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5/13/2015 5:58 am  #1

The Next Bubble

Investment Riches Built on Subprime Auto Loans to Poor

The loans were for used Dodges, Nissans and Chevrolets, many with tens of thousands of miles on the odometer, some more than a decade old.

They were also one of the hottest investments around.

So many asset managers clamored for a piece of a September bond deal made up of these loans that the size of the offering was increased 35 percent, to $1.35 billion. Even then, Santander Consumer USA received more than $1 billion in investor demand that it could not accommodate.

Across the country, there is a booming business in lending to the working poor — those Americans with impaired credit who need cars to get to work. But this market is as much about Wall Street’s perpetual demand for high returns as it is about used cars. An influx of investor money is making more loans possible, but all that money may also be enabling excessive risk-taking that could have repercussions throughout the financial system, analysts and regulators caution.

In a kind of alchemy that Wall Street has previously performed with mortgages, thousands of subprime auto loans are bundled together and sold as securities to investors, including mutual funds, insurance companies and hedge funds. By slicing and dicing the securities, any losses if borrowers default can be contained, in theory.

Led by companies like Santander Consumer; GM Financial, General Motors’ lending unit; and Exeter Finance, an arm of the Blackstone Group, such securitizations have grown 302 percent, to $20.2 billion since 2010, according to Thomson Reuters IFR Markets. And even as rising delinquencies and other signs of stress in the market emerged last year, subprime securitizations increased 28 percent from 2013.

Taking On More Risk
Deals made up of auto loans to borrowers whom creditors deem riskier have increased since 2010.
Total subprime auto loan securitizations

The returns are substantial in a time of low interest rates. In the case of the Santander Consumer bond offering in September, which is backed by loans on more than 84,000 vehicles, some of the highest-rated notes yield more than twice as much as certain Treasury securities, but are just as safe, according to ratings firms.

Now questions are being raised about whether this hot Wall Street market is contributing to a broad loosening of credit standards across the subprime auto industry. A review by The New York Times of dozens of court records, and interviews with two dozen borrowers, credit analysts, legal aid lawyers and investors, show that some of the companies, which package and sell the loans, are increasingly enabling people at the extreme financial margins to obtain loans to buy cars.

The intense demand for subprime auto securities may also be fueling a more troubling development: a rise in loans that contain falsified income or employment information. The Justice Department in Washington is coordinating an investigation among prosecutors’ offices across the country into whether such faulty information ended up in securitization deals, according to people briefed on the inquiries.

The examinations, which began this summer after a front-page article in The Times reported on potential abuses in subprime auto lending, are modeled on the federal investigation into the sale of mortgage-backed securities — an effort that has already yielded billions of dollars of settlements.

Prosecutors have sent a spate of subpoenas. This summer, the office of Preet Bharara, the United States attorney for the Southern District of New York, sent subpoenas to Santander Consumer and GM Financial. The United States attorney in Detroit subpoenaed Ally Financial in December. And Consumer Portfolio Services, a subprime lender, said last week in a regulatory filing that the company had received a subpoena related to its “subprime automotive finance and related securitization activities.”

“There is so much money looking for a positive return that people get lazy,” said Christopher L. Gillock, a managing director at Colonnade Advisors, a financial advisory firm in Chicago that has worked with subprime auto lenders. “Investors see it is rated triple-A, turn off their brains and buy into the paper.”

Among the borrowers stoking the lending boom are people like Dana Payne.

Ms. Payne, a former administrative assistant in the New York Police City Department, has not made a single payment on a $30,770 Santander loan that was taken out to buy a 2011 BMW 328xi. Ms. Payne, who has no driver’s license, said she took out the loan so her daughter, who lives in New Jersey, could have a car. The loan has an interest rate of 11.89 percent, according to her loan document, a copy of which was reviewed by The Times.

Ms. Payne went with her daughter to a dealership that arranges loans for Santander and other auto lenders to buy the car. She said an employee at the dealership in Great Neck, N.Y., assured her that, even though she was on food stamps, she could afford the loan. At the time, Ms. Payne said she thought she was co-signing the loan with her daughter.

“I looked him in the eye and said, ‘I don’t have any income,’ ” said Ms. Payne.

The dealership did not comment.

The lenders point out they are providing loans to people who might not otherwise be able to buy cars. They say they have acted to insulate investors from losses. In many bonds, lenders take the first losses when loans sour, a safeguard few mortgage deals contain.

“Subprime lending by its nature involves evaluating the creditworthiness and ability to repay of borrowers who may have had financial difficulties in the past, such as a bankruptcy, a foreclosure or difficulty in managing revolving credit,” Stephen Jones, vice president investor relations at GM Financial, said in a statement.

The lenders say they vet their dealer partners, watching for patterns of complaints against dealerships and other warning signs like higher than average defaults.

Laurie Kight, vice president of communications at Santander Consumer, said in a statement that the lender has a “rigorous and active dealer control operation, which is part of the company’s overall compliance framework.” She added, “This operation audits, investigates and — if necessary — ceases operations with any dealers who conduct fraudulent or high-risk activities.”

Investors are betting that the companies are experienced enough to weed out problem loans.

Still, some credit analysts have questioned whether the market has grown too much, too fast.

Some rating firms that faced criticism after the mortgage crisis for blessing shaky investments with top ratings are taking a critical approach to subprime auto deals.

Fitch Ratings will issue its highest ratings only to bonds issued by lenders with long track records and that don’t rely entirely on securitizations to fund their business, like Santander Consumer and GM Financial. And Standard & Poor’s has recently sounded alarms about the declining quality of the loans backing the investments.

Even those warnings, critics say, do not fully capture the fundamental risks.

Mr. Gillock, the financial adviser in Chicago, said that no bond made up of subprime auto loans should ever receive a triple-A rating — a designation that only three blue-chip companies, Exxon, Microsoft and Johnson & Johnson, receive on their debt offerings.

“It is hard for me to place securities backed by subprime auto finance receivables in the same category,” he said.

If You Can’t Beat Him . . .

The financial crisis provided an opportunity for subprime auto loan securitizations.

With the once-enormous market in mortgage-backed securities largely frozen, investors looked for new opportunities. One bright spot was auto lending. Even in the depths of the recession, people needed cars and were willing to pay steep rates for a loan.

Seizing upon this demand, private equity investors began scouring the country looking to acquire lenders or pools of auto loans that banks no longer wanted.

Time and again, however, the private equity firms found that a Texas firm headed by Tom Dundon, an auto finance veteran, had beaten them to the punch.

“We looked on with envy,” said an executive at one of the private equity firms.

Mr. Dundon and a group of partners started the business that would become Santander Consumer in the 1990s, expanding the company — then called Drive Financial Services — from a regional lender in Texas into a national player operating in 35 states.

Drive Financial was known for lending to used-car customers that other lenders rejected. In industry parlance, the company went “deep” — meaning that it made loans to people far down on the credit spectrum.

“They were very popular with dealers because they were able to finance people that others could not,” said Mark Peters, a longtime auto lending executive in Dallas, who is now senior vice president of sales at Skypatrol, which provides vehicle-tracking technology and other services.

In 2006, the Spanish banking giant Banco Santander, looking to expand in the United States, bought most of Drive Financial Services for $651 million.

Mr. Dundon retained a 10 percent stake and was appointed chief executive of the lender, which was renamed Santander Consumer USA.

General Motors, still recovering from a bankruptcy that led to its takeover by the United States government during the financial crisis, was also looking to expand its auto finance business. The car company had sold a majority stake in its in-house finance arm, the former GMAC, which became Ally Financial.

In July 2010, General Motors acquired AmeriCredit, a lender based in Fort Worth, for $3.5 billion.

The rise of both Santander Consumer and GM Financial are a testament to the profits that can be generated by making loans to people with checkered credit histories.

Some of that profit is fueled by securitization, the process of bundling often risky loans into bonds and selling them to investors like mutual funds and pensions.

In the auto market, securitization typically starts at the auto dealerships, which arrange loans for car customers. Lenders then take those loans, bundle them into bonds and then sell them to investors.

Along this chain, there is ample profit. The lenders can often make more loans at a lower cost than if they borrowed directly from the bond market. The Wall Street firms that package the deals earn hefty fees. The investors can earn relatively high returns on securities that the rating agencies have deemed low-risk.

The danger, though, is that lenders may be encouraged to lower their credit standards to churn out loans to keep up with investor demand. The deterioration that securitization can fuel has already begun as lenders reach lower and lower down the credit spectrum to find enough borrowers whose loans can then be put into investments. To entice more borrowers to buy cars, some lenders are lengthening the terms of their loans, for example.

Santander Consumer says it has not sacrificed credit quality in its bonds, and that no investors have lost money on any of its securitization deals. Still, in the $1.35 billion bond deal in September, the number of loans with longer terms rose and the loan-to-value ratio — or the amount of debt compared with the resale value of the cars — also increased, according to a report by Standard & Poor’s Rating Service.

Auto lending has been good to Santander Consumers’ Mr. Dundon. He owns a 13,556-square-foot house in Dallas with a putting green and five fireplaces. Through a company spokeswoman, Mr. Dundon declined to be interviewed for this article.

An avid golfer, Mr. Dundon, 43, has played with the likes of Tony Romo, the Dallas Cowboys quarterback. Pictures of such outings are posted on the company’s website, and Mr. Dundon muses about the business lessons he has gleaned from the sport. After watching the Masters tournament at Augusta, Ga., he remarked how he was moved by the elite golfers competing for the top prize, a green jacket.

“We should all be inspired to seek out the equivalent of a green jacket in our work and life in general,” Mr. Dundon wrote on his blog.

A Bet on Car Dependence

Mandy Gray of Boiling Springs, Pa., is unemployed and depends largely on her partner’s $11-an-hour salary as a forklift operator. She says she has struggled to keep up with the $306 monthly payments on her Santander auto loan.

A lot is at stake not only for Ms. Gray, but for Santander Consumer.

The calculation by the lender is that Ms. Gray and thousands of other troubled borrowers will go to great lengths to keep their cars.

It is a reasonable wager.

For decades, even during rocky economic times, defaults on cars loans have remained relatively low.

In March, Ms. Gray, 35, received a $13,426.64 auto loan from Fifth Third Bank with a 17.72 percent interest rate. She bought a 2009 Hyundai. But five days later, Santander Consumer told her that her loan was “now owned by Santander Consumer,” according to a letter from the lender reviewed by The Times. Ms. Gray, who has been taking online college courses, says she plans to use her financial aid money to catch up on missed car payments.

Americans are so dependent on their cars that investors are betting that they would rather lose their home to foreclosure than their car to repossession.

Or in the words of a Santander Consumer investor, “You can sleep in your car, but you can’t drive your house to work.”

Cracks in that theory are starting to emerge. Delinquencies on auto loans of 60 days or less are rising, and more Americans are losing their cars each month to repossession. Experian said 60-day loan delinquencies rose 8.6 percent in the third quarter of 2014, from a year ago.

Last year was star-crossed for Santander Consumer USA, its first as a publicly traded company. Shortly after Santander Consumer went public last January, one Wall Street analyst heralded the company as an “attractive way for investors to gain exposure to the auto lending market.” Over the last year, shares of Santander Consumer have fallen roughly 23 percent.

Last year was also difficult for some Santander Consumer customers. Dane Carpe, of Creswell, Ore., borrowed $17,115.83 from the company at a 23.74 percent interest rate to buy a 2008 Dodge Charger, according to a copy of his loan document that was reviewed by The Times.

A former mortgage broker who declared bankruptcy, Mr. Carpe fell behind on his $449.94 monthly auto loan payments and has disputed with the lender over how his payments have been applied to his loan balance. On New Year’s Eve, his car was repossessed, he said.

“I lived through the mortgage bubble, and this bubble is going to burst,” he said.

We live in a time in which decent and otherwise sensible people are surrendering too easily to the hectoring of morons or extremists. 

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