In the years after its 2009 bankruptcy, Chrysler looked for a dedicated lender to help customers “finance their cars quickly”…which was code for a lender who could help the struggling OEM expand their market share by making extremely risky loans to subprime borrowers all while laying off the credit risk to unsuspecting pension funds. As such, Chrysler ultimately picked Santander due to its expertise in “automated decisioning”…which was code for the ability to advance credit without actually performing income verification tests on borrowers.
For a time, Chrysler and Santander enjoyed a perfect symbiotic relationship as it offered Santander an opportunity to aggressively expand in the U.S. subprime loan market, and Chrysler, the perennial third wheel among the “Big Three,” was able to target customers that were previously deemed untouchable by lenders. Of course, as Bloomberg points out today, the problems surfaced almost from the start.
Many of them, detailed in the settlement between Santander and authorities in Delaware and Massachusetts, recall some of the excesses of the subprime housing era.
Attorneys general in both states alleged Santander enabled a group of “fraud dealers” to put buyers into cars they couldn’t afford, with loans it knew they couldn’t repay. It offloaded most of the debt, which often had rates over 15 percent, reselling them to yield-hungry ABS investors.
State authorities also said an internal Santander review in 2013 found that 10 out of 11 loan applications from a Massachusetts dealer contained inflated or unverifiable incomes. (It’s not clear whether this particular case involved a Chrysler dealer.)
Santander kept originating the dealer’s loans anyway, even as they continued to default “at a high rate,” the authorities said.
Some dealerships even asked Santander to double-check customers’ incomes because they didn’t trust their own employees, the authorities said. They also said the lender didn’t always oblige because that would put it at a “competitive disadvantage.” At the time of the settlement, Santander said it was “totally committed to treating its customers fairly.”
All of which at least partially explains why auto defaults are soaring to post-crisis highs even as equity markets continue to shrug off bad data.
Of course, it wasn’t just a few dealers in Delaware and Massachusetts that caused auto defaults to soar. As we pointed out back in May, the problems at Santander were pervasive with the lender apparently only verifying income on roughly 8% of the loans they subsequently dumped into ABS facilities and sold off pension and insurance companies.
Santander Consumer USA Holdings Inc., one of the biggest subprime auto finance companies, verified income on just 8 percent of borrowers whose loans it recently bundled into bonds, according to Moody’s Investors Service.
The low level of due diligence on applicants compares with 64 percent for loans in a recent securitization sold by General Motors Financial Co.’s AmeriCredit unit. The lack of checks may be one factor in explaining higher loan losses experienced by Santander Consumer in bond deals that it has sold in recent years, Moody’s analysts Jody Shenn and Nick Monzillo wrote in a May 17 report, which reviewed data required of asset-backed bond issuers that’s recently been made available.
Limited verification of loan applicants’ stated incomes and employment “creates more uncertainty around whether borrowers will be able to afford their monthly payments, which becomes particularly important if they have poor credit records and risky loan terms,” the analysts wrote.
Of course, Wall Street’s voracious appetite for high-yield investments has kept the loans – and the subprime ABS bonds – coming. You can’t possibly expect those overpaid, ivy league-educated financial analysts to be discerning when it comes to credit risk.
In recent years, lending practices in the subprime auto industry have come under increased scrutiny. Regulators and consumer advocates say it takes advantage of people with nowhere else to turn.
For investors, the allure of subprime car loans is clear: securities composed of such debt can offer yields as high as 5 percent. It might not seem like much, but in a world of ultra-low rates, that’s still more than triple the comparable yield for Treasuries. Of course, the market is still much smaller than the subprime-mortgage market which triggered the credit crisis, making a repeat unlikely. But the question now is whether that premium, which has dwindled as demand soared, is worth it.
“Investors seem to be ignoring the underlying risks,” said Peter Kaplan, a fund manager at Merganser Capital Management.
But, just like with the subprime mortgage bubble, we suspect the extra 50 bps of yield garnered from moving down the credit quality curve will ultimately prove to be slightly less than sufficient compensation. Luckily, much of the losses will reside with America’s already bankrupt pension funds which means that taxpayer will get the opportunity to step in and fix everything.