FCA helps drive subprime lending machine

Gabrielle Coppola
Bloomberg News

It’s classic subprime: hasty loans, rapid defaults, and, at times, outright fraud.

Only this isn’t the U.S. housing market circa 2007. It’s the U.S. auto industry circa 2017.

A decade after the mortgage debacle, the financial industry has embraced another type of subprime debt: auto loans. Like last time, the risks are spreading as they’re bundled into securities for investors worldwide.

Subprime car loans have been around for ages, and no one is suggesting they’ll unleash the next crisis. But since the Great Recession, business has exploded. In 2009, $2.5 billion of new subprime auto bonds were sold. In 2016, $26 billion were, topping average pre-crisis levels, according to Wells Fargo & Co.

Few things capture this phenomenon like the partnership between Fiat Chrysler Automobiles NV and Banco Santander SA. Since 2013, as U.S. car sales soared, the two have built one of the industry’s most powerful subprime machines.

Details of that relationship, pieced together from court documents, regulatory filings and interviews with industry insiders, lay bare some of the excesses of today’s subprime auto boom. Wall Street has rewarded lax lending standards that let people get loans without verifying incomes or job histories. For instance, Santander recently vetted incomes on fewer than 1 out of every 10 loans packaged into $1 billion of bonds, according to Moody’s Investors Service. The largest portion were for Fiat Chrysler vehicles.

Some of their dealers, meantime, gamed the process so low-income borrowers could drive off in new cars, prosecutors said in court documents.

Through it all, Wall Street’s appetite for high-yield investments has kept the loans — and the bonds — coming. Santander says it has cut ties with hundreds of dealerships pushing unsound loans, some of which defaulted as soon as the first payment. At the same time, Santander plans to increase control over its U.S. subprime auto unit, Santander Consumer USA Holdings Inc., people familiar with the matter said.

Santander, subpoenaed or questioned by a group of about 30 states regarding its auto loan underwriting and securitization activities, declined to comment on “active legal matters.” In May, Santander agreed to pay $26 million to settle allegations brought by Delaware and Massachusetts as part of ongoing investigations into the auto industry’s lending practices. Santander, whose partnership with Fiat Chrysler goes by the Chrysler Capital brand name, neither admitted nor denied wrongdoing.

Reid Bigland, Fiat Chrysler’s U.S. sales chief, said Santander has been a “good partner.”

In recent years, lending practices in the subprime auto industry have come under scrutiny. Regulators and consumer advocates say it takes advantage of people with nowhere else to turn.

For investors, the allure of subprime car loans is clear: Securities composed of such debt can offer yields as high as 5 percent. In a world of ultra-low rates, that’s more than triple the comparable yield for Treasuries. Of course, the market is still much smaller than the subprime-mortgage market which triggered the credit crisis, making a repeat unlikely. But the question now is whether that premium, which has dwindled as demand soared, is worth it.

Cracks emerge

Asset-backed securities based on auto loans are engineered to keep paying even when some loans sour. Still, some cracks have emerged in the $1.2 trillion market for auto financing. Delinquencies have picked up, as have losses on subprime loans. Auto loan fraud, meantime, is approaching levels seen in mortgages during the bubble.

Auto finance “is not going to bring down the financial system like the mortgage crisis almost did, but it does signal more stress with the consumer,” said Stephen Caprio, a credit strategist at UBS Group AG.

The Chrysler-Santander relationship opens a rare window into the industry.

In the years after its 2009 bankruptcy, Fiat Chrysler looked for a dedicated lender to help customers finance cars quickly. One reason it picked Santander was the Spanish lender’s expertise in “automated decisioning.” At the time, a Fiat Chrysler executive said the process helped Santander “take a little bit more risk and approve more deals because they mine the data” in subprime.

Becoming the carmaker’s preferred lender made sense for Santander. It was aggressively expanding in the U.S. subprime loan market, and Chrysler relied more on buyers with lower credit scores than General Motors Co. or Ford Motor Co.

Problems surfaced almost from the start. Many of them, detailed in the settlement between Santander and authorities in Delaware and Massachusetts, recall some of the excesses of the subprime housing era.

Attorneys general in both states alleged Santander enabled a group of “fraud dealers” to put buyers into cars they couldn’t afford, with loans it knew they couldn’t repay. It offloaded most of the debt, which often had rates over 15 percent, reselling them to yield-hungry ABS investors.

State authorities also said an internal Santander review in 2013 found that 10 out of 11 loan applications from a Massachusetts dealer contained inflated or unverifiable incomes. (It’s not clear whether this particular case involved a Fiat Chrysler dealer.)

Santander kept originating the dealer’s loans anyway, even as they continued to default “at a high rate,” the authorities said.

While Santander takes pains to avoid criticizing Fiat Chrysler, the lender launched a special loyalty and rewards program to vet the carmaker’s dealerships. Those that aren’t deemed fraudulent are labeled “VIPs.” Santander has cut ties with over 800 dealers since 2015 as it tries to boost business without exposing itself to more bad loans.

Fiat Chrysler declined to comment on fraud at its dealer network.

Varying norms

Indeed, with U.S. auto sales falling after a record 2016, many lenders including Santander say they’re tightening standards. Santander’s underwriting practices, however, continue to raise eyebrows. In May, Moody’s said Santander verified incomes on only 8 percent of its loans bundled into bonds.

Yet when it comes to due diligence, there’s no industrywide standard. Unlike the mortgage market, stated-income loans — or “liar loans” — are perfectly legal in car buying. Last month, Jeff Brown, Ally Financial Inc.’s chief executive, said verifying income isn’t the norm. Ally, he said, checked incomes on 65 percent of subprime car loans. GM Financial’s AmeriCredit unit checked roughly the same percentage.

The industry has little reason to change given the success of Wall Street’s securitization machine. Protections built into the bonds have largely insulated investors from losses.

The losers, of course, are people who go into debt for cars they can’t afford.

Jerry Robinson, who worked in Santander’s debt collection unit, has seen trouble firsthand.

Often, he found dealers listed non-existent features like sunroofs to inflate a car’s value and win credit approval. Although Robinson’s job was to make sure dealers reimbursed Santander for loan fraud, borrowers didn’t see their debts reduced. Instead, their loans were usually extended, increasing the compound interest consumers would ultimately pay after their repoed cars were reinstated. More often than not, those payments wind up going to ABS investors.