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Yield-crazed investors pile into US subprime car loans

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Via Financial Times

The market for securities backed by the riskiest US car loans is booming, as yield-crazed investors shrug off nagging concerns over the health of the American consumer.

Deals were “going gangbusters” in subprime auto asset-backed securities (ABS), said Jennifer Thomas, an analyst at Loomis Sayles, a Boston-based firm managing $286bn of assets. At $29bn so far this year, issuance of subprime auto ABS is on track to surpass 2018’s record haul of $32bn, according to data from Finsight, despite softer sales of new cars and trucks this year.

The lower-rated slices of recent deals are “five or six times oversubscribed”, said Ms Thomas. “The market is trading very well.”

The thirst among investors is reflected in tight spreads over equivalent government bonds. An index of ABS with ratings from double-A to triple-B — which includes loans to risky borrowers — is yielding less than 90 basis points more than Treasuries of similar maturities, according to JPMorgan. That is near the low for the year and roughly half the level of three years ago.

Bullish investors and analysts point to low unemployment, rising wages, and low total household leverage as evidence of the solidity of the subprime sector, which normally denotes borrowers with credit scores of less than 620 on the commonly used FICO scale.

“It all comes down to the strength of household balance sheets,” said Nicky Dang of Moody’s Investors Service in New York, noting that debt payments as a percentage of disposable incomes across the country remain near all-time lows.

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Still, concerns are mounting that consumers may have taken on more debt than they can handle. Data from the Federal Reserve Bank of New York show that the total proportion of consumer auto loans more than 90 days late — classed as “seriously delinquent” — has been steadily rising.

Line chart of Loans more than 90 days late showing Delinquent US auto loans on the rise

There was more than $1.3tn of US auto debt outstanding at the end of the third quarter, according to the Fed, following $159bn of originations during the previous three months — the second-highest quarterly haul on record. Of that $1.3tn, 4.8 per cent, or about $62bn, is seriously delinquent, up from 3.1 per cent or $29bn five years ago. That proportion is not far off the peak of 5.2 per cent in the financial crisis. The trend contrasts with mortgage debt, where delinquencies have steadily declined as a proportion of outstanding loans.

This year a blog post by Fed economists showed that the increase in delinquencies was particularly concentrated among subprime borrowers.

Noting the rising delinquencies, Ms Thomas of Loomis Sayles echoed other investors and analysts, pointing out that they have not translated into actual losses on ABS. Since the financial crisis, she said, investment vehicles issuing ABS had generally been structured with higher levels of equity, giving investors in the debt a bigger cushion against losses.

Column chart of $bn showing Subprime auto ABS issuance

Tracy Chen, a Philadelphia-based portfolio manager at Brandywine Global Investment Management, offered another reason for the combination of rising delinquencies and strong ABS performance. Only a fraction of auto loans were packaged into securities, and the credit standards of ABS issuers and rating agencies ensured that some of the weakest loans stayed on the balance sheets of banks, credit unions, fund managers and captive finance companies, many of which were privately held.

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The Fed delinquency data also contrast with the reports of the credit agencies and public companies specialising in subprime auto financing. Equifax, for example, shows auto delinquencies at about 2 per cent of loans outstanding, and stable for several years. Santander Consumer, the largest US subprime loan originator and ABS issuer, reported falling delinquency rates in the third quarter and a one-quarter drop in its portfolio of loans in restructuring.

“I think that reflects [the] kind of the inherent current quality we have in our portfolio,” Scott Powell, Santander Consumer’s chief executive, told analysts at the end of last month. “We are pretty positive as we look to next year in terms of overall credit trends.”

Still, some can see trouble around the corner. Joseph Cioffi, chair of the insolvency and creditors’ rights practice at Davis & Gilbert, a law firm, said that if the economy weakened, structural enhancements may not be enough to compensate, “causing losses to intensify and bubble over”.

That is why some portfolio managers are picking their spots carefully. “Personally I am very cautious — I would invest in the higher tiers” of deals, said Ms Chen of Brandywine, noting that the macro picture was not encouraging.

“We believe we are late in the credit cycle, and when you are late in the cycle, you should go up the credit ladder.”

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