A Federal Reserve blog post in November 2016 attracted widespread attention to subprime auto lending and the similarities easily drawn, at least on the surface, to subprime mortgage lending leading up to the financial crisis of 2008. The warnings of commentators who have sounded the alarm in the past six months have been rebutted at every turn, due mainly to the small footprint of the auto loan and related ABS market relative to subprime mortgages and RMBS at their peak. However, crises come in all sizes. The auto lending industry could be thrown into a tailspin, if sales and lending practices to subprime borrowers — including fraudulent sales activities that inflate vehicle values — extended terms on used vehicles and lax underwriting, collide with any shock to the economy.
As we noted in the Financial Times, even if auto loan ABS does not carry the same systemic risk as subprime RMBS, there could be significant losses within the auto loan industry that spread to the broader auto industry and impact the economy. After all, continued weak performance, in turn, may lead to less available credit, which could negatively impact sales volume, driving used vehicle prices down and creating greater negative equity on the next vehicle purchase. The end result is increased consumer debt and at a time when it is already at a record high. As we noted in American Banker, the winners in the industry will be those who look back to the subprime crisis, learn from it and adapt their practices.
There are signs that some lenders and investors are maneuvering to avoid the problems of the past. In response to deteriorating market conditions, certain lenders are taking precautionary measures, cutting back on auto loan originations and tightening credit standards by decreasing loan-to-value (LTV) ratios, to guard against further losses. Although demand for subprime auto ABS remains strong, investors have been requiring greater credit enhancements, suggesting greater caution in the market.
However, there’s also evidence that some of the worst practices of the subprime mortgage days may be making a comeback. Pre-financial crisis, a significant percentage of subprime loans were based on no (or minimal) income verification or minimal documentation due to extreme competition in an overheated market. Today, loans originated by lenders to borrowers who have low or no credit scores, no co-signer and no verified income can make up a sizeable balance of loans backing subprime ABS.
The question should no longer be whether the subprime auto loan market is following the same track as the subprime mortgage market of a decade ago. At a high-level, it is. At the same time, we’re seeing evidence of lenders and investors seeing a fork in the road and choosing their path. Some people may be willfully blind to the choice, but those folks probably shouldn’t be in the driver’s seat in the first place.
James R. Serritella is a partner in the Insolvency, Creditors’ Rights & Financial Products Practice Group of Davis & Gilbert and his practice focuses on complex litigation in the financial services sector, bankruptcy litigation and insurance recovery on behalf of policyholders.