Did Santander Consumer's Credit Picture Just Get Harder to Read?

Santander Consumer USA Holdings made several headlines Thursday, but perhaps the most significant development was a shift in the way the embattled auto lender calculates its set-asides for bad loans.

By changing how it determines its quarterly provision for credit losses, the Dallas company boosted third-quarter profits — and raised questions about the transparency of its loan book at a time when regulators are second-guessing rapid growth in the auto-loan sector.

The line item—an indicator of overall asset quality—has caused headaches for the subprime lender over the past year. The company's provision has climbed steadily since the fourth quarter, as it aggressively courts borrowers with blemished credit.

The change helped Santander Consumer reverse course. Its third-quarter provision dipped 3%, to $744 billion. Without the changes, the provision would have been $878 million, the company said. Overall, profits rose 17% from a year earlier, to $223.9 million, because of a variety of factors.

"The provision model has been a focal point each quarter since the [initial public offering]" last year, Jason Kulas, the $36 billion-asset company's chief executive, said during a call with investors. "We hope this provides more clarity around our loan-loss provisioning, and there should be less fluctuation from quarter to quarter."

The timing of the accounting change is significant. Competition in the market for subprime auto loans has intensified over the past few months, executives said during the call.

"This is a little bit of a developing story," Kulas said, noting competition from "players across the board" has put pressure on prices, particularly for lease contracts for subprime borrowers.

Competition has primarily increased for borrowers with credit scores between 550 and 640, Kulas said. That, in turn, has put pressure on revenue from subprime leases.

Still, the company has shifted its loan book to "lower credit, higher-loss loans," Kulas said.

Credit scores for the company's retail installment contracts have declined over the past year. In the third quarter, 64% of borrowers had FICO scores under 600, compared with 60% a year earlier.

Santander's decision to overhaul its accounting model also comes as banking regulators increase their scrutiny of auto financing.

In a speech last week, for instance, Comptroller Thomas Curry urged auto lenders to be more cautious in the way they grant credit.

"How these auto loans, and especially in the nonprime segment, will perform over their life is a matter of real concern to regulators. It should be a real concern to the industry," Curry said.

Santander Consumer, of course, has been the subject of several investigations into risk-taking and consumer protections.

The company—a unit of the Spanish banking giant Banco Santander—was subpoenaed by the Justice Department for information on the way it underwrites and securitizes subprime loans. Officials in New York and Massachusetts have also launched investigations.

During the third-quarter call, Santander Consumer executives emphasized that that the accounting changes will help the company adjust for "seasonality" in its business.

Credit performance fluctuates throughout the year—declining, in particular, in the second half, executives said.

The calculations will have a "smoothing" effect on the company's loan-loss provision, said Jennifer Davis, interim chief financial officer.

"Volatility was a real issue for us," Kulas said, pointing out that higher provisions in the second and third quarters came, in part, because of a "self-imposed" method of calculating losses.

The overhaul shows Kulas making his mark on the company. He took over as chief executive in July in a surprise executive shake-up. He previously served as CFO, after joining the company in 2007.

His comments on Thursday, however, marked a notable shift in tone from the previous quarter.

Kulas defended the company's growing loan-loss provision as a cost of doing business in subprime auto finance during a July call with investors.

There is a "very direct relationship" between higher provisions and higher profits in the auto business," he said.

Analysts welcomed the accounting changes. Under the new method, it will be easier to distinguish changes in credit quality from seasonal effects, said Vincent Caintic, an analyst with Macquarie Research.

"It was a little bit more difficult to see the change in credit underwriting versus seasonality in the past," Caintic said in an interview.

The change puts Santander Consumer in line with other auto lenders, he added.

During the call, Mark Devries, an analyst with Barclays, recommended that Santander Consumer provide additional disclosures, to show how the company moving "up or down the credit curve."

Investors reacted negatively after Santander released its quarterly results. Shares of Santander had fallen 15%, to $18.98, in midafternoon trading.

Meanwhile, Santander Consumer said it plans to continue growing its subprime book and selling higher-quality loans to the secondary market.

As part of that plan, the company said it would sell off its personal lending business, to focus more on making and selling car loans.

"We believe the current auto-lending environment is sufficiently complicated to deserve management's full attention," said Christopher Donat,, an analyst with Sandler O'Neill, in a research note to clients.

Kulas also reassured investors that the company remains "conservative and rational" in its approach to subprime lending.

If price competition continues at an aggressive clip, the company will pull back its focus on the subprime market, he said.

He also said that the company is planning for a "tremendous amount of upside" from its contract to make loans through Chrysler dealers, which involves higher-quality loans. That contract will be in place another eight years, Kulas said.

"We have discipline, and we're going to do the right thing," he said.