Moody's: Repeat of 1990s Subprime Auto Downturn Could Be Ahead
July 20, 2012
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NEW YORK — Veteran executives might remember negative ramifications
from poor strategy some subprime lending institutions faced in the 1990s. Two
officials from Moody's Analytics cautioned investors that the market currently
is showing some trends of a repeat performance.
Moody's acknowledged subprime loan performance has been strong over the past several years, but the investor interest from outside the subprime auto market niche and the potential for increasing competition imply that "losses could increase if a race for profits and market share results in weaker underwriting standards."
Vice president and senior analyst Peter McNally and senior vice president Joseph Snailer from Moody's Investors Service made those assertions and more in the firm's July Auto Navigator.
"The subprime auto lending market is exhibiting some characteristics last seen during the early- to mid-1990s when overheated competition led to poor underwriting and drove unexpectedly high losses that put many smaller lenders out of business," McNally and Snailer indicated. "Then, as now, investor capital flowed into the sector, lured by the profit potential from the ability to charge high loan rates while enjoying low funding costs.
"When the lending boom in the 1990s eventually went bust, the number of lenders contracted drastically, and subprime auto ABS investors suffered losses," they recapped. "If today's subprime auto lending market was to deteriorate as it did back then, investors could suffer comparable or greater losses, especially in the absence of monoline guarantors or other controlling parties available to minimize or absorb their losses."
During the last two years, Moody's believes the sector's profit potential has lured private equity investment into subprime auto lenders. The firm contends many current subprime lenders are relatively small, specialty finance companies that exhibit "speculative characteristics and relatively high medium-term default probabilities."
Nonetheless, Moody's described the subprime auto loan ABS market in the U.S. as "booming," with 2012 issuance on pace to exceed the robust issuance of 2011.
"This kind of competition amidst the burgeoning subprime auto lending market of the 1990s resulted in declining portfolio credit quality that led to high losses," McNally and Snailer stated. "Exacerbating these loan losses was servicers' inability to effectively manage the collections on their rapidly growing but deteriorating portfolios.
"Many foundering lenders eventually lost access to their funding sources as banks pulled their warehouse lines and ABS investors shunned further attempts at securitization," they remembered. "The lenders' financial difficulties drove loan losses even higher because of the disruptions caused by the need to transfer servicing from bankrupt lenders."
Although today's influx of equity to the sector is similar to that which led to the bubble of the 1990s, Moody's emphasized there are also differences among the markets of the two time periods, both positive and negative.
"Today's market is not yet overcrowded and benefits from the limited use of gain on sale accounting, through which past lenders made themselves look much stronger on paper than they actually were," McNally and Snailer pointed out.
"Today's servicing operations, tending to be centralized, also pose less extreme disruption risk than the decentralized operations of the 1990s, which conducted collections at branch offices," they continued. "On the other hand, most recent transactions, unlike in the past, are not backed by monoline guarantors. Those guarantors absorbed losses on transactions that would otherwise have defaulted and, in their capacities as controlling party, limited loan losses by taking over servicing from failing lenders."
Bottom line: Is the subprime auto lending space heading for the same trouble witnessed 20 years ago?
"Although it is too early to predict whether today's subprime lending market will deteriorate as it did in the 1990s, the similarities between the early stages then and now suggest that losses will climb as competition intensifies," McNally and Snailer surmised.
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