Investors in MPL and auto lending should be aware of the similarities between what happened in the subprime lending mess of 2007 and what is happening today. There may not be the same wide-scale issues, but Joe Cioffi of Davis and Gilbert LLP says there are some warning signs for investors.
He suggests investors should look at breach of representations based on failure to comply with laws, reps, and warranties. Looking at transaction documents from those subprime days, better and clearer documentation could have helped some defendants in defending a claim.
Joe Cioffi earned his MBA in marketing while working as a financial analyst at Kraft Foods. He later obtained his law degree while doing product management and marketing at Nabisco (A1 Steak Sauce). Going into multiple directions provides him with deep insight into what is happening in business today.
His firm represents a wide array of clients – from advertising and marketing agencies to financial services and real estate companies, private individuals and non-profits. They offer a wide variety of legal services – advertising and marketing, real estate, litigation, labor & employment and corporate. His group in particular helps clients manage distressed assets, unwind transactions and prosecute and defend lawsuits concerning complex structured finance and derivative transactions.
On a personal level, Cioffi was involved with a Foreign bank in 2004. He was faced with the task of representing investors as warehouse lenders in originator bankruptcies. Then came holding distress loans, and lawsuits.
Having managed large scale actions like fraud based on misrepresentations, he now chairs the insolvency, creditor rights, and financial products division focusing on the financial services sector. He has seen “the subprime mess from cradle to grave, from heyday until the tail end of the litigation comet.”
The Voice of Experience
Cioffi sees lenders going down the scale as they mine subprime borrowers deeper and deeper. It’s more profitable when times are good and borrowers are paying, which attracts new entrants. Similar to what was going on in the 2005-06 acceleration, smaller companies (like auto finance companies) are going after deep subprime.
What happened then? There was a disconnect between performance and the new money/loans being made. There were profits in securitizing subprime mortgages, but it takes time to get funding and build a pipeline. These new entrants were coming in as the market was starting to deteriorate and delinquencies started to rise.
Around six million borrowers are late on subprime car payments. This rising delinquency rate is not happening over all auto lending, but it is true among the subprime sector. This weakness is similar to what was happening in the housing market. The problem wasn’t in the premium sector at first; it started with the subprime. As the market declined, it affected all market segments.
But houses have an opportunity to rise in value. Cars, on the other hand, depreciate and decline in value. Even though a lender is able to quickly repossess the vehicle, the price drops like a rock no matter what. Mechanisms to disable the car or locate it for towing are not recoupment in the sense of investment strategy. Hence the securitization process.
Securitization of What?
Just like subprime mortgage, all subprime auto loans are being securitized, allowing for transfer of risk. There is less incentive to originate quality loans if you know they will be sold, Cioffi said. There is liability on a repurchase, but that didn’t stop originators from making poor loans before 2007. At that time, large banks were involved in originating and securitizing. Now, the large banks are not making the riskier loans–the ones with rising delinquencies. Smaller companies are doing it. Larger banks are still in securitization as managers, trustees, and primary or backup servicers. This is seen by some as a possible problem, but that problem isn’t coming from subprime mortgages themselves; it’s from their role in securitization.
In RMBS litigation, started with investors going after loan originators for fraud and misrepresentation in materials and sponsors. Trustees sued sponsors and originators on the investor’s behalf. After that first wave, issues with statutes of limitations showed up. Then the same parties introduced lawsuits against the trustees, claiming they failed to perform their fiduciary duties by failing to notify participants there was a problem with the loans.
Failure-of-notification lawsuits can happen where investors have losses from delinquencies and sue originators and sponsors. Cashflow can constrain defense for those who are thinly capitalized. So what happens next? They look at the deeper pockets.
How does this affect the risk-retention rules? It depends on your view of what happened. If originators could get the loans off their books, that was enough to incentivize making poor quality loans, so keeping skin in the game looks beneficial. Some will ask about repurchase on rep and warranties, but that didn’t stop lenders from making loans that went into default.
The hold in risk retention is supposed to avoid issues in subprime mortgages. The idea was that the housing market would enable refinancing. But when the market dropped, refinancing was not an option for many and they defaulted. It wasn’t the quality of all the loans causing the problem; it was the market. Risk retention rules didn’t seem to matter.
Home vs Auto Loans
If the housing market created the mortgage default problem, will the auto market also be a problem? The success of the securitization market in 2007 depended on housing prices continuing to rise. The success of the subprime auto securitization market is not depending on the value of the collateral because vehicles depreciate in value as soon as you drive off the lot.
In subprime mortgage, you trust the house. In subprime auto loans, you have to trust borrowers with low or no credit scores. It’s interesting that it’s still an active market for the receivable. Are they going to pay and be motivated to keep paying when their car gets older and needs more work? Are they going to be willing to pay 21%-26% interest, or are they going to walk away and ruin their credit? People walked away from their homes even though there was a chance the market would rebound. With cars, there is no rebound.
Because of this, everyone has to have eyes open on who the borrowers are and how risky it is. This isn’t quite a defacto unsecured personal loan. It’s similar to an unsecured loan, but there are vehicles backing those receivables. It’s a good idea to get comfortable with enhancement. Honor Finance does this with subordination and over-collateralization. Is that enough?
The Challenge of Subprime Auto Lending
When we are looking at subprime auto loans, we are dealing with a collateral that depreciates with no chance of rebounding. Repossession to the lender is not a workable strategy for being made whole, and it’s not the primary recourse any investor wants.
If we need to rely on repossessing an old car, we are in trouble.
Links for further reading:
- Subprime Auto Debt Grows Despite Rising Delinquencies
- Quarterly Report on Household Debt and Credit
- As Auto Lending Rises, So Do Delinquencies
Author: Nicki Jacoby.