Depending whose money they're using, Wells Fargo and JPMorgan Chase either love subprime car loans or fear them.
Both banks have grown more reluctant to make new subprime loans using money from their own balance sheets. Wells Fargo tightened its underwriting standards and slashed the volume of all loans it made to car buyers in the first quarter by 29 percent after greater numbers of borrowers fell behind on payments. JPMorgan's consumer and community banking head Gordon Smith earlier this year said the bank had cut its new lending for subprime auto loans "dramatically."
At the same time the firms are indirectly funding billions of dollars of the loans by helping companies like Santander Consumer USA Holdings Inc. borrow in the asset-backed securities market, essentially shunting money from bond investors to finance companies. Wall Street banks packaged more loans from finance companies into bonds in the first quarter than the same period last year, and Wells Fargo and JPMorgan remained two of the top underwriters of the securities.
Banks can have legitimate reasons for shying away from making some kinds of loans directly, even as they help investors finance the loans. Money managers like hedge funds have more appetite for riskier assets than a lender with government-insured deposits, for example. And the securities can be built in a way that cushions bond investors against losses in the underlying loans. But giving money managers the chance to invest in debt that banks are increasingly reluctant to touch themselves can at least create the perception that they are foisting trash onto customers, said David Hendler, founder of Viola Risk Advisors.
"Banks always say the securities are well structured. But you can't rely on underwriters' assumptions," Hendler said. "They're there to move a deal."
Spokeswomen for Wells Fargo and JPMorgan declined to comment. Wells Fargo's stock has declined 1 percent in 2017, while JPMorgan has advanced 2.5 percent.
Investment banks took heat after the 2008 financial crisis for bundling debt into bonds that later soured. A U.S. Senate subcommittee report in 2011 said that "investment banks were the driving force behind the structured finance products that provided a steady stream of funding for lenders originating high risk, poor quality loans and that magnified risk throughout the U.S. financial system."
The risks to Wall Street firms from subprime auto bonds are smaller. Big banks provide lines of credit to finance companies that make subprime loans, but these tend to be a small part of major firms' balance sheets. The auto loan bond market is much smaller, too: there were just $192.3 billion of securities backed by auto loans, including prime and subprime, outstanding at the end of March according to the Securities Industry and Financial Markets Association, compared with around $8.9 trillion of residential mortgage bonds at the end of last year.
Banks might not get hurt much by subprime auto securities, but for investors who buy them, the risks are growing. Subprime borrowers are falling behind on their car loan payments at the highest rate since the financial crisis. General Motors Co. expects car prices to drop 7 percent this year and auto lender Ally Financial Inc. reported last month that prices fell that much during its first quarter, so the value of the loans' collateral is dropping. Even Wells Fargo's analysts who look at bonds backed by car loans cautioned in March that it may be a good time for investors to cut their exposure. At least one Wall Street bank has steered clear of underwriting bonds backed by subprime auto loans. Bank of America Corp., which bought the biggest maker of risky mortgages as the housing bubble was bursting, has consciously avoided the subprime auto bond market out of fear that its reputation could suffer in a downturn, according to a person with direct knowledge of the matter. In consumer auto lending, Bank of America focuses on prime customers. The bank paid out more than $65 billion in mortgage-related legal settlements after the crisis.
Demand for subprime auto securities has been strong as investors clamor for debt that offers higher yields than Treasuries. Total issuance jumped to $7.1 billion in the first quarter from $5.9 billion in the same quarter last year, according to data compiled by Bloomberg. The risk premiums, or spreads, that money managers demand for three-year top-rated subprime auto bonds was just 0.27 percentage point in mid-March compared with benchmark swap rates, down from 0.95 percentage point a year earlier, around the tightest since the financial crisis, according to data from Wells Fargo.
As issuance volume rises in the bonds, Wells Fargo is growing along with the market, and JPMorgan is growing faster. Wells Fargo's market share for underwriting subprime auto bonds was around 23.5 percent in the quarter, about the same as for all 2016, according to Bloomberg data. JPMorgan's was 16 percent, up from 14.6 percent for all last year.
Even with overall strong demand, some investors have been skeptical and have sought to bet that subprime auto bonds will tank the way mortgage bonds did a decade ago. Losses in loans backing these securities have jumped in recent months, rising to 7.5 percent in February from 7 percent a year earlier. That's a surprising development because the economy is in a seven-year expansion, and job markets have been relatively strong.
Losses in individual loans may not translate into problems for bond investors, because the securities have protections built in to help them withstand stress. For example, the bonds may be backed by so many extra car loans beyond the face value of the securities issued that up to a point, investors won't suffer losses from bad loans.
That safety for bondholders should be contrasted with the fate of individual borrowers who can get hurt by bad loans, said John Van Alst, a staff attorney at the National Consumer Law Center in Boston.
"These bonds are designed to enrich and protect Wall Street, and only Wall Street," Van Alst said.
Wells Fargo decided in 2015 to limit its subprime auto lending to 10 percent of the car loans it makes, the New York Times reported. Its 29 percent decline in overall car lending in the first quarter, compared with the same period a year earlier, comes after a 15 percent decline in the fourth quarter. In January, Chief Financial Officer John Shrewsberry said, "We currently expect balances in our auto portfolio to continue to decline in the near term."
JPMorgan's Gordon Smith earlier this year said the bank started cutting its subprime mortgage bond underwriting in 2013. In 2016 it looked at its some of its auto loan exposure again, and cut further.
"Instinctively we just felt with the risk team that we didn't like it," Smith said.
