We’re in the 4th cycle of the subprime profit motive after auto-loan securitizations became a thing in the early 1990s.

By Wolf Richter for WOLF STREET.

The 60-plus-day delinquency rate of subprime auto loans rose to 6.15% in December, a new record for December in the data from Fitch, which tracks subprime auto-loan asset-backed securities (ABS), going back to their origins in the early 1990s. Subprime delinquency rates rose to record highs in 2023 and rose further in 2024. They peak seasonally in January in February. If January and February 2025 follow seasonal patterns, subprime delinquency rates will set new all-time highs (gold in the chart below).

But for “prime” auto loan ABS, the 60-plus-day delinquency rate has been in pristine condition, at 0.37% in December, according to data from Fitch (blue in the chart below). Even during the Great Recession, the prime delinquency rate rose to only 0.87% at the worst moments.

The overall 60-plus-day delinquency rate for auto loans and leases has been getting pushed higher in 2023 and 2024 by the surge in subprime delinquency rates. But in November, the latest data available from Equifax, it ticked down a hair to 1.55% though it normally ticks up in November. The seasonal peaks also occur in January and February (red).

Subprime is always in trouble, which is why it’s subprime. Subprime doesn’t mean “poor.” It means “bad credit,” such as a FICO score below 620. The young dentist just starting out and getting into it over his head and falling behind on his debts, and therefor getting his credit score cut to 596, is an example of high-income subprime. Low-income people often cannot borrow at all, often don’t qualify for a credit card, and if they qualify for a credit card, they’re going to have a low credit limit.  Subprime isn’t a permanent state; it’s a phase borrowers go through, and from which most borrowers emerge after they’ve gotten their act together.

In terms of auto loans, subprime lending is largely confined to older used vehicles, sold by specialized subprime dealer-lender chains, or financed by specialized subprime lenders. All these lenders then package these subprime auto loans into Asset Backed Securities (ABS) and sell them as bonds to institutional investors that buy them for their higher yield.

Subprime lending is small in the overall auto world. Lots of buyers pay cash and don’t finance: 60% of used vehicle purchases and 19% of new vehicle purchases were paid for with cash in Q3 2024, according to Experian. Of the deals that were financed in Q3, 16.9% were subprime.

Why this surge in subprime auto-loan delinquencies?

There have been four cycles with spikes in delinquencies of subprime auto-loan ABS. The first occurred in the early to mid-1990s, when subprime auto-loan securitizations were a new thing, and everyone jumped on it:

• Specialized dealers and lenders because it was hugely profitable and low-risk since they sold the dubious subprime paper to Wall Street and were off the hook. So their lending became recklessly aggressive.
• Institutional investors that bought the ABS from Wall Street because they offered higher yields, at minimal risk, since ABS are structured, with the lowest-rated slices taking the first losses, but paying the highest yields. So if you bought higher-rated slices, you’d still get a good yield, but little risk.

Obviously, the whole thing, like so many new financial products, turned into an epic mess with the delinquency rate exploding to 6% in 1996. The episode was followed by tightening credit standards, and delinquency rates dropped.

But then in the early 2000s, the profit motive took over again, and lending standards loosened, and when the economy tanked and unemployment soared in 2008-2010, delinquency rates spiked again. This spike then set off another credit tightening cycle. But by 2014, with the free money washing over the land, here we went again; delinquency rates began to surge until… That cycle was interrupted by the pandemic and the free money that came with it, and the free money flooded the people, and the people paid down their credit and caught up with their arrears, entailing huge profits for the segment, which led to even more reckless lending. And so that blew up again. And now subprime credit is tightening again….

This long view shows those four cycles:

Buyers with a subprime credit rating have few choices and lost their power to negotiate. They were irresponsible with their credit before, which is why they’re rated subprime. They’re considered high-risk, with a high probability of default. Regular dealers, banks, and finance companies have already turned them down. So specialized dealers sell them older used vehicles at gigantic profit margins, provide financing with big-fat interest rates, and then send the loans into the securitization pipelines. These are hugely profitable sales, and the ABS make investors happy because of their higher yields and loss mitigation that comes with the securitization.

What happens when the cycle turns as delinquencies get out of hand, the most aggressive subprime auto-dealer-lenders get in trouble. In 2023, several PE-firm-owned subprime-specialized dealer-chains filed for bankruptcy. Even the large publicly traded subprime dealer-lender America’s Car-Mart disclosed massive problems in December 2023, and its shares [CRMT] tanked and were inducted into our pantheon of Imploded Stocks. This is a high-profit business whose risks are often underappreciated by investors. And after the mess gets somewhat cleaned up, the risk-taking starts all over again because the profits are just too juicy, and eventually delinquency rates will get out of hand again.

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