Santander Consumer USA Bets on Credit Recovery in Auto Lending

The subprime auto lender Santander Consumer USA Holdings surprised investors Tuesday by lowering its provision for credit losses, defying concerns about weaker lending standards across the market.

The Dallas-based lender set aside $560 million in the fourth quarter, down from $629 million a year earlier. The reserve shrunk despite the fact that Santander Consumer's delinquency rate and chargeoffs continued to rise in the fourth quarter.

The decision marked a reversal from November, when the firm indicated that its loss reserve was unlikely to fall. In the third quarter, Santander Consumer had reported a 29% year-over-year jump in its quarterly provision for credit losses.

Chief Executive Officer Thomas Dundon explained the move Tuesday by saying that he believes credit losses started to stabilize last year. He also made the case that the price borrowers are paying has now risen to the point where lenders are being adequately compensated for risky loans.

"As risk increases, sometimes the market lags behind in terms of getting the correct risk-adjusted yield," Dundon said during a conference call with analysts. "We are happy with the price and the risks that we're taking."

The company's fourth-quarter results lent some credence to the idea that its losses remain manageable. Santander Consumer reported net income of $247 million in the fourth quarter, up from $114 million a year earlier. The company's return on average assets rose to 3.1% from 1.8% in the fourth quarter of 2013.

Mark Palmer, an analyst at BTIG who has a "buy" rating on Santander Consumer, wrote in a research note Tuesday that "somewhat higher losses are acceptable within the context of the company's business model insofar as it is well compensated for the additional risk it takes."

Investors, who have punished Santander Consumer's stock price since its debut in January 2014, drove shares up more than 7% on Tuesday. Still, the stock has lost about 20% of its value since last year's initial public offering.

Santander Consumer is 60.5% owned by the U.S. unit of the Spanish giant Banco Santander, while 29.1% of the shares are publicly traded. In addition to subprime auto lending, the company also makes prime auto loans and personal loans to consumers.

But it is the subprime business, which has come under sharp scrutiny from regulators, that has been weighing down investors' perception of Santander Consumer. The firm has received subpoenas from the Justice Department and from state regulators in both New York and Massachusetts.

Dundon said Tuesday that Santander Consumer has adjusted its understanding of what regulators expect. "What we've tried to do is incorporate those expectations into our risk management and governance processes, and that's clearly a transition that costs you time and money," he said.

"So we're going to continue along those lines and try to find a way to make this enhanced process work for our business," Dundon added. "You can still make money and follow regulatory expectations. It's just a little harder, and we're prepared to do it."

Dundon also said that Santander Consumer is looking to build the portfolio of auto loans that it originates and sells, while holding onto the servicing rights. The boom in subprime auto lending has been driven by strong demand from bond investors.

"We are putting in a lot of time and energy to be more sophisticated in determining what we want to hold on our balance sheet, and what we want to sell and service for others. And building out that marketplace is a big focus of ours," he said.

Despite Santander Consumer's assurances about stabilizing credit performance, the percentage of its loans that were 31-60 days delinquent rose to 9% in the fourth quarter, up from 8.5% a year earlier. Net chargeoffs increased from $494 million to $591 million.

In its most recent report on risks in the banking business, which was published last fall, the Office of the Comptroller of the Currency warned that the length of auto loans has been increasing at the same time that the amounts being financed and size of loans as a percentage of the automobiles' value have both been on the rise.