Subprime Auto Loan Crisis Chronometer

Crisis /krīsis/: A turning point that results in a battle over loss allocation.

Will there be a crisis? Are we near one?

Practices and factors similar to those contributing to the subprime mortgage meltdown are now impacting subprime auto lending and related ABS. The gauges reflect our take on how they are impacting risks for lenders and investors.

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The Subprime Auto Loan Crisis Chronometer shows the risk of battles over loss allocation.
May 2018
Lending Practices and Factors i
Subprime and deep subprime lending and securitization have risen sharply; delinquencies are on the rise, but not yet above peak levels. Risky practices exposing specific lenders and their investors to losses; other lenders will be similarly exposed if they chase market share.
ABS Practices and Factors i
Credit enhancements such as excess spread, overcollateralization and subordination continue to create a buffer from riskiest lending practices. Investors have not yet felt the sting of riskiest practices.
Auto Market Risks i
New vehicle prices are at all-time highs, but sales incentives and high supply of off-lease vehicles are depressing used vehicle prices, accelerating depreciation and driving up negative equity on trade-ins. Advances in technology will likely accelerate depreciation further.

New Tech, New Risks

There are always risks to forging a new path. When it comes to electric vehicles (EVs) like the Model S and Model X that back Tesla’s latest deal, there are peculiar risks beyond those that normally accompany auto asset-backed securities (ABS). Given a lack of historical data, there is the risk of uncertain residual or resale values, and moreover, the potential for those values to fall below expectations for any number of reasons. For example, new technology may emerge that leapfrogs the manufacturer’s current offering, or production start-up problems may prevent the manufacturer from fulfilling demand. There’s even the risk that problems with any product within the manufacturer’s vehicle line-up – whether in production, supply of critical parts (e.g., batteries) or in-use failure of technology – could taint the manufacturer’s image, affecting values of vehicles backing the loans or leases in the deal.

Tesla’s Roadblocks

Tesla, in particular, has had massive problems producing its lower-priced mass market offering, Model 3, and has hit several other roadblocks as well. Tesla’s inability to meet sales goals for the Model 3, divergence of corporate attention across a wide variety of projects, accumulated deficit over $500 million and litigation over its auto-pilot performance could negatively impact the market’s perception of the brand, leading to lower than expected residual values for its Model S and Model X. Also, the ambitions of Tesla and its founder, Elon Musk, create a unique risk for investors. Scientists are actually concerned that Musk’s decision to launch a red Tesla Roadster into space could contaminate Mars with bacteria from Earth. It would be a black eye for a green company to be branded an intergalactic polluter. Will a Tesla product be worth less if scientists confirm that the red Roadster will ultimately wind up sullying the Red Planet? It seems a celebrity founder or celebrity-type status of a vehicle could carry risks similar to signing an athlete to endorse a cereal.

Investors Will Seek Protections

Higher cost EV models may benefit from the self-selection of higher credit borrowers. This is the case with the Tesla offering, though average FICOs are still lower than recent deals from BMW and Mercedes. Even with high quality credit, manufacturers will likely make up for the residual value risk with credit enhancements. Specifically, overcollateralization – the excess value of collateral above the amount investors pay in to the deal – will need to be high enough to cover the risk caused by uncertain residual or resale values. For any deal, there would likely be a level of credit enhancement sufficient to attract investors, but a potential issue is the increased costs that go along with such higher levels.

Auto Innovations Will Spur Innovations in Finance

2018 is set to be a transitional year for the auto industry as EVs become more prevalent and manufacturers move ever so closer to making “Level 5” autonomous vehicles a reality. Some of the buzz regarding fleet financing is related to the goal of a driverless future. Daimler and Ford envision using automated technology to supply fleets of robo-vehicles, rather than privately-owned vehicles, but that message seems to get lost in the hype.
And, as I mentioned on an episode of “The Roadmap,” a podcast from the Center for Auto Finance Excellence, car ownership is not as desirable across the country as it has been in the past given the proliferation of ride-sharing and ride-hailing alternatives. Those alternatives create the prospect of finance models based on income stream rather than asset value.

Are We Headed for the Sky?

In any event, so much has to happen before consumers, our infrastructure and our laws are ready for the transformation to a driverless economy. Along the way to that seemingly inevitable day, there will be opportunities to bundle similar cohorts of vehicles based on their green technology or level of self-automated capability. And the road ahead may take some unexpected turns. Manufacturers are caught up in a race to build ever-faster EVs, but since when have we set aspirations so low? Does anyone remember the fantasy of flying cars? Porsche and Uber are already dreaming of the day. If they make it a reality, we’ll find technology advances may not merely leapfrog current offerings, they’ll fly over them instead.

James Serritella, a partner, and Massimo Giugliano, counsel, contributed to this post and are members of the Insolvency, Creditors’ Rights & Financial Products Practice Group of Davis & Gilbert.