If the industry doesn’t want to be characterised, once again and with renewed virulence, as nothing but a wealthy group of bankers helping predators to feast on struggling and desperate families, banks needs to do something about deep subprime, of their own volition, and fast.
Subprime in and of itself isn’t a bad thing. There are plenty of people who badly need credit and will work hard to repay it but have few options for obtaining it due to their credit histories. But the US subprime auto industry, spurred on by the yield hunt, has exploded over recent years, and there has been a proliferation of new lenders, precipitating what looks like a race to the bottom.
It is no secret that some deep subprime lenders are appallingly predatory, making loans based on car values that are multiples of blue book prices at exorbitant interest rates to people highly unlikely to be able to afford it. In fact, these practices and the bubbly looking rise of subprime auto lending have regularly been the subject of media scrutiny in the last year.
When those borrowers default, the car is often repossessed and lent on again on similar terms. Of course, one can always argue that it is those consumers’ own fault for overextending themselves. But that’s a small part of the story, and neglects the broader picture while ignoring practical truths about lower income consumers — ones that some in the deep subprime industry are happy to exploit.
First off, that argument won’t fly with regulators and the public if the used car salesman really hits the fan belt. Second, borrowers are usually sold on the idea that these offers are great for them and that "credit history" is just some term used by bureaucrats. The very language of some advertisements is geared toward taking advantage of a lack of financial sophistication among its target consumer — a lack that will be fully exploited in court if the borrower can’t repay.
In many areas of the US, a car is all but a necessity, and the US economic recovery has been particularly hard on the deep subprime consumer base, meaning these practices also depend in large part on practical needs combined with financial desperation — as well as a lack of sophistication. That’s not morally sound business, but if you don’t like the idea of considering morality when doing business, then at least imagine what politicians could do to your industry with loaded phrases like that.
Even if a deterioration in the market doesn’t have a prolonged and deep effect on the broader economy (which it probably wouldn’t), in these times of market volatility that kind of development would almost certainly have a disproportionate effect on overall market sentiment, at the very least. And, frankly, there doesn’t need to be anything even close to a 2008-style crash for an industry like this to become the next political pariah.
If and when a subprime auto crash happens, these practices — as well as, by association, those of lenders that abide by better standards of behaviour — will be the subject of intense and prolonged public scrutiny. Ring any bells? The fallout won’t affect the deep subprime or even just subprime sectors alone. The securitization industry will be lucky if it doesn’t spread any further than just the auto ABS sector as a whole.
First, no bank with a securitization business can honestly purport to have learned the true lessons of the crisis while selling ABS deals backed by loans with no credit scores, at least without a robust proprietary credit assessment platform (and lending terms that don't take severe advantage of financial destitution). That’s because the lessons of the crisis only partly had to do with the effect the crash had on investors and markets. The big lesson was, if you remember, “don’t treat consumers in a way that makes people generally feel ill”. (And also: “Don’t lend large amounts to certain borrowers, like a) those you never did any due diligence on, b) are dead, or c) both.)
Leaving aside the lessons of structure and the fact that the subprime auto market isn’t anywhere close to the size of the subprime mortgage market (plus the volume of RMBS credit default swaps that effectively magnified the size of the market), here are some other lessons the deep subprime auto market seems to have ignored:
1) Originate-to-distribute is bad, even though the line between that and ABS as a funding tool can be fuzzy. Still, you can usually tell when it’s happening. Even if you can’t, securitizing loans with no credit scores sure looks a lot like it, for political purposes, at least.
2) Securitization can have and should have social value. It is excellent for certain purposes and markets, and can be a meaningful tool for helping to boost the economy. Indeed, not all sectors of the financing world have the potential to create as much recognisable social value. Securitization can. It’s fairly obvious that the industry needs to monitor itself to minimise the social harm securitization can cause, not least as a moral responsibility, but also because one more big screw up and the market is probably pretty much finished. That would be bad for ABS bankers, yes, but also bad for economies that can benefit from securitization.
It’s disingenuous for these businesses to sell consumers on debt by saying they are faster and less complicated than the traditional methods. The fact is, if you take out a loan to pay an exorbitant amount for a mediocre car and default, the lawsuit that will follow will be infinitely more complicated than going through normal credit checks. Unless the borrower doesn’t show up in court, in which case they lose by default. And seven years with a big default on your record pretty much eliminates the convenience of “fast” credit.
These lenders aren’t units of the banks that are securitizing them, but that won’t be enough to distance securitization desks from any turmoil that arises out of them. Banks involved in doing these deals for clients are putting themselves at serious risk of reputational damage in the future. They’ll be seen as having helped a deeply problematic market take advantage of economic conditions that disproportionately impact lower income consumers. And it won’t be yield starved institutional investors that decide to put a stop to the market — that much probably doesn’t even need to be said.
A downturn in deep subprime lending, even if it doesn’t lead to serious widespread trouble, will at the very least spill into the regular subprime market, since there isn’t a standard, clear and widely accepted difference between the two. Which means the rest of the market is threatened by these deals, as well.
Too much should already have been learned from the crisis to risk the progress on deep subprime auto ABS. Too much, though perhaps not enough, has been done to get securitization on the right track. Involving your institution in the deep subprime business risks a hell of a lot of that.
Update: Payday the right way?
Again, subprime lending, in any asset class, isn't an a priori bad idea. One former Royal Bank of Scotland banker recently signed up with a "social benefit" short term lender in the UK to make short term loans to underserved borrowers with some key business model differences to normal payday and subprime lenders. It's a start-up, so of course, the scale of its impact is yet to be seen.
Ubermina charges the same the eye-wateringly high nominal APRs that other payday lenders do, but with some very important differences. Half of profits go to the effort of creating a more affordable credit market for borrowers in tricky financial situations. The company won't sell defaulted debt on to collectors, it doesn't charge fees, encourages borrowers to pay loans back as quickly as possible (there are no prepayment fees) even though that pushes the optical interest rate up, and borrowers can pay and extend loans up to 12 months at will. Rejected borrowers, and some defaulted ones, will be directed to charities that help distressed borrowers sort out their finances.
Ubermina does have its eye on the securitization market in the long term. Former RBS banker Richard Bartlett explained: "There are also complications with a pool that revolves with an average life of less than six months and has so many small loans but we think we have some good technology to solve a number of these issues."
Barlett says the company intends to have ABS in mind when structuring the financing.
He added that “the market is reputationally difficult, many participants have been very exploitive so many mainstream providers of services that support lending just say it’s not worth getting into. But this pushes up costs for those who can least afford it. Well, I’d say this is a market that reputationally you absolutely should be involved in.”
The future is untold, but the securitization industry would do well to keep an eye on Ubermina and other profit seeking companies that follow similar models. It could provide a way not just to mitigate the risk that securitization is identified with — however mistakenly — predatory practices, it could be a fantastic way to show the best side of the market: as a funding tool with a social purpose.