What the Subprime Auto Pullback at Santander Consumer Means for All

Months after mounting an aggressive play for subprime auto borrowers, Santander Consumer USA Holdings is scaling back its presence in the market, citing aggressive risk-taking by smaller competitors.

The Dallas-based auto lender – a unit of the Spanish banking giant Banco Santander – on Wednesday reported its first decline in auto originations in more than two years. Total originations sunk 6% from a year earlier to $6.8 billion as the company slowed down lending to borrowers with blemished credit.

Chief Executive Jason Kulas described the move as a way to protect the $38 billion-asset company from an overheating market. Pricing has declined to a level that does not warrant the credit risk, he told analysts on a quarterly earnings call.

But the pullback raised questions about the changing dynamics of the subprime auto market – and the long-feared risk of a credit bubble. Large banks have recently curtailed their exposure to troubled borrowers, as smaller players have expanded – and potentially taken on outsize risks, analysts said.

"Some of the legacy peers have effectively pulled back," said Steven Kwok, an analyst with Keefe, Bruyette & Woods. He noted that Ally Financial also trimmed its subprime auto exposure in the first quarter.

Broader changes in the credit markets have been a boon to smaller competitors, Kwok said. The cost of securitizing auto loans has come down in recent months. That has allowed a host of smaller, nonbank companies to use the proceeds to fund more loans.

But red flags have emerged. Kulas said that many small-bank players lack the "sophisticated" tools necessary to assess credit risk in the marketplace.

"We have more data than almost anyone in the subprime space," Kulas said. "We feel very comfortable with risk, but it has to be appropriately priced."

Santander's note of caution marks a notable change of tune. During the first half of last year, the company made an aggressive lending push, with auto originations reaching $7.5 billion in the third quarter.

But it has since reversed course. During the first quarter, originations in the company's core, subprime auto business plunged 15%, to $2.6 billion. Additionally, loans made through Chrysler dealers to borrowers with scores of under 640 fell 8%, to $1.2 billion.

The company signed a 10-year, private-label agreement with Chrysler in May 2013.

Meanwhile, originations to prime borrowers increased 11%, to $1.2 billion

Santander is looking to turn the corner after a tumultuous stretch marked by a series of accounting woes and regulatory snafus.

The company last month restated its earnings going back to 2013 in response to an inquiry from securities regulators about the way it calculates its provision for loan losses.

Throughout the year, Santander has also rattled investors' nerves, as a jump in chargeoffs raised questions about asset quality. But Kulas has repeatedly assured investors that Santander has its business under control.

Analyst agreed with that assessment. Santander has demonstrated an ability to take appropriate – and profitable – risks in the auto market, according to Christopher Donat, an analyst with Sandler O'Neill.

"The ideal environment for Santander Consumer isn't blue skies and clear sailing," Donat said.

Compared with smaller firms unaffiliated with banks, Santander has a business model that is better suited to handling the risks of subprime auto lending, Donat said. It has a more diverse revenue base, and it also has the infrastructure necessary to spend time with troubled borrowers, he said.

In addition to Santander, Ally Financial has also scaled back its subprime auto lending. During the first quarter, loans to borrowers with credit scores below 620 accounted for 12.6% of originations, compared with 13.9% a year earlier.

But not all big banks are pulling back. Capital One Financial, for instance, said in a conference call Tuesday that it had seen an uptick in subprime originations compared with a year earlier.

If one looks at long-term trends, though, larger banks are stepping away from the market, Kulas said.

"We have not seen among the larger players a sustained" attempt to increase market share, he said.

While Santander continues to focus on higher-quality loans, it is still feeling the pinch from its aggressive subprime push last year.

During the first quarter, the net chargeoff ratio was 8.2%, compared with 6.1% a year earlier. That figure is expected to rise in the coming months.

"Some of the loans originated in 2015 are going through their higher loss stage," Kulas said, noting that he expects chargeoffs to climb in the coming months.

Additionally, the company expects declines in the prices of used cars to result in lower recoveries on repossessed vehicles.

Over the long term, though, analysts said that Santander's recent efforts to pull back on subprime will likely bode well for its loan book.

"There's not too much to be concerned about," Donat said.