Educated buyers support growing subprime auto bond market

NEW YORK, Sept 25 (IFR) - Subprime auto loan borrowing and financing is again becoming big business in the US, as more privately-owned lenders tap the asset-backed securities (ABS) market and meet keen demand.

The trend is allowing companies to increase lending and helping borrowers with tarnished credit histories obtain loans at lower rates.

Two California-based companies, Westlake Financial and United Auto Credit, tapped the subprime auto ABS market last week, bringing their third and first deals, respectively.

The Federal Reserve's low interest rate policy has caused demand for auto-loan bonds to skyrocket. The high-quality, short-duration, higher-yielding nature of auto ABS makes it a desirable alternative to Treasuries.

In fact, bond investors' rabid appetite for auto ABS this year means that subprime auto lenders have found an eager audience for their bonds, allowing them to originate more loans at more attractive rates. At the same time, robust car sales have promoted a spike in auto financing, paving the way for increased subprime lending.

There has already been $14.3 billion of subprime auto ABS issued year-to-date, compared to $12.69 billion for all of 2011, according to IFR Markets.

Most of the investors buying the paper are sophisticated and know the auto industry inside-out. As the investor base expands, new investors are also being cautious, meeting issuer's management team first to better understand the product.

"Investors are doing extensive homework," said Paul Kerwin, the CFO of Los Angeles-based Westlake Financial, who priced a $377 million subprime auto ABS last Wednesday.

"More than ever, investors who are buying in this space know the industry well. All of our investors have a team dedicated to auto, and more specifically, to subprime auto. We are pleased to have a good mix of investors who are long-term investors in our program."

While the company has only issued three ABS in the span of three years, "we hope to become a frequent issuer, perhaps one or two deals per year," Kerwin told IFR.

One ABS portfolio manager at a northeast investment management firm who invests in the subordinate pieces of subprime auto ABS said he met with the management teams of both Irving, Texas-based Exeter Finance Corp and Westlake before deciding to buy slices of recent transactions.

"This way, we knew what to expect, and we have expertise about the sector and the issuer," he said. "When you've done the work to understand it, that makes it a little easier to buy."

PEDAL TO THE METAL

The volume of subprime auto loans is set to increase. Experian Automotive recently announced that loans to customers in subprime accounted for more than one in four new vehicle loans during the second quarter of 2012.

With 25.41% of all new vehicle loans to customers in the non-prime, subprime, and deep subprime risk tiers, loans to credit-challenged customers were up 14% compared to the second quarter of 2011.

Moreover, the robust bond activity means that funding is becoming cheaper for subprime auto lenders, and all-in costs are decreasing. Westlake paid an average yield of only 0.73% to investors on its offered certificates last week. Two junior tranches were retained by the company. A similar bond offer from the company in May 2011 cost the lender slightly more.

Another recent subprime issuer, Credit Acceptance Corporation, paid an average yield of 4.05% to investors on an ABS earlier this month, compared to 5.20% in a June 12 deal.

Yet another new entrant into the ABS market, Exeter Finance, paid an average of 2.91% to investors in its recent issue, compared to 4.36% for a deal in February.

An inaugural $184 million ABS transaction last week from Orange County, California-based United Auto Credit, managed by Wells Fargo and RBS, offered an average yield of 1.85% to investors across the capital structure, which is considered attractive execution for a subprime auto lender.

The company, which has been around for 16 years, is affiliated with more than 2,500 auto dealers across 35 states. The fact that it is only now entering the subprime auto ABS space -- along with other newcomers such as Exeter and J.D. Byrider -- points to the growing financing opportunities available for lenders in the securitization markets as investors chase anything with even a modicum of extra yield.

Just recently, Santander Consumer USA, one of the most active subprime auto ABS issuers, agreed to purchase DriveTime's auto finance portfolio, signaling further big-money interest and investment in the growing sector, according to Standard & Poor's. DriveTime is the third largest auto ABS issuer year-to-date, behind Santander and GM Financial.

Santander completed 53% of all the subprime auto ABS this year. DriveTime's total auto loan portfolio at the end of the second quarter was $1.61 billion, up from $1.46 billion at the end of 2011, according to S&P.

Private equity money has flooded the subprime industry over the last year, with firms such as Perella Weinberg Partners, Blackstone Group, Warburg Pincus, Kohlberg Kravis Roberts & Co. and Centerbridge Partners investing in various lenders, including some independent finance companies.

With new players and private equity money entering the market, some securitization experts warn that the potential for relaxed credit standards may increase in order to drive growth in the sector.

"While near-term growth prospects are positive, over the longer term, we expect increased competition to weaken credit standards and lead to increased losses," wrote Amy Martin, an S&P auto ABS credit analyst, in a report from last Friday.

"Nonetheless, we believe that credit enhancement and other safeguards will adequately protect 'AAA' and 'AA' rated subprime auto ABS from incurring defaults should another 'BBB' economic environment ensue."

Martin said that while the market has been making a strong comeback, it is not as overheated as it was pre-crisis, and hence still has room to grow before reaching its prior peak levels.

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