The collapse of two U.S. auto dealers and a growing pile of delinquent car loans are threatening to deliver losses in a corner of Wall Street that, until now, has been a sea of calm: the asset-backed securities market.
Bonds backed by car loans made by U.S. Auto Sales and American Car Center, two used-car dealers that shut their doors earlier this year, have been veering into distress in recent weeks. Borrowers have been falling behind on payments, and Citigroup believes that some of the riskiest parts of three different asset-backed deals could fail to return principal to investors.
Any lost principal would be a rare event in the ABS market, where subprime auto bonds haven't failed to return investors' money since the 1990s, Citigroup said. Prices on a bond issued by U.S. Auto Sales, owned by the private equity firm Milestone Partners, have dropped to distressed levels, trading at a little over 18 cents on the dollar on June 26, according to Trace data.
The disruption is a major test for the subprime auto ABS market, where issuance grew by more than 70% to $40.5 billion in the five years through 2021, according to data compiled by Bloomberg News.
"The economy is not doing well, and there's a flood of shaky issuers that are going out of business" in the auto market, John Kerschner, head of U.S. securitized products at Janus Henderson, said in an interview. When lenders do fail, "it's hard to get borrowers to pay back their debt, especially because sometimes it's not clear where to send the payments."
Milestone Partners didn't reply to a request for comment, while a spokesperson for York Capital, which backed ACC before the bankruptcy filing, declined to comment.
As the Federal Reserve ends quantitative easing and tightens the money supply, credit is harder to come by across the economy. Consumers, meanwhile, are burning through their pandemic-era savings.
The deterioration of the bonds issued by ACC and U.S. Auto Sales comes months after both companies announced they were closing their dealerships. Both firms transferred the collection of payments on their loans, known as servicing, to Westlake Portfolio Management after going bust. A spokesperson for Westlake declined to comment.
"The bonds are deteriorating in part" because it takes a few months to transfer the servicing of the loans "and meanwhile consumers may cease making payments," Eugene Belostotsky, a securitized products strategist at Citi, said in an interview. "The lenders went under because borrowers were not paying back the debt, now that's just accelerating."
Moody's Investors Service further downgraded some of U.S. Auto Sales ABS in late June, for moving the E note of the 2022 deal to a C rating. The ratings firm noted that there are shortfalls in the pools of money available to pay bondholders because dealerships haven't fully reimbursed trusts for items like unearned vehicle service contract payments.
One of the reasons auto ABS losses are almost unheard of is the use of investor protections known as overcollateralization. That means the amount of loans backing the bonds exceeds the size of the principal on the bonds, allowing at least some borrowers to default without any losses for bondholders.
But for the two subprime issuers that ran into difficulties this year, those protections have waned dramatically on some securities. The overcollateralization for the 2022 U.S. Auto bond has fallen to just 5.5%, compared with a target of 35%, according to a Citigroup report dated June 30.
Not all bonds in these ABS deals will be impaired, money managers who are monitoring the bonds say, but investors who hold the riskiest portions of the deals could be wiped out.
"We are going to see more securities getting hit going forward," said Dan Zwirn, chief investment officer at Arena Investors, in an interview. "Subprime lenders are in for a reckoning."
— With assistance from Charles Williams and Scott Carpenter
