Subprime loans are back

Subprime loans are back, according to two pre-Thanksgiving stories. But it isn’t for those looking to buy a home, now banks are issuing them to business owners and those looking for cars.

The New York Times had a story about small businesses using subprime loans. Banks are issuing them as investor demand for yield rises and they’re able to package and sell them:

A small, little-known company from Missouri borrows hundreds of millions of dollars from two of the biggest names in Wall Street finance. The loans are rated subprime. What’s more, they carry few of the standard protections seen in ordinary debt, making them particularly risky bets.

But investors clamor to buy pieces of the loans, one of which pays annual interest of at least 8.75 percent. Demand is so strong, some buyers have to settle for less than they wanted.

A scene from the years leading up to the financial crisis in 2008? No, last month.

The company involved was Learfield Communications, of Jefferson City, Mo., which owns multimedia rights to more than four dozen college sports programs and which made just under $40 million last year in a common measure of earnings. But its $330 million loan package from Deutsche Bank and GE Capital on Oct. 9 highlights how five years after a credit bubble burst, a new boom is taking shape.

Companies like Learfield are the belles of the ball this year. Wall Street and private equity firms, hedge funds and other opaque financing pools have grown frustrated by low returns on other forms of debt and turned instead to riskier but more lucrative bets on ever-smaller companies. The Learfield case is notable for the leverage involved — the company was able to borrow more than eight times its earnings — and that has raised eyebrows in some credit circles.

The story went on to chronicle the history and some of the downfalls of subprime loans:

Leveraged loans became popular before the 2008 collapse but nearly disappeared afterward, regarded as a symbol of unbridled lending. But they started to return in 2010 and are now back in force, with volumes of $548.4 billion this year through Nov. 14, already exceeding the precrisis level of $535.2 billion in 2007.

The type of leveraged loans that Learfield took out are known as covenant-lite, financial lingo for loans that lack the tripwires that could alert investors to any potential financial troubles at the company that could affect repayment. More than half of all leveraged loans issued this year have been the so-called cov-lite types, double the level seen in 2007 on the eve of the credit crash.

Bloomberg Businessweek wrote a piece about the rise of subprime car loans, another area banks are turning to in order to increase profit:

As the fifth anniversary of the Federal Reserve’s policy of keeping interest rates near zero approaches, the market for subprime borrowing is again becoming frothy, this time in the car business instead of housing. U.S. auto sales, on pace for the best year since 2007, are increasingly being fueled by borrowers with spotty credit. They accounted for more than 27 percent of loans for new vehicles in the first half of the year, the highest proportion since Experian Automotive (EXPN:LN) began tracking the data in 2007. That compares with 25 percent last year and 18 percent in 2009, as lenders pulled back during the recession. “Perhaps more than any other factor, easing credit has been the key to the U.S. auto recovery,” Adam Jonas, an analyst with Morgan Stanley (MS), wrote in an October note to investors.

The money for subprime loans comes from yield-starved investors who buy bonds backed by them. Issuance of such bonds, which pay higher rates than U.S. government debt, soared to $17.2 billion this year, more than double the amount sold during the same period in 2010, but still below the peak of about $20 billion in 2005, according to Harris Trifon, an analyst at Deutsche Bank (DB).

The interest rates on subprime auto loans can climb to 19 percent, according to Standard & Poor’s (MHFI). “Right now, you have to have fairly bad credit to be paying above 3 percent,” says Jessica Caldwell, an analyst with auto research firm Edmunds.com. Chrysler Group (F:IM) has been a beneficiary of the subprime boom. Fifty-eight percent of loans taken out to purchase its Dodge brand vehicles in October were above an annual percentage rate of 4.2 percent, the industry average, according to Edmunds. The average loan for a Dodge charged an APR of 7.4 percent, and 23 percent of the loans had APRs of more than 10 percent, making Dodge the brand with the highest percentage of loans at more than 10 percent, followed closely by Chrysler and Mitsubishi (7211:JP). Dodge’s U.S. sales rose 17 percent this year through October compared with a year earlier, propelling Chrysler Group to 43 straight months of rising sales.

About 13 issuers have raised money in the asset-backed bond market to make subprime auto loans this year, according to Citigroup (C). Among them are GM Financial, the lender known as AmeriCredit before it was acquired by General Motors (GM) in 2010, and new entrants such as Exeter Finance, owned by Blackstone Group (BX). Exeter has issued $900 million of bonds linked to subprime auto loans this year, data compiled by Bloomberg show. Exeter has higher loss rates compared with other lenders, S&P said in a Sept. 17 report. A spokeswoman for Exeter declined to comment.

While banks and investors in loans are looking for new ways to increase returns, what is dangerous is the potential outcome. Those with cars loans and business loans may end up defaulting, which doesn’t bode well for the economy.