Sub-Prime Lending – Will It Be Different This Time? – Santander Consumer USA Holdings Inc (NYSE:SC)

In late 2015, Nathan Hayes published a piece on Santander Consumer USA (SC) describing the issues the company has and the fact that it may not be properly provisioning for the default risk it faces. Since then, a few of us have been discussing the developments in the comments section of that article, and I thought I should post a summary along with my thoughts on this company.

As we all know, sub-prime lending plays a beneficial role in our capitalist economy as it allows lower income consumers with higher credit risk to purchase the same high-ticket goods as the rest of us while providing firms due compensation for their risk in the form of higher interest rates. The problem with lending, however, is that it is an extremely competitive business. Differentiation and barriers to entry are limited, as firms simply offer their capital to consumers – a commodity-type service. As the economy improves through the business cycle, new firms enter the lending industry by offering their funds to consumers at lower rates. As usually happens, firms lower their lending standards in order to retain and expand their lending business. This, of course, cannot continue forever, and it tends to end with defaults and losses as the risk of those loans were not adequately priced. This leads to lenders exiting the industry, less aggregate lending, and a recession – this is how it goes.

I believe that Santander Consumer is at high risk and will be particularly exposed in the case of used-auto loan defaults or an industry downturn.

As can be seen below from SC’s 2016 Annual Report, 83.1% of its loan portfolio has been allocated to subprime borrowers (<640 FICO score), 12.2% of which have no FICO score at all.

The company has been experiencing higher delinquency rates and chargeoffs in the past few years and has increased its troubled debt restructurings as a result. From 2012 to 2016, the total net chargeoff ratio has increased from 5.1% to 7.8%, the delinquency ratio on personal loans has increased from 5.6% to 11.3%, and the delinquency ratio on loans held for investment increased from 4.6% to 5.1% while its net interest margin has decreased from 13.8% to 12%.

To date, Santander has done well provisioning for defaults and delinquencies, with the allowance ratio increasing from 10% in 2012 to 12.6% now and has continued its run of profitability. The problem for current shareholders is that it has had to continually expand its book of loans to tread water in terms of earnings as it increases chargeoffs and allowances. From 2012 to 2016, revenues have increased about 60%, while net income has decreased 23% in total. This is because chargeoffs have increased 158% over this period. It has rapidly expanded its book of loans and interest income, but each loan is much less profitable than it was before. Similarly, assets have increased from $18 billion to $38 billion from 2012 to 2016, and yet, it is less profitable than it was at this lower asset base – this is clearly not a good sign. Even if there is no dramatic implosion of the used auto-loan industry (which there certainly may be given the poor lending standards), there is no reason to believe that Santander will achieve its historical rates of profitability. This is not unique to Santander, as its competitors Ally (ALLY) and Capital One (COF) have experienced the same issues. Having to increase loans to tread water, auto loan creation is accelerating industry-wide.

To briefly discuss the used-auto loan industry as a whole, the situation does not look attractive whatsoever and has been reminiscent of the home-mortgage industry of 2007 for some time now. There is no auto bubble, as consumers do not speculate on the rising prices of cars, but lending standards have deteriorated dramatically and have become truly obscene. The aggregate amount of used-auto loans is now at around $1.1 Trillion, with 25% of that being sub-prime.

Used-auto lenders seem to be willing to lend to anyone with a pulse at this point. There have been reports of lending high amounts to people in bankruptcy or who are unemployed (they are even directly targeting bankrupt folk in ads now). Fraud in the auto-lending industry has risen to the heights of mortgage lending in 2007 and approximately 1% of all car loans involve “some sort of material deception” as backgrounds aren’t checked. Used-car dealerships advertise with material such as “No Credit. Bad Credit. All Credit. 100 percent approval.” as mentioned in this NY Times article.

I highly recommend that NY Times article as it presents such details as: “Even when they are presented with clear evidence of fraud, the banks ignore it,” said Peter T. Lane, a consumer lawyer in New York. “The typical refrain is, ‘It’s not our problem, take it up with the dealer.’ ”

Similar to 2007, there seems to be a lack of accountability and as a result a moral hazard in the creation of these loans. Dealers advertise to any and all, financial institutions lend to any and all, and sell those loans to any and all. Of course, some would blame the low-income consumers for taking the loan out in the first place. Fault is to blame on all parties in general, and none in particular. It is an abhorrent Ponzi-like system in my opinion, as it is always unsustainable.

The dealerships refer their customers to sub-prime lenders who then attempt to securitize these loans and sell them to unwitting investors in search of yield. These securitizations are becoming more and more subprime as lending standards decrease, with 32.5% of auto-loan securitizations now considered sub-prime versus 5.1% in 2010. These securitizations are “experiencing cumulative net losses expected to hit 15% – even higher than those of 2007.”

Those 15% losses are expected to accrue to the 2015 ABS’. The paper created in 2017 will surely be worse. According to Santander’s 2016 Annual Report, “for most of its securitizations, the Company retains one or more of the lowest tranches of bonds”. This is obviously a highly disturbing risk for Santander. Santander is in the business of “the indirect origination and securitization of retail installment contracts principally through manufacturer-franchised dealers in connection with their sale of new and used vehicles to retail consumers.” Aka, its first priority is to securitize and sell off those loans rather than hold them for investment- it is likely not interested in or happy with holding the worst tranches of those sub-prime securitizations.

High rates are charged to these borrows with sub-prime FICO scores, and increasingly, many of them are unable to pay off the debt. Of course, when the debt is defaulted upon lenders retrieve their collateral and attempt to resell it. There are reports of cars being repossessed and resold up to 10+ times- with these low-income consumers paying “cost of repossession and sales” fees as the cars they defaulted upon are taken. In many cases, they are still left with the debt despite the repossession.

Some commentators have publicly noted that cars can be quickly repossessed, so this won’t be an issue compared to the housing crisis if defaults were to rise – that’s not the point. Given the total lack of lending standards, and the fact that these borrows are increasingly unable to pay their loans off, lenders have to increasingly repossess the cars and resell them. On an aggregate basis, this clearly leads to lower used-car values as more cars are put up for sale. With higher chargeoffs and having to resell those used cars at lower prices, lenders will experience a cycle of declining profits. The data on used-car prices supports this theory, with the average used car declining 17% compared to the past year in August of 2017. This depreciation is accelerating, and I expect used-car prices to continue to decline sharply as charge-offs increase.

Santander is fully involved in these lending discretions as one of the nation’s largest sub-prime lenders. It was recently discovered that Santander checked income on only 8% of borrowers in its recent subprime ABS. This honestly impresses me in a disturbing way – they managed to avoid asking 92% of those borrowers about their incomes – I’m not sure what you call that but ‘highly irresponsible’ is conservative to say the least.

Massachusetts Attorney General Maura Healy recently spoke out against Santander’s policies after it settled for $26m in a case for “giving high interest loans to car buyers whom it knew could not afford them”. For Santander, “the global economic collapse wasn’t a cautionary tale. It was a blueprint” and that “Santander’s practice of working with car dealerships that falsified or inflated borrowers’ incomes was “outrageous,” said Ms. Healey in announcing the settlement. The bank would then resell the loans, knowing they were unsound, to investors.”

Another strange point to note is that Santander has had two CEOs leave the company in the past few years, with Thomas Dundon leaving in 2015 and Jason Kulas leaving this month – with both of them going to “pursue other opportunities”. Its extremely odd and unsettling behavior.

Another random point that concerns me about the industry in general is that in January, the head of Citi’s ABS group said that the auto-industry is “not the next big short”, and “It’s not wise to believe everything you see in a movie and hit films are not the best source for trade ideas”. If this is the case, and auto loans are of no concern, why is her group refusing the mass of hedge-funds who would like to purchase credit-default swaps on those auto loan securitizations? If auto loans are of no concern, it would be easy money for her firm. Maybe it’s just me, but I’ve never heard of a financial institution refusing the money of their customers because they want to protect them from giving away their money to them. Maybe it’s because they are unwilling to act as the counterparty to those securities? Sounds much more likely. Jamie Dimon, CEO of JP Morgan would likely agree, as he noted that “someone is going to get hurt” from car loans earlier this year.

If there is to be an implosion in the used-auto loan industry, it has not yet happened. All metrics are getting worse, but we are not experiencing recessionary conditions or massive defaults in this sector. What do we think will happen if and when those conditions occur, however? Do we believe that Santander, with 83% of its loan portfolio held in subprime and currently checking less than 10% of borrower’s incomes in its securitizations will do well if defaults were to rise industry-wide? Santander has a loan portfolio of around $23bn and total equity of around $5.7bn. It is provisioning for a 12% allowance, but if another 10% of its loans sour, the company’s equity is cut in half. Is that a likely scenario if things in the used auto-market continue to deteriorate? It certainly seems possible.

I won’t speculate on whether this industry will implode or not, and the ramifications of that, but it should be clear that things are deteriorating. When sub-prime lending standards deteriorate industry-wide, bad things happen. I would advise all investors to stay far away when they do.

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

Additional disclosure: Aaron J. Saunders is the Owner and Manager of Comus Investment, LLC., a Registered Investment Adviser with the state of Washington. The commentary does not constitute individualized investment advice. The opinions offered herein are not personalized recommendations to buy, sell or hold securities.

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