A blog this month from Davis & Gilbert partner Joseph Cioffi argues that credit enhancements in subprime auto ABS are actually not as much of a safeguard as investors believe them to be. Cioffi argues that investors have been able to rest easy knowing that overcollateralization levels protect them from even the most catastrophic losses, but that there is more risk in the system than people recognize.
Shaky subprime lending practices, a push toward subprime borrowers and auto market fundamentals point to a looming crisis, Cioffi says. ABS investors are supposed to be protected by their deal structures — but that didn't save buyers of subprime RMBS.
“…RMBS investors would have expected that the combined amount of protection from O/C and equity cushion would have exceeded the stated principal of ABS certificates…by more than 22%, and that’s before factoring in any expectations of appreciation. This level of protection far exceeds the amount provided by subprime auto O/C given the vehicles backing the pooled loans are indisputably depreciating assets,” Cioffi writes in his post.
“Subprime RMBS was doomed by the faulty assumption of ever-increasing home values…Subprime auto ABS makes no such mistake regarding vehicles, but the corollary to the assumption of never-ending real estate appreciation may be the presumed continued performance by auto loan borrowers.”
Striking a nerve
The blog struck a nerve with ABS analysts. A note from Wells Fargo on October 17 argues against Cioffi’s position.
“We believe that the subprime auto ABS sector overall is adequately enhanced to account for the current credit and market risks. We reiterate our opinion, expressed in previous research, that there are more differences than similarities between subprime auto loans and subprime mortgage loans,” the Wells analysts write.
An instance of history rhyming, perhaps?
But it isn’t only subprime auto where there is a disconnect between riskier loan pools and investors’ comfort with the risk in holding the bonds. Unsecured consumer lending has boomed this year, driven in part by online lenders who often offload these loans to investors in the form of ABS.
Prosper, Marlette Funding and Avant have all issued deals this year backed by a larger portion of loans made to borrowers with FICO scores below 680.
Kroll highlighted the trend in a presale report for a deal from Marlette this month, stating that loans made to borrowers with credit scores below 680 have risen to 31%, compared to 23% for the lender’s previous deal. Marlette also structured its offering to include a ‘D’ tranche in order to meet demand for higher yielding paper.
And yet, despite a higher volume of lower quality loans, investor demand for the bonds is insatiable, and issuers have enjoyed tighter pricing with each new offering. Avant managed to shave 25bp of coupon costs off senior notes in its deal this month compared to a transaction in April, despite a considerable increase in deep subprime borrowers — 17.3%, up from 12.8%.
Some have taken notice of the trend, and have bemoaned the hunt for yield and lenders’ drive to grow market share as a volatile cocktail at a time when the economic recovery may be running out of steam.
Mostly, though, the market seems content to keep its blinders on, hoping that the rating agencies, the underwriters and the analysts are all correct in assuming that history won’t repeat itself.
But if history rhymes, it won’t have to. It won’t take a subprime MBS-level catastrophe to send shockwaves through the market.