November 8, 2013 - 1:27 pm ET
NEW YORK (Bloomberg) -- Alan Helfman, a car dealer in Houston, served a woman in his showroom last month with a credit score lower than 500 and a desire for a new Dodge Dart for her daily commute. She drove away with a new car.
A year ago, with a credit ranking in the bottom eighth percentile, "I would've told her don't even bother coming in," said Helfman, who owns River Oaks Chrysler Dodge Jeep Ram, where sales rose about 20 percent this year. "But she had a good job, so I told her to bring a phone bill, a light bill, your last couple of paycheck stubs and bring me some down payment."
As the fifth anniversary of the Federal Reserve's policy of keeping interest rates near zero approaches, the market for subprime borrowing is once again becoming frothy, this time in the car business. As with mortgages in 2006 and 2007, the central bank's stimulus is making it easier for people with spotty credit to buy cars as yield-starved investors purchase riskier bonds linked to auto loans.
While surging light-vehicle sales have been one of the bright spots in the U.S. economy, it's increasingly being fueled by borrowers with imperfect credit. Such car buyers account for more than 27 percent of loans for new vehicles, the highest proportion since Experian Automotive started tracking the data in 2007. That compares with 25 percent last year and 18 percent in 2009, as lenders pulled back during the recession.
Issuance of bonds linked to subprime auto loans soared to $17.2 billion this year, more than double the amount sold during the same period in 2010, according to Harris Trifon, a debt analyst at Deutsche Bank AG. The market for such debt, which peaked at about $20 billion in 2005, was dwarfed by the record $1.2 trillion in mortgage bonds sold that year.
Not mortgages
Shoddy home loans packaged into bonds by Wall Street banks fueled the financial crisis. Experience showed that loans on vehicles are safer because the underlying asset can be more- accurately valued, it's easier to repossess and people who need a car to get to work prioritize that payment.
"It's a good investment" for lenders, Helfman said. "A person that has to get from point A to point B, they're not going to jeopardize their job. They have to pay the car payment before they pay anything else."
His Dodge Dart customer with the bad credit had to pay a higher than average interest rate.
"It wasn't pretty, but it wasn't crazy," he said. She was "so happy she couldn't see straight."
Higher rates
Fifty-eight percent of loans taken out to purchase Chrysler Group's Dodge brand vehicles in October were with loans above the industry average of 4.2 percent annual percentage rate, according to Edmunds, a researcher that tracks vehicle sales.
The average loan for a Dodge charged an APR of 7.4 percent, and 23 percent of the loans had APRs of more than 10 percent, making it the brand with the highest percentage of loans for more than 10 percent, followed closely by Chrysler and Mitsubishi.
Rates on subprime auto loans can climb to 19 percent, according to S&P.
Dodge U.S. sales rose 17 percent this year through October compared with a year earlier, propelling Chrysler Group to 43 straight months of rising sales.
"Right now, you have to have fairly bad credit to be paying above 3 percent," said Jessica Caldwell, an analyst with Edmunds.
Late payments on subprime auto loans remain contained. After declining to as little as 2.83 percent in 2011, delinquencies rose to 3.1 percent of the debt in August, compared with 13.3 percent in 2009, Standard & Poor's said in an Oct. 22 report.
The Federal Reserve Bank of New York, in an Aug. 14 report on its website, said it didn't see evidence that a "disproportionate or unusual" volume of new loans are being given to riskier borrowers.
New competitors
An influx of new competitors into subprime auto-lending since 2010 is sparking concern of eroding underwriting standards, according to S&P. About 13 issuers have accessed the asset-backed market to fund subprime auto loan originations this year, according to Citigroup Inc.
Among the issuers accessing the asset-backed market this year are GM Financial, the lender founded in 1992 and known as AmeriCredit before it was acquired by General Motors in 2010, and new entrants such as Blackstone Group LP's Exeter Financial Corp.
"We are still skeptical that all of today's subprime auto players will thrive," Citigroup analysts led by Mary Kane said in an Oct. 10 report. The successful companies will be those that can underwrite and collect on loans while holding costs and defaults to a minimum, the Citigroup report said.
Exeter Finance
Consider Exeter Finance Corp., which was acquired by Blackstone Group LP in 2011. Moody's Investors Service won't grant high-investment-grade rankings to asset-backed deals sold by the Irving, Texas-based company, citing its limited experience and performance history.
It has had higher loss rates compared with other lenders, S&P said in a Sept. 17 report. Julie Weems, a spokeswoman for Exeter, declined to comment on the company's losses.
Exeter has issued $900 million of the bonds this year, including $589 million of securities rated AAA by Toronto-based DBRS LTD and AA by S&P, data compiled by Bloomberg show.
In Exeter's most recent deal in September, a $500 million issue backed by 26,591 loans, the average loan was 112.4 percent of the value of the car, up from 111.9 percent in a previous offering sold in May, according to a presale report from S&P. The average loan-to-value ratio, or LTV, on vehicle sales to consumers with spotty credit is 114.5 percent this year, compared with a peak of 121 percent in 2008.
Financial crisis
Higher LTV ratios typically lead to lower recovery values when a vehicle is repossessed in the event of default, and borrowers are less able to stay current if they owe more than the car is worth, S&P said.
The company sold the top-ranked bonds maturing in about a year to yield 1.49 percent in September, compared with 1.29 percent in the May issue, data compiled by Bloomberg show. Ford Motor Co.'s finance arm paid 0.55 percent to issue bonds with a similar maturity linked to prime customers on its most recent offering in July, data compiled by Bloomberg show.
U.S. auto sales, on pace for the best year since 2007, are increasingly being fueled by borrowers with imperfect credit as such lending also soars to pre-recession levels.
U.S. auto sales averaged 16.8 million a year from 2000 to 2007 and may rise to 16.1 million next year, the average of 13 analyst estimates in a Bloomberg survey.
Recovery 'key'
"Perhaps more than any other factor, easing credit has been the key to the U.S. auto recovery," Adam Jonas, a New York-based analyst with Morgan Stanley, wrote in a note to investors last month.
The rise of subprime lending back to record levels, the lengthening of loan terms and increasing credit losses are some of factors that lead Jonas to say there are "serious warning signs" for automaker's ability to maintain pricing discipline.
Discounts and other incentives increased in October by 12 percent to $2,574, outpacing a 3 percent rise for the first 10 months of the year, according to researcher Autodata Corp.
Chrysler Group, which markets the subprime-heavy Chrysler and Dodge brands, trimmed its incentives by 2 percent in October and 1 percent for the year to date.
As for Helfman's poor-credit customer, if she makes her payments, her next car loan will be cheaper, he said. In the past, he said, "she'd have to go to some of those We-Break-a-Leg finance companies."
