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A Match Made In Subprime Hell

Coming off of the best year for ABS issuance in the U.S. since 2008 and just in time for both total auto loans and total student debt outstanding to top the $1 trillion mark, we get a match made in FICO hell as the subprime lending unit of AIG (the poster child for misjudging credit risk via CDS) Springleaf has purchased OneMain, another subprime lender that’s been relegated to Citi’s Citi Holdings trash bin for years. Springleaf, whose shares rose 25% today as if no one had seen this deal coming, is paying $4.25 billion for OneMain and expects the deal to be accretive to 2017 earnings by nearly $500 million. 

The deal creates a subprime lending powerhouse with some $14 billion in possibly-not-toxic receivables. It also brings together two companies that have spearheaded the unlikely re-emergence of ABS backed by subprime personal loans. In 2013 for instance, Springleaf did a $604 million ABS deal backed by nearly 200,000 personal loans (average FICO 602) with maturities ranging from 2-4 years and carrying fixed rates as high as 35%. Here’s what we had to say about the deal at the time: 

Yet even in the last days of the bubble, Wall Street had a certain integrity - it sold securitized products collateralized by houses, which as S&P, and certainly Moody's, will attest were expected to never drop in price again. But one thing that was hardly ever sold even in the peak days of the 2007 credit bubble were securitizations based on personal-loans, the reason being even back then everyone's memory was still fresh with the recollection that it was precisely personal-loan securitization that was at the core of the previous, and in some ways worse, credit bubble - that of the late 1990s, which resulted with the bankruptcy of Conseco Finance. Well, in a few short days, those stalwarts of suicidal financial innovation Fortress and AIG, are about to unleash on the market (or at least those who invest other people's money in the absolutely worst possible trash to preserve their Wall Street careers while chasing a few basis points of yield) the second coming of the very worst of the last two credit bubbles.

Nevertheless, the deal was oversubscribed (investors reaching for yield wherever the can find it, even if it’s via a chunk of someone’s jet ski loan) and as Reuters noted at the time, there was “heavy interest in the lower tranches” meaning investors didn’t just want a piece of the deal, they wanted the worst piece (which incidentally carried a 5% coupon). For all the visual learners out there, here’s what this particular deal looked like: 

 

Emboldened (and probably surprised) by their initial success, Springleaf was back at it not four months later, contemplating another $400 million ABS deal. 

In 2014, the company set up two VIEs (Whitford Brook Funding Trust 2014-VFN1 and Springleaf Funding Trust 2014-A's) for the purpose of selling almost $900 million in ABS backed by consumer loans, and just last month, the company priced a $1.16 billion deal. 

For its part, OneMain did a $760 million deal in April of last year (backed by quite a few unsecured loans) followed by a $1.2 billion dollar deal around three months later. The company went on to do 2015’s first securitization backed by consumer loans, a January deal that was upsized to $1.2 billion. 

While the totals here aren’t large relative to size of the ABS market, the fact that these deals are seeing significant interest given the underlying assets is disturbing considering both recent trends in the subprime auto market and the fact that investors are likely to become even hungrier for yield as central banks continue to keep a lid on spreads for higher quality assets. 

The larger concern however, is that today’s deal combines the two largest players in this market, both of which have undoubtedly been emboldened by the success they’ve seen with recent securitizations. For evidence of this, look no further than the following exchange between Springleaf CEO Jay Levine and Citigroup (imagine that) analyst Donald Fandetti on the company’s Q3 call: 

Fandetti:  

Jay, I was wondering if you talk about the depth of the securitization market for personal loans. Obviously, you did a big deal this quarter. Are investors very receptive to this product? And also, it looks like you retained some of the notes, was that more opportunistic this quarter?

Levine: 

Great question. What I'd say is a couple things. I think there are 2 different types of transactions. First, on the personal loans, which is supporting our business and I think we've seen both ourselves and our OneMain competitor both tap those markets. I think we've both experienced overwhelming demand, large numbers of new investors coming into each transaction. And probably both times and a few times we've gone, as well as I think from what we've heard. When they went to the market, there's been real demand and we all could have of done larger size than was anticipated at the time.


So I would say while it's a reasonably new market or a back to the future market, what that had been bigger while ago but has been renewed over the last couple years. We think there's significant room to expand beyond where either of us have gotten so far. And the piece that we kept on the SpringCastle, Don, it was strictly opportunistic. We had cash, there were liquid securities, there was significant demand. But we thought it was a good place to put some of our cash to work given our comfort with the portfolio.

 

This makes it abundantly clear that the combined entity will almost undoubtedly look to meaningfully increase the number of personal loan securitizations brought to market, and with only $14 billion in combined receivables, it’s not hard to imagine the company looking to ramp up lending in order to feed a market that’s taking down $1 billion in notes at a time. As we saw during the real estate boom, increased demand for loans to feed the securitization machine invariably leads to a relaxation of lending standards something the market for subprime personal loans backed by everything from appliances to jewelry can ill afford if it’s to retain any modicum of stability. Indeed, the companies are already discussing how to speed things up and boost creativity.

From UBS: 

OneMain recently invested $100MM into a new front end system for underwriting to increase efficiencies which will be rolled out across the combined business. Management expects a 5.6% ROA for the combined company (up from the current 3.9% ROA experienced by LEAF). LEAF, which has been growing its loans per branch, anticipates the combined company should be able to achieve beyond the $7MM/branch which OneMain currently experiences.  


LEAF plans to expand its product capabilities including direct auto finance, as well as launch an online origination business in 3Q15. 

...and here’s Barclays: 

Given that neither OneMain nor Springleaf, as standalone entities, has access to cheap deposit funding, we think it is likely that any combined entity would continue to tap the ABS markets for financing. 

Levine (who, by the way, will head the combined company), sounded disturbingly nonchalant on the quarterly call when asked a softball question about the behavior he seems among borrowers: 

Fandetti:

Got it. And then on your customer behavior, what are you seeing these days? Are your customers more willing to take on debt? Obviously, gas prices have come down, that's meaningful to the sub prime market. Does that make you feel a little bit better about the portfolio as well in terms of coverage?

Levine:

Absolutely. It's funny how important just gas on the margin can be to a lot of our customers. I've used this stat probably on every call and every time. Nearly one out of 2 Americans doesn't have the liquidity they need in the bank to support an emergency. And certainly gas prices help. But in general, we're seeing better job stability, we're seeing better income numbers, I think across the board our customer tends to be in better shape.

Actually Jay, it’s not funny at all. Gas prices are that important to your customers because your customers generally don’t have much disposable income. In case the point isn’t clear enough: they are absolutely not the kind of people who can afford to get stuck underneath high interest loans, and besides, if gas prices are that important, it must mean that when oil prices rise, these same customers will once again struggle to make payments. 

Finally, notice how the issue of regulation is quite literally written off as a formality by the Citi analyst: 

Fandetti:

Okay. And then just lastly, to check the box on regulatory for personal loans. Any updates from last quarter, or is it pretty much the same?

Levine:

I'd say status quo. You see what we see. The CFPB has yet to write specific rules around installment loans. There was guidance put out and regs put forward in terms of auto lending. We think that's largely focused on the indirect lenders. 

In other words: nothing to see here folks, move it along.  

*  *  *

It seems to us that the Springleaf and OneMain deal is the product of a yield-starved investor base that, as we’ve mentioned in the past, is predisposed towards Einsteinian insanity thanks largely to an abject refusal to learn from the past. Here we have the two main players in an exceptionally risky market (that has mercifully lain dormant for nearly two decades), merging at a time when investors are literally being forced to take just the kinds of risks the combined entity will be peddling by the billions. 

While the market for non-traditional ABS may currently represent a relatively small percentage of total issuance, note that last month, ABS backed by assets like personal loans was second only to securitizations backed by auto loans (another incredibly dicey market):

In closing, note what we said earlier this week about the inevitable collapse of the subprime auto market, as it is equally (if not more) applicable here: 

This is perhaps the clearest sign yet that we have learned literally nothing from the crisis years. That is, this is precisely the same dynamic and it will end precisely the same way: defaults will rise, investors in assets backed by these loans will suffer outsized losses, and the assets themselves will become completely illiquid.