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Weekly Comment - Week 29, 2017Speaking in London last week, the U.S. Federal Reserve Chair, Janet Yellen announced that there would not be another financial crisis for as long as she lives thanks to all the reforms and regulations put in place as a result of the 2008/9 financial crisis.

The reforms and regulations, which U.S. President Trump has promised to moderate or shelve, apply to the banking sector. However, in the auto loan market in the U.S. non-bank lenders are taking an ever-larger share of the market. Fitch reported in March 2017 that “independent finance companies and credit unions [have] 20.5% and 25.4% market share respectively”. Typically, these companies operate in the subprime market as prime borrowers simply go to their banks. A comparison of the two types of borrowers serves to illustrate the difference. According to Morgan Stanley, commenting on the asset-backed securities (ABS) market, currently, 0.5% of prime borrowers are delinquent (over 60 days behind), and 1.5% are defaulting completely. In contrast, 4.5% of subprime borrowers are delinquent with a massive 12% defaulting.

This has led to a new term – deep sub-prime – being coined to describe borrowers who are even less likely to pay back their loans than sub-prime borrowers! The growth in the last year in the respective categories of borrowers is shown in the chart below.

Chart 1

Even though the loans are issued by “specialist” sub-prime lenders, such as Exeter Finance and Skopos Financial (both in Texas), the Financial Times reports that they are finding their way into ABS products packaged by Wells Fargo and JPMorgan Chase.

Santander, a regulated bank, has been active in this space in the U.S. but has recently cut back its lending after reaching a US$22m settlement with the Massachusetts Attorney General over flaws in its auto loan securitisation. Delaware also fined the bank for “harming consumers” by issuing them loans they could not afford.

The banks have recently been reassuring investors that the problem can be contained. Wells Fargo’s Q1 auto loans were 29% down on a year earlier and JPMorgan Chase similarly down 17%.

A further challenge is the massive glut of used cars in the U.S. driven by the consummate ease with which just about anyone can buy a new car. Depressed used car prices mean that the car owned by the defaulting driver is not worth the outstanding loan when repossessed by the lender.

In an attempt to “manage” the challenges faced by struggling drivers, lenders are extending loan terms beyond the standard 60-month contracts to 72 months or even 84 months, which for most drivers, simply delays the inevitable with an increasing loan and a depreciating car.

The auto-loan problem is not limited to the U.S. The Bank of England expressed concern this week over the level of consumer credit as Ford Europe came to market with a sterling-denominated securitisation deal consisting of £542m of auto-financing contracts. Asset managers such as Aberdeen Asset Management, quoted in the Financial Times, admit that auto-loan securitisation is a “risk point” and a “brewing risk”. Moody’s, though, has assigned a AAA rating to the Ford issuance.

Steve Eisman, whose story about profiting from the mortgage meltdown in 2008 was made famous in The Big Short, is also looking at the auto-loan industry. He does not think the problem is as bad as the mortgage meltdown though, “At the height of the sub-prime mortgages, the standard was ‘can you breathe?’ It never got that bad in sub-prime auto – they definitely checked your pulse.”

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