Not Quite Time For Five Alarms, Moody’s Says

A recent report from Moody’s Analytics says it’s not quiet time to sound the alarm bell alerts surrounding the subprime auto lending markets.

That said, the report’s author, senior director of consumer credit at Moody’s Analytics, Cristian deRitis, told Auto Finance News that subprime auto lending players may have reached a critical point in the lending cycle, and it might be time to start taking measures to prevent any significant spike in delinquencies and defaults.

deRitis wrote in Moody’s Dismal Scientist that the rapid expansion of subprime credit is raising concerns about the sector’s long term sustainability.  Instances of fraud and questionable lending need to be addressed before they become systemic. He said tightening compliance and increasing consumer education are important as well as punishment of unscrupulous dealers, but, restricting credit to severely could end up pushing subprime consumers into the shadow banking industry where there’s even less regulation.

During a wide-ranging conversation, deRitis told AFN that some of the high-profile anecdotal stories illustrating the problems in subprime, such as the unfortunate details surrounding consumers profiled by a July New York Times investigative story, were largely based on individual interviews and short on solid industry data and information.

Heightened attention stemming from the Times‘ consumer-driven narrative as well as news that the Department of Justice was investigating the underwriting standards for several subprime loan pools, has all led to industry jitters on one side as well as calls for tighter regulations from the other.

But the stories have also raised awareness, even among investors in the ABS markets.

Still, the Moody’s report cautions against drawing comparisons between the subprime mortgage meltdown that led to the recession and the patterns seen in subprime auto today.

“There’s some hysteria around all this being another housing bubble, that if we don’t nip this subprime flood in the bud right now, the whole system is going to collapse,” deRitis.

He said while there are indeed some similarities, the subprime auto market is vastly different than the mortgage world pre-crisis.  First and foremost, it is smaller and more contained, and even if there is a sharp deterioration, it’s not likely going to lead to the sort of financial shock like the one seen in mortgage meltdown.

Nonetheless, deRitis says he’s hopeful that all the heightened awareness curbs or mutes behaviors that might lead to any sharp rise in delinquencies or defaults, tell-tale symptoms of a significant loosening of credit in the space.

In other words, just because the sky’s not falling, the industry should not look the other way.

The level of losses are relatively low in the subprime tent, but that could lead to a false sense of security among some subprime players.  And when lenders get to comfortable, the real risk sometimes gets muted, because people are only factoring in history that is more recent.  The complacency then gets coupled with a climate of heated competition and that leads to lenders undercutting each other in a race to the bottom.

“A lender will offer more competitive terms, or lower fees and the competition just gets more heated,” said deRitis.

“Each month the data comes out, we’re tracking the delinquency and growth rates, and so far, it looks to be a little out of the club, not quiet to the alarming state yet, but certainly something that could get out of hand very quickly if there’s isn’t some control,” said deRitis.

He said lenders have a responsibility to make sure borrowers know what they’re getting into with a subprime loan.   Borrowers need to understand terms, and interest rates and other fine print.

Meanwhile too, investors in the ABS market, where much of the subprime space is getting its fuel to lend, should make an effort to understand the lending processes that are underwriting the collateral of a bond, deRitis said.

“Investors are asking to see more underwriting guidelines or proof that incomes are being verified, they’re being more cognizant of some of the risks, having learned some lessons from the mortgage meltdown, from that standpoint, we are seeing some corrective action,” said deRitis.

But while they’re peaking under the hood, they might ought consider the geographic composition of the loan pool. The Moody’s report says for the most part, auto credit has mirrored the regional patterns of the recession while deviating in other ways.  Credit growth has been fastest in the West as demographic and investment trends have increased output there.

Credit growth in the Northeast and Midwest, while positive, has been slower as those areas rebuild their economies. Strong credit growth in the South is attributable to a lower base value. There is also larger concentration of subprime borrowers in Dixie.

“If a bond is particularly heavy in an area that has weak economic fundamentals, that’s something to be concerned about, that is a red flag,” he told AFN.

In the end, deRitis said people are asking a lot of questions, but it’s not likely there’ll be any additional regulatory measures beyond CFPB or spot checks by entities such as the Department of Justice, for now. In order for that to happen, there would likely have to be significant systemic shifts.

“There’d have to be some sort of spark to move that through. On one side, you have manufacturers and dealers who say, let’s not break something that seems to be working. Auto sales are coming back, auto manufacturer jobs are back, there are positive benefits, so, let’s not toss out the baby with the bath water,” he explained.

But, if loss rates do spike significantly, or, if even one single bond starts to suddenly erode, and triple-A bond holders are not getting paid off on time, that could trigger more regulatory actions.

If, in the course of current events, a regulator finds some type of large-scale fraud, that too, could lead to congressional actions.

“I think it will be more of the spot checks,” said deRetis. “There are a lot of smaller players, who may not be as ethical as others, but, you’ll see some investigations, and if there are small enough, it’s not going to lead to any sort of regulatory changes.”