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Market Extra: Why worries over subprime auto bonds might be only getting started

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Investors already bracing for a recession and rising borrower defaults now face another kind of worry after a new lawsuit claimed Credit Acceptance Corp misled them in more than $7 billion worth of its subprime auto bonds.

The lawsuit filed Wednesday against Credit Acceptance adds heightened regulatory scrutiny to the list of concerns investors face as used-car prices fall from record levels and as lower-income borrowers struggle to keep up as the Federal Reserve jacks interest rates up.

Credit Acceptance
CACC,
+3.60%

is one of the largest publicly traded auto lenders, originating over $4.9 billion in loans in 2020 alone. It has contributed to the last decade’s boom in subprime asset-backed securities (ABS) tied to used-car loans.

The U.S. Consumer Financial Protection Bureau and New York Attorney General Letitia James sued Credit Acceptance on Wednesday, claiming it tricked low-income borrowers into high-cost loans that exceed interest-rate caps, resulting in a debt spiral for borrowers.

Notably, the complaint also claimed the company engaged in fraudulent practices and misleading investors in about $7.4 billion worth of its subprime auto loans packaged into ABS deals from 2015 to 2021.

“It’s an indication of where the focus at the CFPB is,” said Joseph Cioffi, a partner at law firm Davis+Gilbert in New York City, who in the past decade has been active in subprime mortgage securities litigation. “Now, the question is what may be discovered, if anything, that could concern investors.”

Risks of subprime auto boom

Fears of fallout from the booming subprime auto industry have been around for years, but perked back up with growing recession fears and in the aftermath of used-car prices hitting record highs during pandemic shortages.

Cioffi called the threat of underwater borrowers saddled with expensive car loans a “witches brew of more economic pressure” for subprime borrowers seeking new financing in today’s higher rate environment.

Since the summer, delinquencies and losses on subprime auto ABS have been shooting up (see chart) as pandemic stimulus faded.

Delinquencies and losses on subprime auto bonds shoot higher as pandemic stimulus fades

Intex

The rate of past-due subprime auto ABS loans climbed to about 4.9% in December, for delinquencies of 60 days or more, up from a pandemic low of 1.9%, according to Intex, a tracker of bond performance.

Dave Goodson, head of securitized credit at Voya Investment Management, said new claims against Credit Acceptance aren’t likely to trigger a spillover effect into the broader subprime auto bond sector, even though “it keeps the regulatory risk fresh, potentially ahead of a negative credit cycle.”

Several holders of Credit Acceptance ABS were testing market clearing levels after the complaint was filed by regulators, according to Empirasign data. A small slice of a senior bond issued in 2020 traded at a $94.75 price on Thursday, down from $101.34 in September 2021.

Bond prices have been battered as the Fed quickly raised its policy interest rate to its highest level in 15 years to cool rampant inflation, while U.S. central bankers also warn its rate could top 5% this summer and stay elevated for some time.

Read: No Fed official expects an interest-rate cut to be appropriate this year, meeting minutes show

But even before the Fed’s monetary tightening cycle kicked in, nearly 90% of all Credit Acceptance loans to borrowers in New York from 2015 to 2021 exceeded the state’s 25% criminal interest-rate cap, according to the complaint.

Cioffi said Credit Acceptance and other subprime lenders have been known to pay fines, without admitting wrongdoing, to settle similar unfair lending allegations, including those made in 2020 by Massachusetts Attorney General Maura Healey. Early settlement preclude allegations, true or not, from ever becoming known facts. If another settlement happens it could limit what comes to light publicly about subprime lending operations, he said.

A Credit Acceptance spokesman declined to comment beyond his initial response, calling the complaint “without merit” and saying the lender “intends to vigorously defend ourselves in this matter.”

Still, Goodson at Voya hopes for changes in subprime auto lending. “These are dead-end loans, in a lot of cases,” he said. “Honestly, I think we should have reforms.”

His team in recent years has invested in subprime auto ABS from only by a select few issuers whose lending practices better align with the “s” part of their environmental, social and governance (ESG) strategy.

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