U.S. banks spent much of the last five years grappling with the legal fallout from the subprime housing bubble.
Now, with the launch of a surprise inquiry by a hard-charging federal prosecutor in New York, lenders are wondering if subprime auto loans are next.
U.S. Attorney Preet Bharara's office sent a subpoena to General Motors' finance arm on July 28 asking for documents related to its underwriting of subprime auto loans. The subpoena also sought information about the assurances that GM Financial provided to investors in securities that are composed of its bundled subprime credits.
GM Financial, which emerged from General Motors' 2010 purchase of the subprime lender AmeriCredit, has made clear that it believes the government's investigation is wider than just one company. "Our understanding is that the request is focused on the subprime auto finance space in general," GM Financial spokeswoman Chrissy Heinke said in an email.
Ally Financial, JPMorgan Chase, Santander Consumer USA and Wells Fargo all declined to say whether they've also received subpoenas. Wells downplayed its potential exposure to the probe, with a spokeswoman saying the bank "principally" holds auto loans on its balance sheet, rather than selling them on the secondary market.
Although there is very little public information about the nascent probe, several key questions are starting to come into focus. Below is a look at four issues that will help determine the investigation's ultimate significance to the subprime auto lending business.
What is the Justice Department's legal theory?
GM Financial's disclosure about the subpoena makes reference to the Financial Institutions Reform, Recovery and Enforcement Act, which suggests that prosecutors see certain parallels between subprime mortgages and subprime auto loans.
Bharara's office in the southern district of New York has used the 25-year-old law known as Firrea to win a series of settlements regarding residential mortgage-backed securities that were packaged by banks.
For the Department of Justice, Firrea provides a relatively easy avenue for the prosecution of financial fraud, as long as there's an effect on a federally insured financial institution. Courts have generally read the language of the 1989 law broadly, to mean that banks can be "affected" by financial fraud even when the bank's own conduct is what's at issue.
As a result, banks have faced Firrea suits for allegedly making faulty representations to the investors in residential mortgage-backed securities.
But in auto lending, the situation may not be exactly analogous. Some of the auto lenders that securitize subprime loans are federally insured financial institutions, but others, including GM Financial, are not.
However, if banks or credit unions invested in auto loan securities that were packaged by GM Financial, that could provide prosecutors the legal justification they need.
In any case, defense lawyers say that prosecutors appear to have been emboldened by the run of success they've had with Firrea in mortgage cases.
"The government has recently been adopting aggressive interpretations of Firrea," said Anand Raman, a partner at Skadden Arps. "And time will tell whether they're pushing it too far."
What is the damage to investors?
One big difference between subprime mortgage securities and subprime auto securities is that the performance of the latter held up much better during the recession.
For residential mortgage backed securities issued between 2001 and 2011, 9.9% of the original balance had expected or realized losses, according to a 2013 report by Fitch ratings. For asset-backed securities, which include auto loans, the comparable figure was just 0.5%.
If auto lenders are eventually sued over alleged misrepresentations about the quality of their loans, they may argue that any defects had a negligible impact on the performance of the securities.
"In the mortgage space, you had MBS that didn't perform. Here we're talking about assets that have performed," said Bill Himpler, executive vice president of the American Financial Services Association, a trade group that represents auto lenders.
He expressed surprise over the GM Financial subpoena, given the auto lending sector's performance. "I'm at somewhat of a loss. And I will tell you, I'm hearing from a lot of folks in the industry that are asking the same questions."
But Chris Kukla, senior counsel for government affairs at the Center for Responsible Lending, countered that the underwriting standards for subprime auto loans are deteriorating. He said it makes sense for prosecutors to start asking questions now rather than waiting for the market to crater.
"This is absolutely appropriate given everything we know about the mortgage crisis," he said. "The last thing we want the regulators to do is stand idly by."
Do auto dealers face potential exposure?
If indirect auto lenders are eventually found to have inadequately disclosed the quality of the subprime loans they packaged, they may seek to be compensated by the auto dealers with whom they partner.
Representatives of both industries auto dealers and lenders have spent time this week researching the question of whether dealers could be on the hook. Ultimately, the answer may vary on a case-by-case basis, depending on the details of specific contracts.
Unsurprisingly, the auto dealers are seeking to downplay their role in the lending process.
"Based on the very limited information that has been reported about the subpoenas that the Justice Department has issued to GM Financial, it is premature to speculate on what, if any, impact this investigation could have on automobile dealers who neither develop the underwriting criteria nor make representations to investors who purchase asset-backed securities," Jonathan Collegio, vice president of public affairs for the National Automobile Dealers Association, said in an email.
Could this investigation have any impact on the battle over dealer markups?
On its face, the securities probe doesn't appear to have anything to do with the long-running fight over the discretionary markups that auto dealers often tack on top of the borrower's approved interest rate.
That dispute, which involves allegations of discrimination against minority borrowers, has been a focus of the Consumer Financial Protection Bureau's efforts in the auto-lending sphere. In December, the CFPB reached a $98 million settlement with Ally after concluding that minority borrowers paid higher prices.
One source close to the lending industry dismissed the notion that the Justice Department's new investigation might have an impact on the battle over dealer markups.
But Stuart Rossman, director of litigation at the National Consumer Law Center, argued that there may be a connection. If the size of the dealer markups is not disclosed to the buyers of auto loan securities, there's a case to be made that the investors have been misled about the risks involved, he said.
A hypothetical auto loan with a 10% interest rate carries a higher risk of default than one with an 8.5% interest rate, of course. But it may not be clear to the investors how much of that difference is due to the borrower's underlying creditworthiness, and how much is due to the markup tacked on by a dealer, Rossman said.
"I would be surprised that any of it is being disclosed to the investors," he said.