How Much Are Banks Exposed to Subprime? More than We Think

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Wolf Richter,

Wells Fargo has $81 billion in exposure to loans that, on paper, it isn’t exposed to.

A couple of days ago, when I wrote about the soaring delinquency rates in subprime auto loans – the worst since 1996 – and the collapse of three specialized small subprime lenders, I stumbled over a special nugget.

One of the collapsed small lenders, Summit Financial Corp, when it filed for bankruptcy on March 23, disclosed that it owed Bank of America $77 million. This loan was secured by the auto loans Summit had extended to subprime customers, who’re now defaulting in large numbers. In the bankruptcy documents, BofA alleged that Summit had repossessed many of these cars without writing down the bad loans, thus under-reporting the losses and misrepresenting 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 tiny lender and doesn’t really matter. But there are a whole slew of these nonbank lenders, specializing in auto loans, revolving consumer loans, payday loans, and mortgages. Some of these nonbank lenders specialize in “deep subprime.” And some of these lenders are fairly large.

Since the Financial Crisis, big banks have mostly avoided subprime lending. Instead, they’re lending to the companies that then provide financing to subprime customers. And BofA is finding out just how much risk it was taking with its loan to Summit that was secured by now defaulting auto loans that were secured by cars that, once repossessed, are worth only a fraction of the loan value when they’re sold at auction.

How much banks are exposed in this manner to subprime loans – not just auto loans, but also subprime mortgages, and subprime consumer loans – is somewhat of a mystery. But some clues are percolating to the surface. According to an analysis by the Wall Street Journal of regulatory filings, bank loans to nonbanks lenders have surged sixfold since the Financial Crisis to nearly $345 billion at the end of 2017. Here are the top contenders:

  1. Wells Fargo: $81 billion, up from $14 billion in 2010
  2. Citigroup: $30 billion
  3. Bank of America: $30 billion
  4. JP Morgan: $28 billion
  5. Goldman Sachs: $22 billion
  6. Morgan Stanley: $16 billion.
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Banks extend these loans at relatively low interest rates because the loans are collateralized and don’t expose the banks directly to the risks of lending to subprime consumers. Nonbank lenders make money off the spread between the relatively low cost of money and the often double-digit rates they charge consumers. The spread is so sweet and enticing that it caused a boom in the sector and attracted private equity firms.

Among the PE firms that plowed into the auto loan subprime businesses is Blackstone Group, which acquired a majority stake in Exeter Finance in 2011. And it has been rough. The company cycled through three CEOs. As of September 2017, Exeter charged off about 9% of its loans, according to S&P Global, cited by the Wall Street Journal.

At the same time, Wells Fargo’s own pristine-credit auto-loan portfolio experienced charge-offs of only 1%.

But Wells Fargo – along with Barclays, Deutsche Bank, and Citigroup – is exposed to Exeter’s subprime loans via a credit line of $1.4 billion. Exeter draws on this line to fund the subprime loans, and then periodically, it creates subprime auto-loan-backed securities that it sells in slices as bonds to investors. It likely hangs on to the riskiest junk-rated slices that take the first losses. At the same time, there is intense interest in the higher-rated slices. Exeter then uses the proceeds to pay down the credit line, which creates room to fund new business.

So via these asset-backed securities, the risks get spread some more. But Exeter remains exposed to the first losses of the asset backed securities, and it remains exposed to the loans that it hasn’t sold off yet. And the banks remain exposed via the credit line to Exeter and its loans. This works really well, and the fees and spreads are really sweet, until consumers begin to default more than anticipated, which is the case now.

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Still, banks won’t lend 100% of the value of the collateral – namely these subprime loans. They might lend 80% or so. And in a bankruptcy they have a right to those loans, and when those customers default, and when losses from prior defaults had been hidden, it gets messy in a hurry for the bank, with the collateral value plunging by the day.

Before the Financial Crisis, the spreading of risk in all directions away from the banks was thought to protect the banks. In the end, risk may have been spread, but it didn’t stay spread, so to speak. Some of it snapped back to where it had come from. And the banks’ exposure to nonbanks that are engaged in subprime lending is one of those snap-back risks.

We still don’t fully understand the magnitude of it, and even the banks might not, as BofA is finding out in the Summit bankruptcy. Summit is tiny, and any losses will be a rounding error for BofA. But as far as we know, BofA has $30 billion in exposure, and Wells Fargo $81 billion, to loans that they are, on paper, not exposed to. And those are more serious numbers.

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