The booming market for securities backed by subprime car loans is riskier than their ratings imply, say two of the biggest assessors of bond credit quality.
Moody’s Investors Service and Fitch Ratings analysts said in interviews that the grades their competitors have assigned to a crop of new issuers -- most of which are backed by private-equity firms -- are too high. The lenders lack a track record in the bond market proving their underwriting acumen and ability to handle the specialized task of collecting on soured debt during a downturn, according to the analysts.
Half the issuers tracked by Standard & Poor’s hadn’t sold bonds before 2010, and concern is mounting that growth in the market for securities backed by car loans to people with poor credit poses a risk to the whole auto industry. Wall Street banks have arranged $20.6 billion of the deals this year, up from $8.6 billion in 2010, according to Barclays Plc.
Moody’s and Fitch, which are trying to rebuild their reputations after being blamed for fueling the credit crisis with inflated mortgage-bond ratings, say they haven’t assigned grades to the new issuers’ debt because they would give them lower rankings than those bestowed by S&P, Kroll Bond Rating Agency Inc. and DBRS Ltd. Those firms say they assess securities on an individual basis.
“We would be more than happy to rate them,” but it “might not be the rating they’re looking for,” said Mack Caldwell, an analyst at New York-based Moody’s.
Fitch said in a September report it would decline to grade some of the new deals, or cap its ranking on others at single-A, below the grades given out by competitors.
“DBRS reviews auto ABS deals on a case-by-case basis as it does for all asset classes,” Chuck Weilamann, head of U.S. asset-backed securities at Toronto-based DBRS, said in an e-mailed statement. “We do not artificially place any caps or floors on any ratings ahead of a review, whether it be for a new or frequent issuer of debt.”
The market benefits from a diversity of opinions on credit risk, said April Kabahar, a spokeswoman for S&P. The New York-based rating firm declines to rate companies with short operating histories or weak operations and has ratings caps for others, she said.
Kroll “reviews the experience and capabilities of the company’s management team, its operational capabilities and business model in addition to the characteristics and performance of their loan portfolio,” Rosemary Kelley, a managing director at Kroll, said in an e-mailed statement.
The subprime-auto business has exploded as bond buyers pile into securities offering yields that are about double those on similar debt tied to the most creditworthy borrowers. That’s particularly enticing amid six years of near-zero interest rates from the Federal Reserve.
Private-equity firms have also poured cash into the industry during the last several years, attracted by its performance during the recession and the chance to make loans with interest rates as high as 20 percent. U.S. households continued to make car payments even when they defaulted on their mortgages during the crisis, according to Moody’s.
The firms have seized on cheap funding in the bond market, resulting in profit margins that Moody’s estimated in 2012 are about 12 percent.
The boom in easy financing is helping fuel the fastest pace of car sales in eight years and has drawn scrutiny from the U.S. government as underwriting standards decline amid increased competition from lenders.
The default rate has been rising for three years, reaching 13 percent in September, exceeding the pre-crisis range of 10 percent to 12 percent, according to Wells Fargo & Co.
A loss of confidence at one of the smaller companies could lead to an industrywide funding crunch as bondholders flee, according to Dave Goodson, the head of securitized products at Voya Investment Management, which oversees $213 billion.
“As a sector, you’re beholden to your weakest link,” Goodson said in a phone interview. If one lender buckles under the pressure, he said, “people would start to hit the exits.”
Many of the new companies are focusing on customers with the lowest credit scores or no history at all. The increase in such loans, characterized as deep subprime, is pushing losses on debt underlying asset-backed bonds higher, according to Wells Fargo.
Investors started differentiating more between issuers in the second half of this year, demanding additional compensation to hold bonds from companies deemed riskier, Wells Fargo analysts led by John McElravey said in a report last month.
J.D. Byrider, a used-car dealer that started as a franchise operator in 1979, was bought by private-equity firm Altamont Capital Partners in 2011. It began selling bonds backed by its subprime auto loans in 2012, and has since raised $421 million in the debt market.
Losses on the loans are rising faster than S&P predicted. When J.D. Byrider issued $121.4 million of securities in May 2013, the rater forecast losses of 22.25 percent. S&P has since boosted that to 26.25 percent, according to a September report.
S&P, which ranked most of the debt AA, said it’s not planning on lowering its grades because there’s adequate protection for bondholders from losses. In September, S&P even raised the rankings on a $28 million portion of the deal for this reason.
Royal Bank of Scotland Group Plc underwrote its 2013 offering, while Deutsche Bank AG managed a sale earlier this year.
“We did not consider Moody’s or Fitch, because we were guided by RBS and DB to S&P and DBRS/Kroll,” Linda Jackson, a spokeswoman for J.D. Byrider, said in an e-mailed statement.
Amanda Williams, a spokeswoman for Deutsche Bank, and Sarah Lukashok of RBS, declined to comment.
“We are aware of S&P’s revised loss expectations” on the 2013 transaction, Jackson said. The Indianapolis-based company is focusing on producing “performance that betters S&P’s latest loss estimates,” she said.
J.D. Byrider is just one of a crop of private-equity owned new entrants to the $178.2 billion market for bonds tied to car loans. Blackstone Group LP, the world’s largest private-equity company, acquired Irving, Texas-based Exeter Finance Corp. in 2011. That same year, Perella Weinberg Partners partnered with CarFinance Capital LLC after creating Flagship Credit Acceptance LLC in 2010.
The landscape is similar to the subprime-auto lending environment during the early- to mid-1990s, when overheated competition led to lax underwriting and unexpectedly high losses that put many smaller lenders out of business, Moody’s said in June 2012 report. Leading up to the previous bust, the number of subprime lenders ballooned as the securitization market enabled companies to grow too rapidly, according to Moody’s.
“If today’s subprime-auto lending market were to deteriorate as it did back then, investors could suffer comparable or greater losses,” Moody’s analysts Peter McNally and Joseph Snailer said in the report.
Top-ranked securities linked to subprime auto loans are yielding 50 basis points more than benchmark interest rates, about double the spread investors demand to own similar debt backed by loans to borrowers with good credit, Wells Fargo data show.
Operational risks are also especially high for subprime-auto asset-backed bonds issued by inexperienced lenders with limited financial resources, according to Moody’s. The lenders may not be prepared to service a large volume of soured loans, according to the rater.
The subprime-auto business is exposed to domino risk because financial difficulties at one lender may quickly spread to others, Fitch analysts led by John Bella and Kevin Duignan said in September report. Private-equity firms and banks may withdraw funding simultaneously under that scenario, they said.
Underwriting standards on subprime auto loans have been declining since 2012, leading to the higher-than-expected losses on some transactions, according to S&P. Lenders are enabling buyers to borrow more relative to the cost of a car. The average loan-to-value ratio, or LTV, stood at 115 through September, compared with 112 percent in 2010, S&P said in a report that month.
Longer loan terms, which make monthly payments smaller, are another sign of slackening standards. The 72-month loan is the most common term, though terms as long as 75 months are showing up in 2014 deals, according to S&P.
“As subprime-auto loan credit quality has weakened and collateral losses have risen, our loss projections for these subprime auto loan ABS transactions have increased resulting in higher credit support,” said S&P’s Kabahar.
S&P increased the average credit enhancement on debt rated AAA to 40.56 percent as of June from 36.1 percent in 2011. That means deals would have to suffer losses greater than 40.56 percent for holders of the AAA rated slice to be affected.
Performance could still get weaker given the competitiveness of the industry and the entrance of rapidly expanding newcomers, S&P said in its September report. The firm hasn’t cut the ratings on any deals sold since the crisis, and doesn’t expect to in the near-term.
While bondholders have yet to lose money in this cycle, the unforeseen jump in losses highlights the unpredictability of lending to borrowers with bad credit histories, or none at all.
“Losses on subprime auto loans are vulnerable to large swings even under moderate economic stress,” Fitch said in its September report.
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