United States: Regulations Targeting Auto Lending May Ultimately Increase Litigation Related To Securitizations

A rise in subprime auto lending has captured the attention of regulators, including the Consumer Financial Protection Bureau (CFPB), which in 2015 adopted a new rule bringing certain nonbank auto lenders under the agency's supervisory powers. In addition, the attorneys general of several states have begun to scrutinize sale transactions involving subprime auto lending and marketing efforts directed at consumers. For example, in 2015, the New York Attorney General reached a settlement with 25 auto dealerships across New York State resolving allegations of deceptive marketing and violations of credit laws by auto lenders (to read a previous D&G Alert on the subject, click here).

Prior to 2008, easy credit, defaults on mortgage loans, and declines in home values contributed to reductions in the value of securitized pools of mortgage loans, eventually leading to a halt in securitization activity and, more recently, significant and costly litigation. Today, the increased attention of regulators on abuses in the auto lending market and origination process could result in the discovery of breaches of representations by originators and sponsors and provide the basis of a new wave of litigation should investors in auto loan securitizations incur significant losses.

Background

Given the last wave of subprime lending that occurred in the residential mortgage market and precipitated the financial crisis, much law enforcement efforts are centered on the potential for abuses in the subprime lending process, including potential discrimination against consumers, and limiting risk to lenders that extend credit to consumers with shaky credit and depreciating assets that serve as collateral. Although these regulations serve to protect consumers and lenders, they in turn have the potential to create legal exposure for sponsors of securitizations backed by auto loans, as well as for other securitization participants, to the extent loan-level misrepresentations are made regarding compliance with these regulations. In the event non-compliant loans begin to default, thereby decreasing the value of the related securitization, sponsors and other participants may find themselves subject to lawsuits based on loan-level misrepresentations.

The trends in auto lending and the securitization of auto loans are reminiscent of the run-up in subprime mortgage lending and issuance of residential subprime mortgage-backed securities (RMBS). Auto lending is one of the largest sources of household indebtedness after mortgages, alongside student loans and credit card debt, and, as widely reported, subprime lending in the auto loan industry has increased significantly over the years. In 2015, subprime borrowers reportedly accounted for over 25% of new auto loans. In addition, similar to the mortgage market pre-2008, it has been reported that securitizations (i.e., the bundling together and selling of the subprime auto loans to a trust or special purpose vehicle which, in turn, issues securities to investors backed by the auto loans as collateral) of subprime auto loans has soared, having increased over 300% since 2010.

Types of Potential Litigation

Today, RMBS-related litigation is centered on claims asserted by or on behalf of investors against sellers and sponsors alleging misrepresentations regarding the underlying mortgage loans. This type of litigation has generally fallen into one of two categories:

  • repurchase (i.e., put-back) claims by trustees based on alleged breaches of loan-level representations and warranties in the documents governing the transfer of mortgage loans to the securitization trust and;
  • fraud claims by investors based on alleged misrepresentations in the securitization offering documents.

A common representation in RMBS transactions is that the underlying mortgage loans were originated in compliance with all applicable laws. Accordingly, it is not uncommon for plaintiffs to include in their claims that the underlying originator failed to comply with applicable federal and state lending and consumer protection laws and regulations, including any state anti-predatory lending statutes that may have been specifically identified in the relevant representation. Although these laws intended to protect markets and consumers may be at issue in RMBS litigation, few would seriously consider them to be a catalyst or contributing factor to the commencement of RMBS lawsuits relative to declines in home values following the housing market crash.

The Issue for Auto Loan Securitization Participants

Similar to subprime RMBS deals, sellers and sponsors of today's auto loan securitizations typically represent that the auto loans were originated in compliance with applicable laws. Because auto loan securitizations are ultimately backed by consumer goods purchased on credit, these applicable laws include a broad array of consumer protection laws, including the Truth in Lending Act, the Equal Credit Opportunity Act, any implementing regulations and any anti-fraud laws that may exist at the state and local levels.

Given the breadth of applicable laws and the well-publicized settlement reached by the New York Attorney General, increased scrutiny of auto loans and enforcement efforts at the federal and state level may uncover violations of these types of laws and ultimately form the bases of breach of representation and warranty claims against sellers and sponsors of auto loan securitizations. Thus, in a twist on the historical progression of the events leading to the recent wave of RMBS litigation, instead of a market crash ultimately causing investors and trustees of auto securitizations to assert claims for breaches of representations and warranties, it is the very regulations and increased enforcement efforts arising from the 2008 market crash that may ultimately be the catalyst for these claims.

Bottom Line

The run-up in subprime auto lending and securitizations is reminiscent of pre-financial crisis trends in the subprime residential mortgage market, which has resulted in significant litigation. This time around, regulations aimed at curbing abuses may contribute to a new wave of litigation involving auto loan securitizations.

At this time, both investors and sponsors should consider actions to protect their respective interests going forward, including review of representations and warranties made by originators and sponsors and examining auto loan financing processes of originators for compliance with applicable laws.

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.

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