These days, it’s the car market that could be creating piles of financial junk. Or so it seems.
Nearly seven years ago, as the foreclosure wave and financial crisis entered their first stages, Fortune ran a story called “House of Junk” by Allan Sloan that took a look inside one mortgage bond. It was clear from the article that Wall Street had created loads of worthless debt that had overtaken investors, and looked to becoming something worse. Sloan called the bonds toxic waste.
Recently, some have expressed concern that the banks are once again churning out toxic debt, this time out of subprime auto loans. Last month, The New York Times published a front-page article that said that some banking analysts believe that the entire financial system could be vulnerable if these subprime auto borrowers fall behind on their payments. The article cited a Standard & Poors report that said losses on subprime auto loans were increasing, and hinted at a repeat of the financial crisis. “In our opinion, we’re at a turning point with respect to subprime auto loan performance, similar to where we were in 2006,” S&P analyst Amy Martin wrote in the report.
Regulators also seem concerned. Earlier this month, both General Motors’ (GM) financing unit as well as Santander Consumer USA (SC) said in a filing that federal prosecutors have requested documents related to their bond deals.
Auto lending is up. U.S. banks now have $370 billion of auto loans outstanding. That’s 20% more than two years ago. About a quarter of the newest of those loans have been made to subprime borrowers. And Wall Street is once again bundling loans to risky borrowers into bonds that are sold to investors, who might not understand the potential for losses. Just over $12 billion in subprime auto loan bond deals have been sold so far this year, up from $13 billion for all of 2013, according to Thomson Reuters.
But auto lending is still small compared to the mortgage market, and especially small when you compare it to what the mortgage market was at the height of the boom. In 2006, financial firms made $2.5 trillion in home loans; $450 billion of those loans were subprime and were sold off as bonds. So, for today’s subprime auto loans to cause anywhere near the damage mortgage bonds did, they would have to be some pretty horrid toxic waste.
A look under the hood
Allow me to introduce AMCAR Trust 2012-4.
AMCAR stands for AmeriCredit, an auto finance company that was bought by GM in 2010 and officially renamed GM Financial, which is the unit of the auto maker that regulators are probing for potentially misleading investors into debt deals. The company’s bond deals are still named after AmeriCredit. Unlike mortgage bonds, most auto loan deals don’t file regular public documents. AMCAR, which drove off the loan lot in September 2012, is an exception.
The bankers and bond investors I talked to about my new acquaintance, AMCAR 2012-4, told me it was a pretty typical subprime auto bond deal. If AMCAR is notable at all, it’s because it is big—one of the largest deals done in 2012, and ever since. Made up of 64,278 loans, there were nearly $1.3 billion in bonds tied to AMCAR 2012-4. Seven Wall Street banks assisted in the deal, and Deutsche Bank, Royal Bank of Scotland, and Wells Fargo were the lead underwriters.
All three banks declined to talk about the deal, as did GM.
You shouldn’t judge a book, even a loan book, by its cover. But as you would suspect of a subprime deal, AMCAR 2012-4 is made up of high-risk loans to people with shaky records of paying them back. The average credit score of the borrowers of these loans was 564. That’s nearly 40 points below what is considered the dividing line between prime and subprime borrowers. Over 1,400 borrowers in the AMCAR loan pool had already missed at least two car loan payments in a row on more than one occasion. What’s more, about a quarter of the borrowers in AMCAR 2012-4 had loans that were at least 20% greater than the resale value of the car they had borrowed money to purchase.
Many of the borrowers in AMCAR 2012-4 haven’t fared too well. Nearly two years later, 6,408 of the loans in the deal, or roughly 10%, have defaulted. On another 4,083 of the loans, borrowers are late by at least two payments.
What about AMCAR’s investors? How much have they lost on the deal? Remarkably, zero. The bonds actually trade slightly above their initial value. About $600 million of the bonds in the deal have been paid back in full. It looks like the rest will be paid back as well.
How is that possible? It all comes down to AMCAR 2012-4’s structure. The bankers appeared to know that the AMCAR loans would run into trouble and planned for it. AMCAR 2012-4 had $67 million in excess loans that could be swapped in to cover any loans that didn’t end up paying. The deal also had a reserve account of $27 million. But perhaps the best thing going for the investors in the AMCAR deal, though not the borrowers, were the loans’ high interest rates. On average, the loans in AMCAR 2012-4 charge interest of nearly 14%. Yet over 70% of the bonds tied to the AMCAR deal paid investors less than 1% interest a year. The least risky portion of the deal paid just 0.3% in annual interest to investors. The wide interest gap is meant to cushion any losses, but GM will pocket a hefty portion of those payments as well.
The result: 46% of the loans in AMCAR 2012-4 would have had to go into default for bond holders to lose money, according to one banker who worked on the deal. Even if all the borrowers currently behind on their payments end up defaulting on their loands, that would equate to a little over 16% of the total loan pool.
Other deals have done worse. For example, nearly 40% of the borrowers in DTAOT 2012-1, a pile of over 21,000 loans made to subprime used car buyers, have ended up in default. Yet the bonds have traded up. Earlier this year, S&P upgraded the rating of many of the remaining bonds in the deal to AA. Another rating firm, DBRS, gave those bonds a AAA rating.
A lemon of a bond deal?
I asked Sylvain Raynes, an expert in structured finance and owner of R&R Consulting, what he thought of the AMCAR and DTAOT deals. Raynes has a history of raising the alarm bells about Wall Street deals at the first instance of trouble. He began to raise red flags about problems in the mortgage market back in 2003. This time around, he doesn’t see problems in the auto lending market. “These bonds are safer than U.S. Treasuries,” says Raynes. What’s more, unlike during the housing boom, there are no synthetic derivatives tied to subprime auto bonds that offer higher returns but amplify losses if the loans go bad.
Will the subprime auto loans deals he has seen do the type of damage to the financial system that subprime mortgage bonds did? “No way,” says Raynes.
In fact, one complaint I heard about the subprime auto loan bonds I examined was that they were too safe. The hedge funds managers I called for this story—some of whom made money betting against the mortgage market in 2007 and 2008—said they weren’t shorting subprime auto loan bonds, but they weren’t buying them either. With such paltry yields, they reasoned, they aren’t worth it.
Instead, because of their small yields and short-duration, many of these bonds have been purchased by money market funds. That could be a problem. Buyers of money market funds have an extreme aversion to risk and loss. In 2008, the government had to step in to stop a run on money market funds after some lost money on Lehman Brothers debt. If money market funds were to lose money on subprime auto bonds, that could cause trouble for the financial system. To be sure, no one I talked to thought that the pieces of these deals that money market funds are buying will lose money.
Just the same, not everyone is sold on subprime auto bonds. Abhi Patwardhan, a bond analyst at the risk-averse FPA New Income fund (the first line of the fund’s investment philosophy is, “We do not like to lose money!”) said he thinks some investors don’t understand the risks they are taking. “You’re not getting paid all that much,” says Patwardhan.
Nonetheless, FPA has been buying into the deals, including AMCAR 2012-4, sticking to the higher-rated portions of the deals. Like others, Patwardhan argued that it’s far easier to repossess a car than a house. He also repeated the same phrase that a few other investors told me: You can live in your car, but you can’t drive your house to work. It’s meant to explain why auto loans will never experience the default rates that mortgages did back in 2008. In the second quarter, banks reported that just 0.25% of their car loans, both prime and subprime, were “non-performing.”
Of course, you can be sure if the good times in auto lending persist, we will probably see even lower credit standards and bonds that offer less protection to investors. But remember, Raynes saw the problems brewing in the mortgage market four years in advance. So, hopefully, we’re talking about a 2019 problem at the earliest. By then, driverless cars will be paying off their own loans.