.A. traffic isn’t going to get better any time soon. And the Federal Reserve is a big reason why.
Rock-bottom interest rates have made getting into a new car as affordable as it’s ever been for most. Of course, aggressive auto manufacturers, a recovering economy and even falling gas prices have helped push auto sales toward all-time highs. That has meant big money for L.A.’s auto lenders and increased interest in auto loans from investors.
Wall Street firms are clamoring to invest in securities backed by even the riskiest car notes, and even traditionally buttoned-up credit unions are trying to get in on the market for auto loan-backed securities – a sign of both the hot market for car loans and investors’ search for returns in today’s yield-starved environment.
Some of L.A.’s wealthiest people are in on the action, too. Westlake Financial Services, a Mid-City auto lender founded by billionaire Don Hankey, grew its loan portfolio to $2 billion this summer – just three years after the firm crossed the $1 billion threshold for the first time. And last month, Westlake and Ares Management, a Century City private equity and credit giant run by billionaire Antony Ressler, joined forces to invest in a $180 million pool of auto loans.
All this activity comes as some industry observers are predicting that nationwide car sales could hit the 17 million mark this year, which has only happened twice ever – in 2000 and 2001. And L.A.’s blistering market is even outpacing national trends.
With the Federal Reserve showing few signs of raising rates in the near future, rates are likely to remain low, meaning investors will remain hungry for yield – and the risky loans that come with it. And while the pie keeps growing, don’t expect anyone in the auto industry to pull the alarm.
“If you’re looking for the boogeyman around the corner, that’s going to be tough to find in this environment,” said Warren Browne, an automotive industry consultant in Northville, Mich.
Subprime time
By any measure, the auto finance industry is on a tear. The Federal Reserve Bank of New York’s latest report on household debt shows the total volume of car loans issued has increased every quarter since the middle of 2011. In addition, the total of $105 billion in auto-loan originations in this year’s third quarter was the highest since well before the recession, going all the way back to the third quarter of 2005.
Despite the surge in auto debt, the delinquency rate for auto loans has actually fallen and remains below the delinquency rate for household debt overall.
Auto loans as a whole are booming, but subprime loans – those issued to borrowers with less-than-stellar credit – are leading the way.
Hankey’s Westlake has always played extensively in the subprime market, and he has built a hugely profitable business doing so. Westlake’s loans come with interest rates often topping 20 percent for borrowers with bad credit, though borrowers with FICO scores approaching 700 might pay as low as 13 percent.
Ian Anderson, Westlake’s president, said the company has issued about 8 percent more loans so far this year compared with the same period last year, and the value of those loans has risen 20 percent.
“Demand is up across the board and there’s also plenty of supply,” he said.
According to data from the Federal Reserve Bank of New York, since 2009, auto loans issued to people with credit scores below 660, considered subprime, have nearly doubled, while loans to those with higher scores have only risen by about 50 percent.
‘Stupid rate’
Subprime loans have become popular with lenders because of their higher rates and potential for relatively attractive returns.
Mike Sullivan, who owns the L.A. Car Guy group of dealerships in Hollywood, Santa Monica and the South Bay, said that with rates being so low for qualified borrowers, it’s hard for lenders to make money on them. Prospective auto consumers with credit scores above 700 can get rates below 3 percent.
“If you’ve got great credit, I can get you a stupid rate,” he said. “The banks make no money on ‘A’ credit. They can’t charge enough to get a return. They still want the other business, but if the deal had to stand on its own, most bankers would say they’d be out of business.”
That’s incentivized them to be more aggressive in making loans to people with worse credit – that is, people they can charge higher rates.
The boom in subprime auto debt worries some dealers, including Victoria Rusnak, the president of Rusnak Group, which operates 15 mostly high-end dealerships throughout the L.A. area.
“It makes me a little nervous, quite frankly,” she said. “We saw a very significant impact when we saw people getting into homes they couldn’t afford. I think we should keep a close eye on what’s going to happen to that.”
Still, though subprime loans are by nature riskier, auto lenders and investors tend to see them as relatively safe bets compared with other types of credit, such as home mortgages.
An old truism in the auto-lending business is that when times are tough you can sleep in your car, but you can’t drive your house to work – meaning borrowers often choose to pay their car note before paying the mortgage. In addition, repossessing cars from delinquent borrowers is a much quicker process than foreclosing on homeowners.
There’s another factor, too, that makes subprime auto loans safer than subprime mortgages: Real estate values can spike and plummet, but there’s no speculative bubble pushing the value of a Honda Accord up or down.
Car security
The only things hotter than subprime auto loans right now might be subprime auto securities.
On July 16, Westlake closed a securitization in which the company sold $320 million in auto loan-backed bonds in five separate classes, with ratings all the way from A1+ to BBB. The riskiest, those rated BBB, pay interest of just 2.9 percent, and even those were at least three times oversubscribed as Wall Street investors chase yield.
Westlake has securitized its loans for years, but Anderson said it’s only recently dipped so far down the rating scale.
“In the securitization market, we’re seeing an increase in demand,” he said. “We’ve only issued AAA in the past. But in our last two deals, we’ve issued down to BBB. You see more interest in the lower tranches because the yields are higher.”
As of last month, Wall Street banks have arranged $20.6 billion in auto loan-backed securities deals this year, according to data from London finance giant Barclays. That compares with $8.6 billion for all of 2010.
While the asset class has experienced undeniably rapid growth, it’s also been performing. The New York Fed’s most recent household debt survey reported that only 3.1 percent of existing auto loans are delinquent – lower than the 4.3 percent delinquency rate for all debt.
Paul Kerwin, Westlake’s chief financial officer, said there’s more discipline today, both from the firms putting together the securities and the agencies rating them. After all, wounds from when mortgage-backed securities helped take down the economy are still fresh.
“In the pre-crisis era, investors would buy bonds without looking at the material,” Kerwin said. “They’d just buy based on the rating. Now, you’ve got rating agencies that are being more conservative after the mortgage crisis. They’re more aware of an auto bubble.”
Westlake’s securities, he said, can be structured with a higher allowance for defaults while still delivering relatively high returns. That might sound eerily familiar to people who lost their shirts in mortgage-backed securities, when plenty of highly rated mortgage bundles turned out to be cesspools of default and foreclosure. But Anderson noted that even during that reckless era, auto securities held up well.
“Through the downturn in the recession, not one auto-finance securitization ever defaulted,” he said.
Credit lanes
This auto-lending boom has also boosted the fortunes of an oft-overlooked member of the banking community: the credit union.
The top 25 auto-lending credit unions had a combined total of $48.4 billion in auto loans as of Sept. 30, up 16 percent year over year, according to data from SNL Financial, a data provider in Charlottesville, Va. And with the L.A. area being home to 50 credit unions with more than $100 million in assets, that’s had a real impact locally.
Credit unions’ share of auto loans has grown to 17 percent as of the second quarter of this year, up 9 percent from the same period a year earlier, according to data from Irish financial information provider Experian.
Xceed Financial Credit Union in El Segundo, which started out as the credit union for Norwalk, Conn., copier giant Xerox Corp., is one area firm that has fully embraced the auto-loan business.
Ray Shams, Xceed’s chief operating officer, said about 25 percent of the credit union’s entire loan portfolio is in auto loans, and that the segment is still growing fast thanks to continued demand from members.
Auto loans are attractive assets for credit unions because, unlike home mortgages, another big item for credit unions, they’re shorter term. That means if interest rates rise, the credit union isn’t stuck with 30-year loans paying rock-bottom rates.
“We can have greater control on the interest rate risk and the credit risk,” Shams said. “As that part of the balance sheet grows, we can have better control as the interest rates move.”
Soon, Xceed and other credit unions might even be able to get in on the hot auto-loan securitization market. The National Credit Union Administration, the federal regulator for credit unions, has proposed a rule that would pave the way for credit unions to securitize auto loans.
Shams is excited about the opportunity, which would create liquidity and be a new source of financing for his relatively large credit union.
“We’ve had our eye on it for a while,” he said. “Fortunately, because of the size of our credit union, we can originate enough auto loans and make a package big enough for the secondary market to consider it.”
He knows a package of Xceed auto loans won’t offer the same kind of returns as ones offered by Westlake and other subprime lenders, but he said credit unions can compete because their members tend to stick around and are less likely to pay off their loans before maturity – something investors hate.
“Maybe our overall rate of return of the package will not be as high, but we bring to the market a higher security package with greater member loyalty, so it won’t be paid off early,” he said. “When you are going to the higher interest-rate bracket, you see the loans are paid off earlier and the rate of default and charge-offs are much higher.”
Swashbucklers
Credit unions are historically conservative, but Kerwin said the hot auto-loan market and the low cost of capital have attracted firms that are less experienced – and less disciplined.
“Some of the companies have the ability to lever up very significantly at very low rates,” he said. “That naturally causes them to be aggressive.”
That means more competition for Westlake now, but potential gain later on. As less-disciplined investors move in, some will end up with too many bad loans and be forced to shed some of their debt. Then Westlake can swoop in and buy those loans at a discount.
Case in point: Westlake last month partnered with Ares and New York’s Fortress Investment Group to buy a $180 million pool of mostly subprime and near-prime auto loans from a New York lender that ran into regulatory problems and defaulted on a credit line.
“We’re going to start seeing more and more of these portfolios come to market,” Anderson said.
Kerwin said Westlake, with its history of investing in car loans and proven underwriting model, is well positioned to pick up those lagging portfolios and get them to perform.
“This is a very cyclical business and we’re used to that cyclicality,” he said. “When there’s a downturn, that’s normally when we can pick up market share.”
Auto analyst Browne, too, said the inevitable downturn will leave some of the swashbuckling firms exposed.
“At some point in time, everything that goes up comes down,” he said. “All of those loans will not be repaid. People that are looking for returns have short memories.”
However, he said any red flags that might be out there are being completely washed out by the low-rate wave. And he believes it’s simply not in the nature of car dealers and financiers to take their foot off the gas while the getting is good.
“There are risk factors that exist but they’re being subordinated by low interest rates,” he said. “Nobody’s going to be the Boy Scout. It’s not inherent in the business.”
