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.
Dec 2018
Lending Practices and Factors i
Subprime originations have trended down but securitization volume continues to increase. Subprime delinquencies in the secondary market are on the rise and have surpassed peak levels. Risky practices are exposing specific lenders and their investors to losses, as evidenced by the closure of a number of smaller subprime auto lenders earlier this year.
ABS Practices and Factors i
Credit enhancements such as excess spread, overcollateralization and subordination have increased in new deals and continue to create a buffer from riskiest lending practices. Investors have not yet felt the sting of riskiest practices.
Auto Market Risks i
New and used vehicle prices are at all-time highs, but sales incentives and high supply of off-lease vehicles are accelerating depreciation and driving up negative equity on trade-ins. Advances in technology will likely accelerate depreciation further.

No one had suffered any losses, or at least it seemed no one could remember having done so. S&P had not downgraded any subprime auto loan ABS since just after the turn of the century or any other auto loan ABS since 2011. Credit enhancements were widely deemed sufficient to absorb any worst-case scenario. With a long track record of success and protections in place, few blinked when one non-bank lender, Honor Finance, went decidedly deep down the credit scale.

It was 2016 and Honor Finance had just brought its HATS 2016-1 securitization to market. The appeal of HATS 2016-1 captured our attention as an example of a potentially perilous penchant for subprime auto ABS, but fast forward to the present and all signs – from the performance of HATS 2016-1 to allegations against Honor management – point toward Honor having even greater significance in the trajectory of subprime auto ABS. Honor may provide an example of both the type of performance that would cause demand for subprime auto ABS to eventually stall amid losses and the type of conduct that will require vigilance by all parties to prevent litigation and investigations.

It’s time for the market to rethink what’s possible. Anything can happen.

There Was Always Cause for Concern

As previously discussed, HATS 2016-1 marked a new level of ebullience that was reminiscent of subprime RMBS. And as we wrote in 2017, credit enhancements were not as bulletproof as some suggested, especially when compared to subprime RMBS where home equity was presumed to buttress built-in deal protections.

Since then, the news has been downhill – higher loan balances, longer loan maturities, faster depreciation, bankruptcies of non-bank lenders, lower credit quality masked by higher credit enhancements and the downgrade of HATS 2016-1’s C tranche.

New Twists and Turns

The focus on Honor has put its conduct and practices under the spotlight, and the scrutiny could spread to the rest of the industry.

It’s been revealed that Honor has granted an extraordinarily high number of payment extensions to borrowers. Extensions can increase risk because they are requested by financially troubled borrowers and allow interest to accrue during the deferral period (something borrowers do not always understand), ultimately increasing the amount to be repaid. Although Honor appears to have taken the practice to a new level, it is common in the industry. So much so, that S&P is recommending that going forward investors monitor the level of extensions in their deals.

And now there are accusations by consumers and allegations by “a source close to Honor” that Honor engaged in some unsavory conduct – loading borrowers up with add-ons and warranties and then applying cash received for these items to loan payments, which resulted in defaults being hidden or delayed; repossession tactics that also delayed reporting defaults; and use of an affiliate to repossess vehicles at inflated prices.

At this point, it’s fair to ask that if the allegations are true, is Honor the only one to engage in this conduct? We’ve seen elsewhere that frothy markets create motive and opportunity to work the fringes of acceptable business, where eventually lines can be crossed.

It’s a Bad Time for Bad News

A number of market events are cause for concern. For months there have been warnings that tariffs are driving up the prices of new vehicles. With international trade issues, rising interest rates, and a slowdown in new car sales among other reasons, GM is closing five plants and reducing 14,000 jobs. In addition, subprime lender National Auto Lenders, which recently filed for bankruptcy, adding it to the list of casualties.

What Happens Next?

If others are found to engage in conduct similar to allegations against Honor, how will the market react? How should it react? Will credit enhancements be asked to do double-duty and guard against the risk of management conduct or can the market shrug it off and rely on subprime auto’s track record of success?

We will be conducting a survey in early 2019 of lenders, investors and other securitization participants to provide a 360 view of where industry leaders see the ABS market going. We’ll soon see if investors and deal participants will stay in the same lane or if they are now starting to move in opposite directions.

Visit the blog in January to gain access to the survey or subscribe here to receive an invitation to participate.

James Serritella, a Partner, and Nicole Serratore, an Attorney, in the Insolvency, Creditors’ Rights & Financial Products Practice Group of Davis & Gilbert, contributed to this post.