Subprime Squeezed as Auto-Lender Costs Increase: Credit Markets

Borrowing costs are rising for subprime auto lenders in the asset-backed bond market, squeezing profit margins and pressuring firms to make even riskier loans.

A General Motors Co. unit that makes car loans to people with blemished or limited credit sold top-rated securities backed by the debt to yield 45 basis points more than the benchmark swap rate on Aug. 7, almost double the spread it paid on similar notes in April, according to a person with knowledge of the transactions. American Credit Acceptance Corp., the Spartanburg, South Carolina-based buyer of “deep subprime” loans, paid 225 basis points over benchmarks to sell A rated debt on July 31, up from 165 in March.

Subprime lenders lured into the market by low financing costs during the past three years now face being pushed out as rates reverse, according to Moody’s Investors Service. Funding costs are climbing as the Federal Reserve considers reducing $85 billion of monthly bond purchases that have steered investors to riskier, higher-yielding debt.

“The smaller guys are more dependent on lower financing costs than top-tier issuers,” said James Grady, a managing director at Deutsche Insurance Asset Management in New York. “They have less of a cushion.”

Subprime Expansion

Lenders owned by private-equity firms from Blackstone Group LP to Perella Weinberg Partners LP have leapt into the subprime auto-financing business to take advantage of annual profit margins that Moody’s estimated at 12 percent in a July 2012 report. Lenders have loosened terms by extending credit to people with lower credit scores, leading to higher risk of default if the economy sours.

Total sales of securities linked to subprime car loans have surged 24.4 percent to $14.7 billion in 2013 from a year earlier, according to Deutsche Bank AG. Issuance has climbed from $2.4 billion in 2009 and may approach the $20.9 billion sold in 2007, Barclays Plc data show.

GM Financial has issued $4 billion of asset-backed bonds this year, up from $3.3 billion during the same period in 2012, according to data compiled by Bloomberg.

The firm, formerly known as AmeriCredit, has been in the subprime auto business for 21 years and is considered a bellwether issuer in the asset-backed market, according to Moody’s. The Fort Worth, Texas-based company hasn’t yet passed on the higher costs to borrowers because it never anticipated they would remain so low and didn’t cut loan rates, according to chief financial officer Chris Choate.

‘Unsustainably Low’

They “have come off of what we viewed as unsustainably low in the first place,” Choate said in an Aug. 19 interview. “We didn’t adjust our loan pricing or origination appetite to the positive, so we haven’t had to react to the negative.”

The average interest rate on a 72-month subprime loan has held at about 14 percent throughout 2013, he said. If funding costs continue to climb along with interest rates, the company will adjust its pricing, he said.

The rising funding costs also may push lenders to finance less creditworthy customers that will pay higher rates as they seek to maintain profit margins, Moody’s analyst Yan Yan said in an interview.

“The space expanded very quickly,” she said. “People with money didn’t have anywhere else to put it so they were looking for yield” and buying the bonds, she said.

Default Swaps

Elsewhere in credit markets, the cost of protecting corporate debt from default in the U.S. declined, with the Markit CDX North American Investment Grade Index, which investors use to hedge against losses or to speculate on creditworthiness, decreasing 2.1 basis points to a mid-price of 82.2 basis points as of 11 a.m. in New York, according to prices compiled by Bloomberg.

The measure typically falls as investor confidence improves and rises as it deteriorates. 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 debt market stress, climbed 0.62 basis point to 19.25 basis points as of 11 a.m. in New York. The gauge widens when investors seek the perceived safety of government securities and narrows when they favor assets such as company debentures.

Bonds of Bank of America Corp. are the most actively traded dollar-denominated corporate securities by dealers today, accounting for 5.5 percent of the volume of dealer trades of $1 million or more as of 11 a.m. in New York, according to Trace, the bond-price reporting system of the Financial Industry Regulatory Authority.

$56 Billion

Bonds tied to auto loans spanning buyers from the weakest to the most creditworthy make up the largest part of the asset-backed bond market, accounting for about $56 billion of $164 billion in sales, Bloomberg data show.

Securities tied to subprime loans this year account for the highest proportion of auto deals since 2007, representing 27 percent of transactions in 2013, Barclays data show. That compares with 4 percent in 2009 and 30 percent in 2007.

The higher funding costs for subprime-bond issuers are coinciding with underwriting requirements that have loosened from the tight standards that prevailed after the worst financial crisis since the Great Depression, according to Citigroup Inc.

Scores Falling

Credit scores from Minneapolis-based Fair Isaac Co., known as FICOs, have “deteriorated significantly,” Citigroup analysts said in an Aug. 8 report. The average score for loans in bond deals completed this year fell to 578, from 587 in 2006, according to the New York-based analysts led by Mary Kane.

GM Financial’s Choate said underwriting is returning to normal after the stringent post-crisis terms common in 2009. While he doesn’t view current standards as loose, the company has lost business to more aggressive lenders as competition increased, he said.

“Some of these new entrants are pushing a little bit on pricing or a little bit on credit,” Choate said.

The New York Fed addressed concerns that that a bubble may be forming in the subprime auto market in an Aug. 14 report on its website, saying that there isn’t evidence that a “disproportionate or unusual” volume of new loans are being given to riskier borrowers.

Losses Increase

“While originations to borrowers with the lowest credit scores have increased, they are just recently approaching historically normal levels and are below those that we saw during the boom years leading up to the crisis,” according to the district bank’s research and statistics group.

Historically, rising interest rates coincided with an improving economy, meaning increases in funding costs were offset by lower losses on loan portfolios, Choate said. Slow growth coupled with increased borrowing costs could put pressure on some of the smaller lenders, he said.

The loss rate on asset-backed bonds linked to subprime auto debt increased 33 percent to 4.24 percent in June, S&P said in a report yesterday, citing a seasonal tendency for losses to climb in the summer months. That’s down from a peak of 13.3 percent in January 2009, the ratings company said. Losses on deals linked to prime borrows also rose in June, increasing 37 percent to 0.23 percent, according to the report.

“The end of tax-refund season may be responsible for the increase in losses,” said the New York-based analysts led by Mark Risi. “We will be watching closely to see if losses continue to rise beyond August.”

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