Photographer: Daniel Acker/Bloomberg

Subprime Auto Debt Is Booming Even as Defaults Soar

Updated on
  • Risk premiums shrink on auto loan bonds as loss rates rise
  • Eisman of ‘Big Short’ fame and Morgan Stanley flagged concern

A boom in sales, a pickup in defaults, and risk premiums keep on dropping.

It’s all happening in the market for subprime auto bonds, where loans to American consumers with some of the patchiest credit histories are packaged into securities to be sold to big investors. A decade after risky mortgage lending toppled the U.S. financial system, the securities have rarely been so popular. But the collateral behind the bonds is getting less safe: car-owners are increasingly falling behind on bigger loans with longer repayment terms made against depreciating assets.

“As used-car values drop a bit and delinquencies and roll rates begin to increase, the subprime sector will show significant underperformance and lack of decent liquidity,” said Don McConnell, senior portfolio manager at Bank of Montreal’s BMO Global Asset Management in Chicago, who helps manage $15 billion of taxable bonds. He’s reinvesting cash from maturing notes elsewhere.

Wall Street has rushed to sate investors’ hunger for subprime auto asset-backed securities with $3 billion worth of fresh supply so far in 2018, according to JPMorgan Chase & Co. data -- almost double the $1.8 billion worth sold in the same period a year earlier. That’s despite warnings from Steve Eisman, featured in Michael Lewis’s book “The Big Short,” and Morgan Stanley in the past year.

As demand grows, a combined gauge of both prime and subprime auto bonds shows spreads have dropped to the lowest 4th percentile of their seven-year ranges, according to Goldman Sachs Group Inc. research. Annual loss rates on subprime loans, meanwhile, have climbed to 8 percent from 5 percent in 2013, according to Goldman.

Even though borrowing costs haven’t fallen as much as on plain vanilla company debt -- where spreads are in the 0th percentile of trading ranges -- they underscore confidence that defaulting consumers won’t trouble bondholders. That sentiment helped Santander Consumer USA Holdings Inc. reduce the cost of selling BBB notes by 50 basis points on a deal priced in January compared with a previous issue in September.

“Much of the ABS complex is at multi-year tights, so investors naturally begin to look anywhere they can for a few extra basis points,” McConnell said.

Shock Absorbers

One concession to the buyside is heftier cushions against soured loans, winning fans who think so-called credit enhancement will be enough to offset losses. Lax loan-underwriting standards between 2010 and 2016 are to blame for the current wave of defaults, according to Goldman Sachs strategists, and the latest bonds have bigger shock absorbers.

But credit enhancement may offer little solace if lenders become so stressed they lose access to the bond market.

“We don’t know how those losses will play out on a cumulative basis,” said Peter Kaplan, a senior portfolio manager at Merganser Capital Management, who added that he avoids deals backed by riskier lenders. “At the end of the day if the servicer is unable to perform their duties that’s not good news for you as a bondholder. It’s not necessarily about the credit enhancement. It’s more about the sponsor risk.”

‘Priced to Perfection’

To be sure, even a wave of defaults by subprime borrowers on their auto loans is unlikely to cause global financial markets to seize up like those on home loans a decade ago. Last year, $25 billion of bonds pooling subprime auto loans were issued, about the same as the previous year. That compares to the $1.2 trillion of bonds backed by home loans sold in 2005 and 2006, during the prelude to the credit crisis. About $400 billion of that was subprime for each year.

Other features including the terms of the loans -- they are fixed-rate and typically come due within three years -- limit the risk they pose to the wider economy, according to Tracy Chen, head of structured credit at Brandywine Global Investment Management in Philadelphia.

“The risks or damages are of different magnitude, both to the bondholder and to the economy in general,” said Chen, who doesn’t hold the debt because the spreads are insufficient to compensate for collateral risks.

Still, investors shouldn’t expect to reap returns on a par with last year. Goldman Sachs strategists said spreads will “move sideways in 2018.” Given the industry’s “challenges and the pickup in running loss rates,” Goldman is “cautiously neutral on better quality” bonds.

“This sector seems to be priced to perfection at the moment and offers very little value,” said McConnell at BMO. “We are limiting our exposure.”

— With assistance by Adam Tempkin

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