issuance of 2011. Loan performance has been strong over the past several years, but the investor interest from outside the subprime auto market niche and the potential for increasing competition imply that losses could increase if a race for profits and market share results in weaker underwriting standards. Emphasis ours. It's interesting to think about whether the absence of monolines backing these transactions increases rather than decreases their safety. Ditto for the fact that these smaller lenders are increasingly being acquired by private equity firms rather than receiving public equity injections. Hard to say. At the moment there are thirteen securitisers of auto loans in the US, many fewer than existed in the 1990s, when there were more than 30. But the space is beginning to fill up again, no surprise given the currently big spreads between the lenders" lending rates and borrowing costs: Subprime auto ABS transactions issued since 2010 that we've rated, for example, have earned yields ofroughly 17% per annum on their underlying loans while paying coupons averaging less than 2%. Because of the very tight lending standards that followed the financial crisis, their net losses have been low, 1%-3% per annum, which means that the issuers are earning average spreads of around 12% per annum. So perhaps it should be that lending into the sector and securitization of these loans has tried to keep up - and that underwriting standards have begun to fall again. Is it too much to hope that lenders will be more prudent this time round, or investors more discerning? It's early days and we don't wish to be alarmist. Auto loans and ABS are small in amount compared against what was happening mortgage market anyways, and some of this is a reversion after tigher lending standards post-crisis. But, well, the answer to the above question is yes, probably: Competition in the lending industry usually leads to declining portfolio credit quality because lenders are increasingly willing to lower their credit standards to compete and maintain their share of the pool of potential borrowers. Even if lenders don't lower their minimum standards, the average credit qualityof their portfolios will weaken amidst the competition for stronger borrowers. Lenders also often reduce pricing, thereby reducing the protection against the risks they are taking. The credit quality of pools securitized in 2011 and 2012 indicate that credit has loosened since 2010. Recent data from Experian show that the average APR on loans for used autos decreased to its lowest level since 2008, to 8.61% from 8.71% between the fourth quarters of 2010 and 2011, even as the average borrower credit score also decreased, to 670 from 679. The credit loosening reflects increasing competition as well as a return to pre-recession normalcy after the lenders that remained following the financial crisis put more stringent underwriting in place. Of course, the issue isn't just about the decline of underwriting standards and collateral quality; it's equally about whether the decline is recognised by investors. The problem with the MBS market wasn't just that lending standards sucked, but that their suckitude was "hidden" because of the misunderstood riskiness of securitised products and the awful work of the rating agencies. At least in this case, Moody's is trying to get out front. Whatever the case, we noted in May that while the pace of car sales in the US has picked up this year, it's still much slower than for most of the past decade. More and more it's clear that this is an ongoing rebound following the end of a depreciation cycle. The pickup in lending activity is at least a sign of expected sustained demand in this sector, so there's that. In other words, this trend is likely to continue for a while. This entry was posted by Cardiff Garcia on Wednesday, July 18th, 2012 at 22:45 and is filed under Capital markets. Tagged with auto, auto ABS, US car sales.