After the credit bubble comes the credit bust.
Subprime auto loans, a big force behind booming car sales in recent years, are getting crushed by defaults, particularly those originated between 2013 and 2015 when the proportion of subprime loans began to surge while underwriting standards became loosey-goosey, as private-equity-backed auto finance companies with a ravenous appetite for risk, subprime, and securitization elbowed into the market, amid the exuberance of the greatest credit bubble in history.
“Bad deals are made in good times,” says the old banking saw.
Auto lenders package their loans into asset-backed securities (ABS) and sell them as bonds to yield-hungry institutional investors. Fitch Ratings, which rates auto lenders and auto-loan ABS, just reported on the state of the industry.
The Fitch Auto ABS Indices show that 60+ day delinquencies were relatively low for prime auto loans at the end of Q4, but for subprime loans they’ve surged to 5% of outstanding balances, the highest since at least 2008, during the depth of the Financial Crisis!
Net charge-offs show a similar scenario, only worse. Net Charge-offs from prime loans ticked up to a still low 0.75% of outstanding balances. But net charge-offs from subprime loans surged to 10.5%, the highest since at least 2008!
Subprime is “particularly vulnerable,” Fitch says. It expects credit performance to deteriorate further.
Simultaneously, another trend is biting lenders and investors in subprime auto loan ABS: While for the overall market, average loan terms have reached a record 67 months, for subprime borrowers they’ve jumped to over 72 months.
Fitch adds icily:
[T]he data conflict with commentary from several large auto lenders that have suggested the loan term extensions in recent years have been primarily targeted at prime borrowers.
No one wants to accuse the industry of lying to investors about risks. But this is pretty close.
And it’s important. Longer loan terms make payments more affordable for cash-strapped consumers. Thus they pump up sales volume. And they allow finance companies and dealers to make higher profits. As underwriting standards got very loosey-goosey starting in 2013, loan terms (along with loan-to-value ratios) wandered off into new territory.
But as loan terms lengthen, depreciation of the vehicle outruns the amortization of the loan principal for longer, and borrowers have negative equity for longer, which raises the risk of loss, particularly for subprime loans. Fitch:
This will pressure recovery values on defaulted loans and also hurt customer trade-in values, which could negatively affect future new car sales/financings.
Why is this important for the industry as a whole, not just lenders and their investors?
Lenders are starting to feel the bite of those losses that are made worse by extended loan terms, higher loan-to-value ratios, a higher proportion of subprime loans, more negative equity for longer, and hence subprime defaults and net charge-offs that are soaring to crisis levels.
This spiral is made worse by dropping wholesale prices of used vehicles when they’re sold at auction, which is where lenders unload repossessed vehicles.
To tamp down on future losses, lenders began tightening underwriting standards, particularly in the subprime segment, in 2016. Fitch cited the Federal Reserve’s January 2017 senior loan officer survey:
In the survey, pricing, minimum down payment and minimum credit were all tightened by respondents on a net basis, although the maximum loan maturity continued to lengthen.
So at this point, despite tightening in some areas, lenders continue to lengthen loan terms. Why? Because shortening terms, in face of high prices, and hence unaffordable payments for stretched consumers, would strangle sales volume and profits. But they are getting nervous.
The overall tightening of underwriting standards is consistent with comments made by several banks on earnings conference calls over the past couple of quarters. Fitch believes the tightening of underwriting standards is a response to expected deterioration in used vehicle prices and the weaker credit performance experienced in the subprime segment.
This deterioration in used vehicle wholesale prices came to the fore in the National Association of Auto Dealers’ gloomy report on February: Its used vehicle price index plunged 8% from a year earlier and 13% from the peak in 2014, to hit the lowest level since September 2010. And it’s just the beginning:
Fitch continues to expect used car values to gradually decline over the next several years as used vehicle supply rises driven by increasing volumes of off-lease vehicles, which are expected to increase by over 50% between 2015 and 2018.
So Fitch expects lease turn-ins to surge by 50% between 2015 and 2018. These are the vehicles that customers turn in at the end of the lease and that are then sold at auction. Dealers buy them and retail them.
This surge in supply comes as rental car companies are “rightsizing” their fleets, and their units are flooding the auctions. And it comes as automakers are piling on incentives to sell down bloated dealer inventories of new vehicles and keep plants open, thus making new vehicles more competitive with late-model auction units.
New vehicle demand is “believed to have plateaued,” as Fitch put it. This lack of demand, in face of surging supply, pushes vehicle values lower, which adds “downward pressure on lenders’ recovery values and lease residuals.”
“Lease residuals” is a term that has started to crop up in earnings warnings. When you lease a car, the lender puts an estimated value on the vehicle at the end of the lease term. This is the part of the vehicle that you never pay for. The higher this “residual value,” the lower the monthly payment. At the end of the lease, you turn the vehicle in, and it is then sold at auction. As wholesale prices drop, residual values are under water, and lenders are taking losses on them. This is starting to happen.
How big is leasing? It’s huge. Leases account for 30% of total auto financings. Hence the earnings warnings. And Fitch “anticipates” that this chorus will get worse.
Then there are knock-on effects. Bleeding lenders lower residual values on new leases. This causes monthly payments to rise, making the vehicle less affordable for stretched customers, and thus more difficult to sell, just when demand has already peaked, and when subprime is getting crushed.
Let’s hope that the problems piling up in the used vehicle market — and their impact on new vehicle sales, automakers, $1.1 trillion in auto loans, and auto lenders — is just a blip. Read… Is this the Sound of the Bottom Falling Out of the Auto Industry?