Santander Consumer Continues Aggressive Push into Subprime

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Santander Consumer USA Holdings isn't backing off of its aggressive play for borrowers with blemished credit, even as the company's auto lending practices remain under intense scrutiny from regulators.

The Dallas company — a unit of the Spanish banking giant Banco Santander — said Thursday that it plans to expand the size of its subprime auto book.

It is a move that will involve taking on increasing — and ongoing — credit losses, said Jason Kulas, the company's chief executive, who pointed out that there is a "very direct relationship" between higher provisions and higher profits in the subprime auto business.

"We feel like we are doing it in a way that makes sense. We are doing it with conservative structures, and we are seeing — we are capitalizing on the opportunity in the market," Kulas said during the company's quarterly earnings call.

Santander Consumer increased its second-quarter estimate for loan losses by 25% from a year earlier, to $739 million. Still, the company's profits rose 16%, to $285.5 million.

The call marked a debut of sorts for Kulas, who took over as CEO earlier this month in a surprise executive shake-up.

Kulas, who previously had served as chief financial officer since 2007, succeeded Thomas Dundon, who left Santander Consumer to "pursue new opportunities," the company said in July 2 release. Dundon remains on the board.

As part of the reshuffling, Blythe Masters, a longtime JPMorgan Chase executive, took over as chairman of the company. Masters also currently serves as CEO of the blockchain technology company Digital Asset Holdings.

Kulas told investors during the call not to expect major changes now that he holds the reins.

"Many aspects of the strategy of this business were developed together with Tom and I discussing the business literally every day," he said.

The company's push to hold a higher concentration of risky loans comes as federal authorities have launched investigations into its risk-taking and consumer protections.

Santander Consumer was subpoenaed last year by the Justice Department over its underwriting and securitization practices for subprime loans. Other subprime lenders — including GM Financial, Ally Financial and Consumer Portfolio Services — have received subpoenas from federal regulators.

State regulators in New York and Massachusetts also have investigated Santander Consumer.

Additionally, Santander Holdings USA — the auto lender's parent company — has had a tumultuous year. The Federal Reserve earlier this month hit the company with an order to improve its risk management processes.

The holding company has failed its Federal Reserve stress test two years in a row, and it also entered into a written agreement last year over its capital distributions.

"Even though maybe the letters aren't addressed to us, we are a big part of the organization and we intend to be a part of the solution," Kulas said, addressing the issues associated with the holding company.

Expect a "continued marginal increase" in expenses related to compliance matters, Kulas said. Operating expenses rose 19% in the second quarter, to $253.4 million.

Despite those concerns, executives said that Santander Consumer is building a profitable, long-term model that includes a hefty amount of risk.

A central part of that strategy involves selling off high-quality assets and retaining lower-quality loans, Kulas said.

Asset sales to the secondary market drove the company's quarterly profits. Gains on investments — including loan securitizations — more than quadrupled, to $86.6 million.

Many of those gains came from the sale of prime loans, generated, in part, from the company's partnership with Chrysler. More than a third of the company's $7.6 billion in originations came from its financing relationship with the Detroit-based automaker.

"If you look at the real growth opportunity in this business over time, it will be in prime and super-prime paper through the Chrysler relationship," Kulas said.

That means there will be a "migration down market" in the company's loan book, Kulas said, pointing to lower credit scores among its borrowers.

Loans with FICO scores under 600 accounted for approximately 65% of retail installment contracts, compared with 59% a year earlier.

Rivals are following similar paths. Ally Financial, one of Santander's primary competitors, recently received approval from regulators to fund a higher portion of its car loans with deposits. Auto loans to borrowers with FICO scores of 620-660 will now be allowed into Ally Bank, the Detroit company's online deposit franchise.

Shares of Santander Consumer USA fell 2.2%, to $24.55, in trading Thursday. One reason may have been its decline in return on average equity to 28% last quarter, compared with 33% a year earlier.

The trading decline will likely be short-lived, Mark Palmer, an analyst with BTIG, wrote in a research note to clients. "We view the provision increase as benign insofar as it arose from a previously disclosed shift to a higher-margin portfolio mix," he wrote.

Kulas said the company has a handle on the subprime market, and he urged investors not to draw a comparison with the subprime mortgage bust.

There are more regulatory controls in place today than in previous bubbles, he said. Plus, many of the biggest players in the auto lending market come from the banking industry, which is highly regulated.

Santander Consumer will pull back its subprime strategy if it sees a rise in the number of competitors "willing to do things for margins and returns" that aren't sustainable over the long term, Kulas said.

"We sort of know how that story ends," he said.

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