As we said in our last post regarding vulnerability in credit enhancements and litigation risk, subprime auto ABS investors have historically slept easy in light of ample credit enhancements that have provided a protective cushion from losses. Based on the reactions, it seems some have been stirred from their slumber. The question now is what’s next? Will market participants, after kicking the tires, find reason for alarm or will they hit the “snooze” button and go back to sleep? To paraphrase the Bard, “Aye, there’s the rub – for in that sleep what dreams may come.”
Several events have occurred recently warranting a recalculation of the Subprime Auto Loan Crisis Chronometer’s measurement of the overall risk of loss allocation battles. Based on these events, the Crisis Chronometer has now ticked closer to “high risk.”
Wells Fargo analyst John McElravey took note of our post and made a reasoned assessment that there appear to be more differences than similarities between subprime auto ABS and subprime RMBS, but nevertheless advised investors to exercise caution. In fact, given the significant differences, we believe subprime RMBS should not be looked to as a mirror reflecting subprime auto ABS. It may, however, be considered by some to be a blueprint. The blueprint can be ignored or it can be followed for offensive or defensive purposes. In any event, people have a tendency to see what they focus on, and the increased attention on potential issues with lending practices, deal structures and the auto market increases the probability that issues will be uncovered.
This greater focus on sources of risk is coming at a time when defaults are reported to be at their highest point in three years. September marked the third consecutive month that the vehicle finance segment of the S&P/Experian Consumer Credit Default Indices has climbed after hitting its lowest point in June.
As we have advised on Credit Chronometer, an indicator of crisis is the growth and relative mix of deep subprime and subprime in an overall securitization market. Since that advice posted, it’s been reported that subprime auto ABS deals, including from “deep subprime” lenders, are expected to make up a larger percentage of auto ABS – partly a result of prime auto lenders pulling back from the riskier edges of the market.
We identified climate events as a new disruptor to loan performance and since then, lenders have begun to tally the impact of this summer’s major hurricanes – up to one million vehicles literally underwater, a figure that is sure to rise when data from Puerto Rico is finally collected. Already, Capital One, Ally and Wells Fargo have stated they are bracing for losses and including hurricane-related losses in significant loss reserves.
Some commentators have expressed optimism for the used car market given the historical bump in prices after a natural disaster due to the need for replacement vehicles, but we wouldn’t expect history to repeat itself this time – borrowers have a growing list of ride-hailing and ride-sharing service providers from which to choose, rather than continuing to make payments on aging vehicles that are already worth less than the amounts borrowed to purchase them.
History may not repeat, but it may rhyme. Those who hit the snooze button and ignore the reasons for caution could soon be singing a different tune.
James Serritella, a partner, and Massimo Giugliano, an associate, contributed to this post and are members of the Insolvency, Creditors’ Rights & Financial Products Practice Group of Davis & Gilbert.