Subprime Auto ABS Grows as Lenders Chase Margins: Credit Markets
Sales of bonds tied to payments on subprime car loans are accelerating at the fastest pace in five years as investors seek high yields amid speculation the Federal Reserve will keep interest rates at record lows until mid-2015.
Led by Santander Consumer USA, issuance of $10 billion this year in asset-backed debt linked to vehicle loans to borrowers with spotty credit records compares with $8.2 billion in the same period of 2011, according to Barclays Plc. Top-ranked securities backed by the loans yield between 15 and 25 basis points more than benchmark swap rates, versus 5 to 8 basis points for similar debt of prime borrowers, Deutsche Bank AG data show.
Sales are surging with the central bank holding its benchmark rate near zero to spur growth following the worst financial crisis since the Great Depression. Investors are seeking riskier assets to generate returns as private-equity firms such as Blackstone Group LP and Perella Weinberg Partners are drawn to the high profit margins in subprime auto lending.
“There is broad-based demand for any reasonably safe bond that offers any meaningful amount of yield,” said Harris Trifon, a debt analyst at Deutsche Bank in New York. Investors are realizing that “interest rates may remain extraordinarily low for years to come,” he said.
The subprime auto finance business has grown during the past two years as new lenders compete to make loans with rates of about 17 percent annually, while being able to finance themselves at an average rate of less than 2 percent, Moody’s Investors Service said in a July 17 report. With losses ranging from 1 percent to 3 percent, originators collect annual spreads of about 12 percent, according to the New York-based firm.
Asset-backed securities tied to vehicle debt have been buoyed the past three years by rising used car values, which boost recovery rates on defaulted debt and ease losses for bondholders. Used vehicle values rose to a record in May 2011 before leveling off, according to Manheim Auctions Inc. Manheim’s used vehicle index fell 3.2 percent in June from a year ago.
Elsewhere in credit markets, the cost of protecting corporate debt from default in the U.S. rose for the first time in four days, with the Markit CDX North America Investment Grade Index, which investors use to hedge against losses or to speculate on creditworthiness, adding 1.5 basis points to a mid- price of 106.7 basis points as of 11:23 a.m. in New York, according to prices compiled by Bloomberg.
The measure typically rises as investor confidence deteriorates and falls as it improves. Credit-default swaps pay the buyer face value if a borrower fails to meet its obligations, less the value of the defaulted debt. A basis point equals $1,000 annually on a contract protecting $10 million of debt.
The U.S. two-year interest-rate swap spread, a measure of bond market stress, decreased 0.6 basis point to 19.5 basis points as of 11:23 a.m. in New York. The gauge, at the lowest level on an intra-day basis since July 6, 2011, narrows when investors favor assets such as corporate bonds and widens when they seek the perceived safety of government securities.
Bonds of New York-based Goldman Sachs Group Inc. are the most actively traded dollar-denominated corporate securities by dealers today, with 35 trades of $1 million or more as of 11:22 a.m. in New York, according to Trace, the bond-price reporting system of the Financial Industry Regulatory Authority.
Lenders have issued about $129 billion in asset-backed securities linked to consumer and business borrowing this year, with auto debt accounting for $62 billion, Bloomberg data show. Citigroup Inc. boosted its 2012 asset-backed forecast this month by about 50 percent to $183 billion as vehicle sales climb.
Santander Consumer has issued $4.9 billion of the auto ABS this year, according to Barclays. The Fort Worth, Texas-based company sold top-ranked securities maturing in 1.87 years yielding 52 basis points more than benchmark rates on June 26, Bloomberg data show. That compares with a spread of 90 basis points on similar debt issued by the lender in January.
U.S. auto sales for June beat analysts’ estimates, accelerating to a 14.1 million seasonally adjusted annualized rate, researcher Autodata Corp. said in a July 3 statement. The pace exceeded the average 13.8 million light-vehicle estimate of 15 analysts surveyed by Bloomberg.
Perella’s CarFinance Capital LLC funded more than $100 million in auto loans in its first 10 months of business as it works with more than 1,500 auto dealers serving “non-prime” consumers, who now account for more than a third of U.S. car buyers, the Irvine, California-based company said in an April 24 statement announcing an expansion in Texas.
The Fed has kept its target rate for overnight loans between banks at zero to 0.25 percent since December 2008, and said it expects to keep it “exceptionally low” through at least late 2014. Implied rates of Fed funds futures traded on the Chicago Board of Trade are below 0.5 percent for every maturity going out as far as June 2015.
Investors have returned to this segment of the asset-backed market since shunning the debt when losses on mortgage bonds linked to subprime borrowers sparked the financial crisis.
“People are looking back with rearview mirrors and reflecting that away from mortgages, AAA ABS did very well,” Martin Attea, a managing director at Barclays in New York, said in a telephone interview. “Very few people lost money,” on those bonds, he said.
Autos have performed better than other parts of the consumer loan market, particularly when financing non-prime borrowers, according to Nadim El Gabbani, a principal in the private equity group at New York-based Blackstone.
“Nobody expected a car to increase in value over time,” he said. “Whereas everybody had home price appreciation” baked into their models, Gabbani said.
Payments more than 60 days late on subprime auto loans contained in securities peaked at 4.94 percent in early 2009, compared with the November 2009 high of 45.23 percent for subprime mortgages, according to Moody’s.
The current lending environment bears some similarities to the 1990s when the number of subprime auto lenders ballooned leading to lax underwriting and higher losses, though today’s market is not ”nearly as overcrowded,” according to Moody’s.
“Loan performance has been strong over the past several years,” Moody’s analysts Peter McNally and Joseph Snailer said in the report. “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.”
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