Is a soft landing possible?
Last week Oodle Financial Services successfully priced its fifth UK Auto ABS transaction, Dowson 2022-1. The deal was a strong success with the AAA notes almost 3x covered and the mezzanine tranches close to 5x, allowing the arranging banks to tighten pricing significantly from Sonia +1.1% to Sonia +0.92% on the senior notes. While we were unsurprised to see plenty of demand for one-year floating rate AAA notes and three-year floating rate mezz at these levels in today’s environment, we do have some ESG concerns over this type of lending.
Oodle is a sub-prime auto lender (mainly for used cars) based in Oxford. Sub-prime Auto ABS is a common product in the US, in the UK we only see a handful of these kind of lenders, with Oodle and Blue Motors being two of the more regular issuers. From a credit perspective the structures of Oodle’s trades are sound in our view; there is a lot of structural protection and excess margin, and the deals pay down quickly, so bond investors tend to be well protected. However, as investors we of course need to look beyond the technical details and scrutinise the assets and lending standards backing the platform.
Sub-prime auto loans have particular characteristics, such as the type of borrower being targeted and the rates being charged. These borrowers typically have lower credit scores and it’s not uncommon to see historic payment problems. Most lenders in this part of the market will use risk-adjusted pricing, meaning they charge more to higher risk borrowers to compensate for the higher credit risk. This is also the case for Oodle, whose typical APR ranges from 6% to 33% on top of commissions of up to 14% of the loan.
This high APR helps Oodle’s ABS structures absorb higher levels of losses, a helpful feature because in recent years Oodle has been running annual default rates of 8-10%. That means nearly one-in-10 customers is failing to make payments and having their car repossessed each year. A 8-10% default rate is already very high, and that worries us given the economic environment has recently been strong with unemployment low. Now with a higher risk of recession and soaring inflation levels, we see a risk that more vulnerable borrowers will struggle to keep making payments. We don’t expect that these will be high enough to put Oodle’s ABS bondholders at risk of losses, but it does highlight why we often take a dim view of lenders offering high interest loans to borrowers that should arguably be protected against taking on more debt. We appreciate there are higher risk categories of borrower that need servicing, and while there may be a valid reason for someone to finance a six-year-old diesel vehicle at a high rate, we have to question whether some of the borrowers in these pools should have been denied credit rather than being charged over 30% APR.
If we then couple this with the limited ‘skin in the game’ from the originator in this transaction – Oodle retained a 5% vertical slice of the deal but also sold 5% excess spread notes, making their risk retention practically zero – then this looks to us like a fee business, particularly when compared to typical funding trades from the more traditional auto lenders. Clearly this trade hasn’t been labelled as a ‘social’ bond and we are aware there is a price for everything.
However, it does worry us that the book was so handsomely oversubscribed when investors claim to take ESG seriously. For the reasons above this transaction isn’t something we could consider investing in, and we’d need to see some significant development before this would pass our ESG screening process.