RMBS and the changing investor landscape
May 2016 | SPOTLIGHT| BANKING & FINANCE
Financier Worldwide Magazine
In a persistently low-interest rate environment, investors have been scrambling for high-yield opportunities across a variety of asset classes. The last several years have seen an explosion in the issuance of high-yield debt, collateralised loan obligations, and securities backed by consumer automobile loans. This surge, however, has been met by cautionary messages regarding the combination of loosened underwriting standards and increasingly greater investor demand to ‘reach for yield’.
Securities backed by subprime auto loans in particular have attracted attention similar to the issues that characterised and helped fuel the issuance of residential mortgage-backed securities (RMBS) prior to the financial crisis. This includes questionable lending practices, lax underwriting, falsified borrower information and market exuberance. Exasperating the situation is a flood of new auto finance companies entering the market, creating concern that they are lowering standards in order to fight for market share.
In 2015, outstanding balances on auto loans reached an all-time high of more than $1.25 trillion, with second quarter subprime auto loans comprising around 20 percent of the auto finance market. Securitisations based on these auto loans increased to $20.2bn in 2014, up 28 percent from 2013 and 302 percent from 2010. Continuing this trend, a total of $16.8bn of auto-loan-backed securities were sold through early August of 2015, and, already in 2016, Santander Consumer USA is marketing close to a billion dollars in securities backed by subprime auto loans through its Drive Auto Receivables Trust 2016-A.
Similar to the RMBS that caused the drastic losses during the financial crisis, subprime auto loans are pooled and divided into tranches based on the risk and return of underlying loans and then sold to investors. Many of the top tranches are given investment-grade ratings by ratings agencies, which enables major investors, like pension funds and insurance companies, to purchase the bonds.
A possible bubble in the subprime auto securitisation market has caught the attention of government regulators. In June 2014, the Office of the Comptroller of the Currency released a report which warned banks about risky practices in indirect auto loans citing loosening credit standards, longer terms and rising average losses on defaulted loans. In August 2014, the Department of Justice began an investigation into underwriting criteria in the securitisation of subprime auto loans. The SEC and United States Attorneys from New York, Michigan, New Jersey and Georgia, among other states, are looking into General Motors, Santander Consumer USA Holdings, Capital One, Ally Financial, Toyota Motor Credit Corp., American Honda Finance Corp. and Consumer Portfolio Services. Deutsche Bank AG officials are performing their own review of whether employees exaggerated demand in marketing new securities backed by risky auto loans, potentially suppressing yields for investors.
The dynamics at work in the market for subprime auto-backed securities are eerily similar to the problematic RMBS issuances in the early to mid-2000s, creating fertile ground for potential litigation. In the fallout of the subprime mortgage market, investors pursued a number of successful claims against issuers, underwriters and rating agencies regarding their role in the sale of RMBS. Federal claims were generally brought under Sections 11, 12 and 15 of the Securities Act of 1933 (Securities Act) 15 U.S.C. § 77a et seq., with state claims stemming from Blue Sky laws covering breach of contract and warrantees, negligent misrepresentation, as well as fraud.
Given the similarities between RMBS and securities backed by subprime auto loans, it seems more than plausible that the same types of lawsuits may also arise in the subprime auto loan context. While there have yet to be any suits filed regarding auto-loan securitisations, it is important to note key developments in RMBS litigation as it could be applicable to future auto-loan securitisation suits, especially as government investigations near completion.
First, in RMBS proceedings, while plaintiffs must plead and ultimately prove that they suffered a cognisable injury for claims under the Securities Act, the standards are not particularly demanding. For instance, plaintiffs don’t necessarily have to plead out-of-pocket losses as long as they can allege a cognisable injury caused by a decline in the value of securities, even if investors continue to receive scheduled distribution payments. Secondly, plaintiffs in a Securities Act class action can represent a broad class of investors. In a 2012 decision, NECA-IBEW Health & Welfare Fund v. Goldman Sachs & Co., the United States Court of Appeals for the Second Circuit held that a pension fund had standing to sue on behalf of other investors who purchased certificates in different trusts under separate prospectus supplements issued under the same shelf registration statement, so long as the originators of the loans underlying the certificates were the same.
Finally, during the RMBS debacle many investors waited to file lawsuits, or held off intervening in existing class action suits in order to see how cases were developing. Potential subprime auto securities plaintiffs should be aware that the statute of limitations for Securities Act claims are relatively short, in some cases as short as one year from the purchase of a security. It is also worth noting that statutes of limitations for state law claims have been strictly enforced in some RMBS cases, causing several proceedings to be dismissed as untimely. Lessons from RMBS litigation demonstrate that investors in subprime auto securities may have actionable claims prior to the realisation of out-of-pocket losses, class actions may be brought on behalf of large classes and statutes of limitations may be strictly enforced, so it may not pay to sit on the sidelines if subprime auto securities follow a similar path as RMBS.
Craig Weiner is a partner and Ofer Reger is an associate at Robins Kaplan LLP. Mr Weiner can be contacted on +1 (212) 980 7400 or by email: firstname.lastname@example.org. Mr Reger can be contacted on +1 (212) 980 7400 or by email: email@example.com.
© Financier Worldwide
Craig Weiner and Ofer Reger
Robins Kaplan LLP