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.
Sep 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.

“They are who we thought they were!”

Observing the rising tide of borrower delinquencies in subprime auto lending, I’m reminded of that famous outburst by the former NFL coach, Dennis Green. No one should be that surprised when subprime borrowers default. The question has always been and will continue to be whether credit enhancements – like overcollateralization and excess spread – will be sufficient to absorb the resulting losses.  Now that lower grade tranches have gained popularity among investors, and lower tranches are in greater danger than ever of going underwater, it’s a critical time for a performance check of the components of risk.

Performance

Total auto loan debt increased to $1.23 trillion in Q1 2018, up from $1.17 trillion versus a year ago, and accounted for 9.3% of the $13.21 trillion in national household debt – remaining greater than credit card debt, but less than student loan and mortgage debt, according to Federal Reserve Bank of New York data.

Originations, Delinquencies and Losses, by the Numbers

In Q1 2018, new auto loan originations totaled $130.9 billion, $39.8 billion of which was subprime. Subprime originations trended down, comprising 30.4% of car loans in the quarter and representing the lowest percentage since 2010. Prime auto originations increased and stood at $91.1 billion in Q1 2018.

4.26% of auto loan balances were 90+ days delinquent in Q1 2018, up from 3.82% in Q1 2017. Subprime auto 60+ day delinquencies in the secondary market climbed to 5.74% in February 2018 – the highest they’ve been in 22 years and exceeding peak financial crisis levels, according to Fitch data. Prime auto delinquencies were 0.4% in the same month.

Subprime auto ABS loss rates also increased. As of March 2018, the annualized net loss (ANL) rate for subprime auto loans was 8.81%, up from 4.66% five years ago. For prime auto loans, the figure was 0.62% at the end of Q1 2018.

Lending Practices and Factors

Although the share of subprime loans has decreased, the risks seen in subprime auto lending have begun to radiate to the prime sector. Loan terms in prime auto ABS have stretched by 3 months between 2010 and Q1 2018, which creates its own set of risks – longer maturities mean borrowers and lenders are exposed to greater economic volatility while borrowers remain obligated on depreciated vehicles.

Competitive pressure is also driving small subprime auto lenders out of the market. Summit Financial Corp. and Spring Tree Lending are among the companies that folded this year, after allegations of fraud and misreported losses caused their banks to withdraw funding. Increased costs of borrowing and lending that will result from rising interest rates could soon steer other auto lenders off the road.

There’s no solace to be had in reports that larger lenders are backing away from subprime. Large banks, such as Wells Fargo, may have hit reverse on subprime last year, but they are finding new ways to finance subprime loans via nonbank financial firms. The trend of “back door” subprime lending has become more prevalent, with bank loans to nonbanks climbing to $345 billion in 2017 from around $50 billion in 2010.

In response to poorer performance, underwriting standards may be tightening. The median credit score for auto loan borrowers stood at 708 in Q1 2018, up from 695 in Q1 2016. But borrowers are paying more on their loans – the average monthly payment for a new car climbed to $523 in Q1 2018, representing an all-time high.

Auto Market

Depreciation on used cars is accelerating and is expected to hit 17% in 2018, in contrast to 13% in 2017. This is due to used vehicles making up a growing proportion of the wholesale market, which has been accompanied by lower recovery rates on securitizations. Car sales declined in 2017 but auto prices remain at record high levels – the average price of a new vehicle in May 2018 was $32,380, up 4% from a year ago, and for used vehicles the figure in Q1 2018 was $19,657, up 18% versus five years ago. Sales incentives and technological advancements have contributed to this trend, in addition to consumer demand for state-of-the-art vehicles.

ABS Practices, Factors and Looking Ahead

Despite all of the concerning trends, investor interest in subprime auto ABS remains strong, resulting in securitization volume likely overtaking 2017’s total of $25 billion. During the first half of 2018, issuance of subprime B-rated bonds reached almost $170 million, which is more than the combined total of the previous seven years, according to S&P. As we noted in Bloomberg, demand is likely being helped by credit enhancements, which are, on the whole, increasing in new deals. But often, greater credit enhancements are accompanied by an even greater drift down in credit quality.

These super-sized credit enhancements have helped garner the sought after credit ratings. But as subprime performance deteriorates and projected losses increase, new issuances are going to have to show ever greater credit support to get desired ratings, all at a greater cost. Ultimately, though, ratings never guarantee a favorable outcome. Fundamentals matter for ratings, but fundamentals can change.

So when will we know if life in the fast lane is about to become more of a white-knuckle tight ride? As we noted in Auto Finance News, Honor Finance’s 2016 inaugural securitization may become the bellwether. It’s already on a downgrade watch at KBRA, but it should also be on issuers’ and investors’ own watch list to see if credit enhancements hold up.  If they don’t, we may soon see a re-evaluation of the sufficiency of current credit enhancement levels in both subprime and prime auto deals.

And there appears to be further trouble down the road – insolvency professionals historically staff up ahead of a downturn. That’s happening now.

Unlike the Chicago Bears that were the subject of Denny Green’s rant, issuers won’t be “let off the hook,” if there is a recession.

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