Debt pile up in US car market sparks subprime fear

Kathy Boluch was in a bit of a state when she visited her local used-car dealership in Quincy, Massachusetts. The rear of her Volvo had been hit by a drunk driver and her insurer was badgering her to buy another vehicle so she could return the rental car it had given her. But her low credit score and irregular income disqualified her from every loan available - until the guys out the back called Santander.

Within a couple of hours she was driving off in an $18,000 Chevrolet sport utility vehicle, financed with a $16,000 loan from Santander Consumer USA, the auto-loans division of Spain's biggest bank. To clinch the deal, the salesman suggested that Ms Boluch, a freelance copywriter, help out the dealership with promotions. He even listed her as an employee on the loan application.

But the work never came. Five years on, Ms Boluch, 60, is still paying $350 a month to bring down an outstanding balance of about $10,000. Meantime, she has spent another $7,000 on repairs to a "terrible" car that would now fetch about $750 in a sale.

"I was basically putty in their hands, totally swept off my rational sensible self, drawn into this vortex," she says.

Ms Boluch's story - which helped trigger an investigation by the state attorney-general and a $22m fine in March for Santander Consumer - is just one of many from a seven-year boom in car loans that has strong echoes of the pre-crisis mortgage frenzy.

In both cases, big banks and finance companies relaxed underwriting standards to keep up with rampant competition. Investors snapped up whatever high-yielding products investment banks could come up with. And consumers signed up to big loans on the assumption that if they had trouble paying them off, they could always just sell the asset.

Just as with mortgages, the car loan business has grown rapidly. Total auto loans outstanding came to $1.17tn at the end of the first quarter of this year, according to the New York Federal Reserve, up almost 70 per cent since a post-crisis trough in 2010. That has helped push total household debt to $12.7tn, surpassing the 2008 peak.

But now there are signs that consumers have had about as much as they can take after eight years of weak economic expansion.

Strains have been evident for at least a year at the bottom end of the auto-loan market, in the world of subprime. But in prime debt, too, delinquencies are beginning to pick up, forcing big banks such as Wells Fargo and JPMorgan Chase to pull back.

Carmakers are now boosting discounts and cutting production to address rising inventories on dealer lots. Falling used car values, in turn, are pushing up defaults, as people find themselves stuck in loans they cannot afford but can't trade out of because they still owe more than the vehicle is worth.

"Here we are again," says Janet Tavakoli, president of Tavakoli Structured Finance, a Chicago-based consulting firm. Car loans are a smaller market than mortgages, she notes, which total about $9tn. But they could still do a lot of damage if consumers keep missing payments.

The share of auto debt more than 90 days overdue rose to 2.3 per cent in the first quarter, the highest in six years, according to the New York Federal Reserve. "It's a new mini-Big Short," she says, alluding to traders who made billions by betting on a housing collapse a decade ago.

If the architects of the Dodd-Frank Wall Street Reform and Consumer Protection Act had their way, auto dealers across the US might have been on a tighter leash. In early drafts of the 2010 law, dealers were to be put under the supervision of the new Consumer Financial Protection Bureau.

But then a Republican congressman from Orange County, California - himself a former auto dealer - pushed for a carve-out and won. The result: the CFPB regulates auto lenders, but car dealers continue to answer to the Federal Trade Commission, which has historically had more of an eye on deceptive advertising than shakedowns at the point of sale.

It is an unsatisfactory situation, says Chris Kukla, an executive vice-president at the Center for Responsible Lending in Durham, North Carolina. He notes that Dodd-Frank required mortgage lenders to take specific steps to determine that home buyers can actually handle their payments. If they do not take those steps, homeowners can sue and potentially win big damages.

No such protections apply to car loans. As a result, he says, dealers have stretched out terms, moving from the standard 60-month contract to 72 or even 84, meaning that borrowers are likely to stay "underwater" on their loans for longer.

At the same time, dealers have cranked up loan-to-value ratios and debt-to-income ratios, putting borrowers under greater strain.

"We're setting people up to be in very expensive loans where they owe more than the car is worth for the duration," says Mr Kukla. "So there's a higher chance of having some kind of life event - such as a big medical bill - where they are forced to sell their car and end up in lots of trouble."

The loss of a car could mean the loss of a job, and other loan defaults, he adds. "What we should have learnt from the last crisis was that we can prevent needless repossessions. But we didn't."

Some of the most rapid growth has occurred at specialist subprime lenders such as Exeter Finance of Irving, Texas, owned by Blackstone, and Skopos Financial, also of Irving, which is owned by Lee Equity Partners, a New York private equity firm. Lenders like these have pumped out billions of dollars of loans, which have been bundled together, then sliced into securities by the likes of Wells Fargo and JPMorgan Chase.

According to Morgan Stanley, the share of auto securities tied to "deep subprime" loans - those given to borrowers with scores below 550 on the commonly-used FICO creditworthiness scale - rose from 5.1 per cent of total subprime deals in 2010 to 32.5 per cent last year.

Santander Consumer, America's biggest issuer of subprime auto securities, says it has smartened up its act since the 2009-2014 period covered by the $22m settlement with Massachusetts. Delaware separately fined the company $3m for allegedly harming consumers by funding loans without having a reasonable basis to believe that the borrowers could afford them. In agreeing to the settlements, Santander Consumer neither admitted nor denied the attorney-general's allegations.

The Spanish bank became a dominant player in the US auto market in 2006, when it bought Drive Financial Services of Dallas. Since then it has bought other auto lenders and built relationships with more than 15,000 dealerships across the country.

According to the Delaware consent order, essentially a voluntary agreement, some of those dealers were engaging in practices reminiscent of the mortgage crisis, when terms like "ninja" loans - short for "no income, no job, no assets" - became part of the lexicon.

The consent order talks of "power booking", for example, or stating - falsely - that a vehicle has additional features that increase its value, thereby supporting a higher loan amount. Then there was "packing", or adding extra products such as warranties to a loan, without breaching maximum loan-to-value ratios.

Santander Consumer had suspected for a while that salesmen at one outlet were inflating customers' incomes as they applied for loans. Those suspicions were right. Of the 11 loans Santander Consumer examined in 2013, just one stated income was accurate and another three could not be verified. Of the seven that were inflated, the smallest overstatement was $45,324 a year.

"Outrageous," said Maura Healey, attorney-general of Massachusetts, as she handed out the fine. The company had continued to buy loans from the unnamed dealer even after the fraud was detected.

Ms Healey drew parallels to earlier home-loan cases featuring Goldman Sachs, Royal Bank of Scotland and Countrywide, among others. "After years of combating abuses from subprime mortgage lenders, these practices are unfortunately familiar," she said.

The big banks have been throttling back and assuring investors that the problems can be contained. Wells Fargo's $5.5bn of auto-loan originations during the first quarter were down 29 per cent from a year earlier.

Last month, Franklin Codel, head of consumer lending, said Wells had been taking "prudent" steps to manage "industry stresses" within its $61.5bn portfolio.

JPMorgan Chase has slammed on the brakes too, adding $8bn of loans and leases during the quarter, down 17 per cent. According to Gordon Smith, head of the bank's consumer banking division, the share of subprime loans within that mix has fallen "dramatically".

But losses look set to rise because when lenders repossess cars from defaulted borrowers and then sell them, they are getting less and less money back.

A flood of used cars has hit the market, depressing prices, and many more are on the way. Another 7m or 8m cars will come off-lease by the end of next year, according to Morgan Stanley estimates, which is about twice the long-term average.

The combination of higher defaults on the loans and lower recoveries on the cars could be "painful" for the banks, says Brian Foran, analyst at Autonomous Research in New York. He notes that Wells or JPMorgan probably "won't be blown up" by their exposures. JPMorgan, which often boasts of its "fortress" balance sheet, has $79bn of auto loans and leases among total assets of $2.5tn.

But for specialists with higher car-loan concentrations such as Capital One, Huntington Bancshares, Ally Financial or Santander Consumer USA, he says, the outlook is gloomier.

Data from Ally's securitisation programme show that the Detroit-based lender, spun out of General Motors a decade ago, got back about 60 cents in every dollar owed in April, from 72 cents a year ago. The recovery rate at Santander Consumer was even worse, dropping to 46 cents from 53 a year ago. Recoveries "drove off a cliff", says Betsy Graseck, an analyst at Morgan Stanley.

Meanwhile, the legal troubles are not over for the subprime lenders. Ally, Santander Consumer and others have been subpoenaed by federal prosecutors as part of an investigation into subprime auto practices and related securitisation activities, according to public filings. New York's Department of Financial Services is also probing several car finance companies, according to a person familiar with its supervisory programme.

As for Ms Boluch, she is expecting a cheque for $8,000 from Santander as compensation for the way she was treated. To this day, she kicks herself for allowing herself to be "manipulated".

"They do seek out people at their lowest ebb, people in a bad frame of mind," she says. "I should have walked away."

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