US debt investors raise alarm over lending standards

US debt investors have raised the alarm over lax lending standards in credit markets after the unravelling of two companies that just weeks ago were deemed to be in strong health.

The failure of subprime auto lender Tricolor Holdings at the start of this month followed by the exploration of bankruptcy proceedings by car parts supplier First Brands Group have wrongfooted investors.

Tricolor had won pristine triple-A ratings as it borrowed in credit markets, while First Brands may have amassed as much as $10bn in debt and off-balance sheet financing and was close to raising even more last month.

Investors were ready to dismiss each as one-off incidents, but taken together, the two offer signs of cracks within credit markets, which have become a critical source of funding for consumers and businesses as traditional banks have retreated since the financial crisis.

Traders and investors told the Financial Times that they have raised questions about the controls in place that would have allowed Tricolor and First Brands to reach the brink so quickly.

One investor who sold out of Tricolor debt last week said the collapse of the company and ensuing market turmoil was one of the “worst things I’ve ever seen in the asset-backed securities” market.

Both companies made use of asset-backed debt, with Tricolor bundling up subprime car loans into bonds and First Brands tapping specialist funds to provide credit against its invoices.

At its core, asset-backed finance is the ability to lend against a specific asset or loan, including consumer credit card balances, leases on railcars and solar panels, aircraft and music royalties.

Some investors said they had recently combed through their portfolios to confirm that other companies they had lent to did not face similar troubles, and were now asking more detailed questions before underwriting new deals.

US investment firms have in recent years pushed deeper into asset-backed debt, often pitching it as a safer product than the loans to junk-rated companies that are their bread and butter.

But Tricolor is now being probed over fraud allegations by the US Department of Justice, while some investors have long had questions around First Brands’ financial reporting and use of invoice factoring, with lenders now concerned that they lacked visibility about the scale of off-balance sheet financing.

First Brands declined to comment for this article, while Tricolor did not respond to a request for comment.

Fear over the unravelling of Tricolor and First Brands threatens to take the shine off one of the hottest corners of finance. Asset-backed credit is not a new product, but it is rapidly evolving, as titans on Wall Street such as Apollo Global Management and KKR devise new ways to lend.

The development had been a boon for non-bank lenders such as Tricolor, which used demand for car-loan backed bonds to turbocharge its lending.

Lenders that provided roughly $2bn against portfolios of auto loans originated by Tricolor are now in a difficult position. The company missed a September interest payment, two people briefed on the matter said, and some lenders are reportedly attempting to seize vehicles.

Several large banks have also been caught up in the collapse, including JPMorgan Chase and Fifth Third, which are exposed to losses on hundreds of millions of dollars' worth of auto loans.

A second investor who has since sold their position in packaged-up Tricolor loans said they had no idea how potential financial irregularities went unnoticed by JPMorgan Chase, one of the banks that underwrote debt offerings.

“That’s the shocking part of it,” the investor said. “JPMorgan is one of the most sophisticated lenders in the entire world. How the hell could they have missed this?”

JPMorgan declined to comment.

Global policymakers have sought to strengthen the banking system since the financial crisis, in part by shifting borrowing away from regulated banks into other parts of the financial system.

Officials at the European Central Bank were briefed last week on the rise of non-bank lenders such as Tricolor, as well as the company’s demise.

Tomasz Piskorski, a professor at Columbia University’s business school, said Tricolor’s failure could prompt investors to “be more cautious”.

“Rating agencies will scrutinise deals more, which means the availability of credit may be somewhat reduced,” he said.

At First Brands, the company’s bankers at Jefferies were marketing a new $6bn loan deal just weeks ago and reassuring investors that the group held nearly $1bn on its balance sheet as recently as March.

Now, First Brands is negotiating for emergency rescue financing from lenders to plug an urgent liquidity hole, a process that may require a bankruptcy filing.

The rapid collapse in the value of its loans, with junior debt trading this week at just cents on the dollar, shook investors in the $1.5tn US leveraged loan market.

Lenders had poor visibility into the more opaque invoice-backed financing in which First Brands’ was engaging, which is typically the domain of specialist funds and carried out on an entirely private basis.

The FT has previously reported that investors including hedge fund giant Millennium Management and an investment unit of Jefferies provided some of this financing to First Brands.

Several receivables finance specialists said that invoice lenders had ignored red flags around First Brands’ financing given the high yields on offer on the supposedly secured paper.

“A lot of people have raised dedicated receivables funds and when money burns a hole in your pocket, you start reaching,” said one fund manager. “This company always offered the highest yields and always had capacity to do more, there was no limit.”

Despite the rapid sell-off in First Brands debt and the collapse of Tricolor, money managers have continued to invest in new asset-backed deals.

Goldman Sachs is this week readying the sale of a $300mn portfolio of subprime credit card receivables from financial technology company Mission Lane, according to people familiar with the matter.

Dylan Ross, the head of asset manager TCW’s asset-backed finance team, said the market’s receptiveness to deals signalled continued comfort with securitised financings.

“Very few investment grade structured products have been impaired since the financial crisis,” said Ross. “Securitisation is not the problem here.”

Additional reporting Akila Quinio and Amelia Pollard