Wall Street Forms Fraud Task Force as Lenders Face Growing Scrutiny

Fraud is rocking Wall Street. Banks and investors are tightening their scrutiny. A Fraud Prevention Task Force was formed with the support of leading Wall Street companies and the Structured Finance Association, a trade body representing banking and investment firms.

This task force will work to examine lending patterns. The plan is to identify vulnerabilities and improve safeguards. This task force operates mainly within the context of business loans. But it will also affect subprime lenders. 

Two big failures set alarm bells ringing. The companies were First Brands, an auto parts supplier, and Tricolor Holdings, a subprime auto lender. Both went bankrupt amid fraud claims. Some firms double-dipped the same loans to multiple creditors. Some also faked their receivables.

These misadventures led lenders to question borrower data and collateral quality. Investors are being cautious, and they’re asking if the same thing could happen with other lenders. Worry is shaking up subprime lending. 

Investors are “being cautious around Tricolor, kind of taking a step back, thinking about could this happen to other issuers, and then there’s concern about consumer credit,” Theresa O’Neill, an asset-backed securities strategist at Bank of America, told The Wall Street Journal.

Why Fraud Scrutiny Matters to Subprime Lenders

Companies that lend to subprime consumers are already dealing with increased risk. In an era of proliferating fraud, weak collateral and unreliable borrowers make for bigger losses.

After the high-profile bankruptcies of Tricolor Holdings and First Brands amid fraud claims, subprime lenders are being put on notice by banks and investors.

False income claims and double-pledged assets can quickly multiply damage. That’s why banks and investors now ask for longer credit histories as well as regular collateral checks. They also want stricter documentation. Investors are telling lenders to produce payment records going back years.

These demands will put stress on nonprime lenders. More paperwork means more time and money, and smaller lenders may struggle to keep up. Spooked investors may also raise funding costs or back away completely.

The Ripple Effect of Stricter Lending Standards

Big lenders like JPMorgan Chase and BlackRock can handle extra regulatory rules. Smaller subprime lenders might not. Warehouse credit lines will likely shrink if investors demand tougher controls. Selling asset-backed loan tranches to investors might get harder to do.

The added caution raises risk premiums. It pushes borrower interest rates higher, too. The market reaction to fraud shows fear on the rise. Lenders are squeezed when investors lose confidence.

“This is sending real ripples in the credit markets,” Colin Adams, partner at Uzzi & Lall, a restructuring adviser, told the Journal. “People are really starting to ask: ‘How does this happen?’”

Tricolor’s bankruptcy has already hit subprime auto loan bonds. Prices dropped and yields climbed, which signals investor fear throughout the whole sector. 

What Sayeth the Crystal Ball?

Fraud usually makes its appearance in the latter part of a credit cycle. This is when easy money obscures fault lines. These could be the first signs of potential danger. It is possible for subprime lenders to shield themselves against fraud. This can be done by tightening controls before the situation deteriorates.

The task force is expected to release its first report in February. The recommendations it makes could have a material impact on how Wall Street lenders and community lenders deal with risk. Audits could become commonplace.

Lenders will have to improve their fraud detection tools and independent audit services to maintain market competitiveness.

Bottom Line

Fraud prevention is an industrywide concern. For subprime lenders, it means tighter rules and higher costs, as well as thinner margins. Stronger fraud control will build healthier credit markets. In addition, it should help instill trust at a time when it’s really needed.