One of the lasting legacies of the financial crisis is the market’s tendency to take any sign of bad news and frame it in the context of 2008. Collateralized loan obligations, for instance, have been deemed scary because of similarities to the collateralized debt obligations that were riddled with bad mortgages.
Now, auto loans are under the microscope. A report last week from the Federal Reserve Bank of New York showed that as of the end of 2018, more Americans than ever — in excess of 7 million — were at least three months behind on their car payments. On a percentage basis, the delinquency rate is the highest since 2012, even though lending has shifted toward more creditworthy borrowers. The share considered “subprime” who are behind on their payments is the highest since mid-2010.
This trend “is a significant red flag and it could cause some serious problems for auto loan securitizations. If you own some of these, I would be giving them a very hard look,” Mark Grant, chief global strategist at B. Riley FBR, wrote in a Feb. 14 note.
That was my first thought, too. After all, subprime lending is rife with opportunities for missteps. Plus, the market is booming, with issuance of U.S. auto asset-backed securities reaching a record $107.3 billion in 2018, compared with $59 billion in 2010, according to the Securities Industry and Financial Markets Association. And delinquencies are increasing when the labor market is hot and economic growth is relatively robust. At first glance, these trends look like reason for alarm.
Yet the more you dig into the auto ABS market, the less likely it seems like a flashpoint for a crisis.
For one, it’s not as if all — or even most — of subprime auto loans are packaged into securities. Only about 10 percent of the $437 billion of low-rated loans have been turned into ABS, according to Wells Fargo. By contrast, at its peak in 2007, the amount of total subprime mortgage debt was about $1.3 trillion. As far as risks go, auto ABS look paltry in terms of size.
Of course, because they’re not securitized, the majority of the loans are kept on lenders’ balance sheets. But large banks, which have $389 billion of outstanding auto loans, only have a 25 percent subprime share, according to the New York Fed. And small banks (those with less than $50 billion in assets) are even more skewed toward creditworthy borrowers, with just a 14 percent subprime share. Instead, auto finance companies have a disproportionate amount of subprime loans, at 50 percent.
Steve Eisman, who was featured in Michael Lewis’s book “The Big Short,” made headlines two years ago when he said that he was concerned about subprime auto loans. “Banks make mistakes on credit quality, and we are in an environment where credit quality has never been this good in anyone’s lifetime, with the one exception of subprime auto,” he said at the time. But even he acknowledged it’s not a big enough asset class to cause problems for the entire financial system.
That doesn’t mean there won’t be isolated problems. Eisman’s 2017 comments came after a period in which underwriting standards loosened as smaller lenders that focus on weaker borrowers stepped into the growing market. In one example, a class of subprime-auto ABS from Honor Finance was downgraded last year by S&P Global Ratings to CCC+ from BB-, the first such cut since the financial crisis. JPMorgan Chase & Co. analysts noted in July that it could be the first auto loan ABS to default since the late 1990s. Moody’s Investors Service flagged Global Lending Services, GO Financial and Skopos Financial as issuers with their first transactions in 2015 that all faced relatively high early losses. Other sponsors with somewhat large losses include DriveTime Automotive, American Credit Acceptance, United Auto Credit and CarNow Acceptance.
Certainly, if the pace of auto loan delinquencies continues to climb, these lenders may struggle. And they’re already dealing with slim margins because of competition and increasingly sophisticated data for evaluating borrowers. As Bloomberg News’s Adam Tempkin noted last week:
Over the last three years, companies that offer loans to the riskiest borrowers tend to be the ones who use securitization the most. And at the same time, strong demand for higher yields has led to more lower-rated bonds in deals.
That’s a concern because there are fewer protections baked into the lower end of subprime ABS. So as a result, investors are starting to demand more robust credit protections than compared with a few years ago, eating away at already-thin profit margins at lenders struggling with deteriorating loan quality.
If the worst-case scenario is that some private-equity backed new entrants to the auto-loan business close shop, and investors who were reaching for yield get burned, that doesn’t seem so bad, and certainly isn’t a systemic risk. Other factors unique to auto loans limit the potential fallout, like their relatively short length, the ease of repossessing cars and the general lack of derivative products.
Meanwhile, the market as a whole epitomizes stability. The Bloomberg Barclays ABS Auto Index has gained between 0.7 percent and 3.3 percent annually since 2010. It’s up 0.55 percent so far this year. By definition, almost all rating actions in auto ABS are upgrades because the structures usually pay principal sequentially, which boosts the credit enhancement on lower-rated portions as the pool balances pay down. Indeed, the largest ABS in the index are triple-A. That reliance on rating agencies might rekindle some bad memories of the financial crisis, too.
Perhaps the biggest difference between subprime auto loans and subprime mortgages is that this sort of stress is a familiar story. In the late 1990s, a surge in inexperienced entrants into the subprime auto market led to bad underwriting, sowing the seeds for a bust. Dozens of lenders were acquired, shut down or filed for bankruptcy. At the time, the auto loan cycle didn’t rattle financial markets or cause a massive shock to the economy. It’s unlikely to now.
— Brian Chappatta (Bloomberg)