Big banks are still exposed to a lot of subprime loans
- The big banks have largely avoided subprime loans since the financial crisis.
- Instead, they lend to companies that can provide finance to subprime clients.
- Bank loans to non-banks have increased six-fold over the past decade.
Wells Fargo has $ 81 billion in loan exposure to which, on paper, it is not exposed.
A few days ago, when I wrote about skyrocketing subprime auto loan delinquency rates – the worst since 1996 – and the collapse of three small lenders specializing in subprimes, I came across a special nugget.
One of the collapsed small lenders, Summit Financial Corp, when it filed for bankruptcy on March 23, revealed it owed Bank of America $ 77 million. This loan was secured by auto loans Summit had granted to subprime clients, many of whom are now in default. In the bankruptcy documents, BofA alleged that Summit had repossessed many of these cars without noting the bad debts, thereby underreporting the losses and distorting the value of the collateral (the loans). This allowed Summit to borrow more from BofA to fund more subprime loans, BofA said.
Summit is just a small lender and doesn’t really matter. But there is a whole host of these non-bank lenders that specialize in auto loans, revolving consumer loans, payday loans, and mortgages. Some of these non-bank lenders specialize in “deep subprime”. And some of these lenders are quite large.
Since the financial crisis, the big banks have mostly avoided subprime loans. Instead, they lend to companies which then provide financing to clients at risk. And BofA finds out how risky he was with his loan to Summit which was secured by defaulted auto loans that were secured by cars which, when foreclosed, are only worth a fraction of the loan’s value when they are auctioned.
To what extent banks are exposed in this way to subprime loans – not just auto loans, but also subprime mortgages and consumer loans – is somewhat of a mystery. But some clues come to the surface. According to an analysis of the the Wall Street newspaper regulatory deposits, bank loans to non-bank lenders have increased six-fold since the financial crisis to reach nearly $ 345 billion at the end of 2017. The main candidates are:
- Wells Fargo: $ 81 billion, up from $ 14 billion in 2010
- Citigroup: $ 30 billion
- Bank of America: $ 30 billion
- JP Morgan: $ 28 billion
- Goldman Sachs: $ 22 billion
- Morgan Stanley: $ 16 billion.
Banks provide these loans at relatively low interest rates because the loans are secured and do not directly expose banks to the risks of lending to risky consumers. Non-bank lenders make money from the spread between the relatively low cost of money and the often double-digit rates they charge consumers. The spread is so soft and attractive that it has caused a boom in the industry and attracted private equity firms.
Among the private equity firms that have entered the subprime auto lending business is Blackstone Group, which acquired a controlling stake in Exeter Finance in 2011. And it has been difficult. The company has gone through three CEOs. In September 2017, Exeter canceled about 9% of its loans, according to S&P Global as quoted by the Wall Street Journal.
At the same time, Wells Fargo’s immaculate credit auto loan portfolio suffered write-offs of just 1%.
But Wells Fargo – along with Barclays, Deutsche Bank and Citigroup – is exposed to subprime loans from Exeter via a $ 1.4 billion line of credit. Exeter relies on this line to fund subprime loans, and then periodically creates subprime automatic loan-backed securities that it sells in installments as bonds to investors. It probably clings to the riskier tranches that suffer the first losses. At the same time, there is a lot of interest in the top-rated installments. Exeter then uses the proceeds to pay off the line of credit, creating room to fund new business.
So, through these asset-backed securities, the risks are spread a little more. But Exeter remains exposed to the first losses of asset-backed securities, and it remains exposed to loans that it has not yet sold. And banks remain exposed through the line of credit to Exeter and its loans. It works great, and the fees and the spreads are really sweet, until consumers start to default more than they expected, which they are now.
Yet banks will not lend 100% of the value of the collateral – namely these subprime loans. They could lend about 80%. And when they go bankrupt they are entitled to those loans, and when those customers default, and when losses from past defaults have been concealed, it quickly becomes messy for the bank, with the value of collateral plummeting day by day. day.
Before the financial crisis, it was believed that the spread of risk in all directions away from banks was supposed to protect banks. In the end, the risk may have been distributed, but it did not remain, so to speak, distributed. Some of them have returned to where they came from. And the exposure of banks to non-banks that are engaged in subprime lending is one of those rollback risks.
We still don’t fully understand the magnitude, and even banks might not, as BofA finds out during Summit’s bankruptcy. Summit is tiny and any loss will be a rounding error for BofA. But as far as we know, BofA has $ 30 billion, and Wells Fargo’s $ 81 billion, in loans to which they are, on paper, not exposed. And these are more serious figures.