“The market is resilient” was the mantra throughout the pandemic. Now that the Federal Reserve is at an inflection point on interest rate hikes and the pause on student loan payments is set to end after three years of relief, “the market is vulnerable” may be a more appropriate refrain. In fact, the cracks have started to show, particularly in subprime auto ABS.
A recession looms, yet never seems to arrive. One could be forgiven for growing weary waiting for it to happen. Unemployment remains low and consumers are spending their money despite higher prices. The trick for the Federal Reserve has been to try to cool the economy through higher interest rates without going so far as to drive the economy into a recession. That’s precisely the tipping point we appear to be at right now. The Consumer Price Index has fallen dramatically from a high of over 9% last summer to 3%, which is very close to the 2% target that is believed needed to stabilize prices. It appears the Fed’s fight against inflation may be finally over, and yet there are concerns that some at the Fed do not believe the battle is won.
If another rate hike happens at a time when the economy is already in cooldown mode, there could be severe consequences, especially to employment, which would negatively impact loan performance.
Auto Loan Originations
Originations have declined as more consumers use cash rather than take out high interest loans. Typically, that would mean more competition and looser standards to spur volume, which creates a greater risk of delinquencies and losses going forward.
Regional banks were leaders in certain sectors of market lending. With the collapse of several regional banks and the market jitters around their financial health, we are starting to see them offload some of their loan portfolios. As we’ve discussed, commercial loan portfolios are being sold off to help balance sheets at some banks. Consumer loans and auto loans are now up for the offering as well.
The recent banking crisis may prevent at least the larger banks from going down the credit scale and smaller lenders are dealing with scarce and expensive capital sources, which will limit their risk appetite. In all cases, this means less credit flowing to the subprime sector.
Case in point, Cox Automotive noted how credit tightened in the spring, reaching a two-year low in May. There was some slight improvement in June, but they reported credit is tighter versus last year and compared to pre-pandemic levels. Subprime’s share has been on a downward trajectory for months, dropping steadily from 13.4% in March to 10.5% in June.
Origination volume of both prime and subprime loans and leases was $162 billion in Q1 2023 per the New York Fed, which was down “from pandemic-era highs but still elevated compared to pre-pandemic volumes.” The most recent NY Fed report also noted that there was some tightening in credit with the median credit score on new auto loans rising to 721.
Spring is usually a positive moment in auto when tax refunds help borrowers pay down debt or improve new car sales. But that has not necessarily been the case this year.
S&P reported in July that the subprime 60-plus-day delinquency rate rose from 4.84% in April to 5.22% in May which is the highest level for May in the history of S&P’s tracking (comparing it to a pre-pandemic example of May 2019 at 4.54%).
They saw this as grounds for concern based on consumers’ struggles with inflation and debt and these numbers may also be a result of more deep subprime lenders populating this market segment.
Losses and Recoveries
S&P published a specialized report on 2022 vintages and their unusual performance issues. Q1 2022 has a cumulative net loss of 6.11% which is a nearly 160 basis-point (bps) increase over the 2021 vintage losses of 4.53% at the same performance month (month 15). It gets worse with Q2 2022 showing elevated losses relative to the 2015-2017 vintages at the same age.
S&P attributes these issues to a number of factors including pandemic aid ending; possibly inflated credit scores due to the pandemic-related, government-mandated reporting deferrals; inflation and its particular impact on subprime borrowers; an increase in loan volume that came at the expense of credit quality; vehicle values dropping and recovery rates falling in kind; and the lag between interest rates at the time of origination versus at the time of ABS issuance.
This has led to notable downgrades on junior tranches. S&P put ten non-investment-grade classes on CreditWatch negative and downgraded six this year.
For the first time since the 1990s, Citigroup is reporting that auto ABS bonds could fail to return principal to their investors. Bonds for US Auto Sales and American Car Center are under severe distress after both dealerships announced their closure. Citigroup’s data claimed that the overcollateralization fell from 35% to just 5.5%.
On a brighter note, and as S&P noted, deal structures have proven incredibly robust, particularly for the senior tranches where the credit enhancement remains strong (and S&P notes upgrades exceed downgrades by a “wide margin”).
Subprime losses reached a level in May 2023 of 5.88%, which is significantly higher than May 2022’s 4.01% but lower than the pre-pandemic 6.34% in May 2019. Recovery rates have been strengthening.
The question now is whether some factor that is yet to be identified will surface as the reason for the poor performance of 2022 vintages and carry forward.
In addition, beyond the Fed’s actions on interest rates, there are several areas of concern that could affect access to capital and lending practices:
- Commercial real estate - in particular the office sector. As we’ve reported, a substantial number of CMBS loans will need to be refinanced soon. They are maturing at a time of higher interest rates and lower valuations. This will mean defaults and more problems for banks in this sector.
- On the legal side, we’re looking to see what the Supreme Court decides in the Consumer Financial Services Association of America v. Consumer Financial Protection Bureau case regarding the Constitutionality of the CFPB’s funding. The Fifth Circuit ruled that the CFPB’s funding structure was unconstitutional and therefore actions taken by the CFPB were void. The CFPB petitioned the Supreme Court on an expedited basis arguing the Fifth Circuit’s decision was erroneous and the authority/existence of the CFPB hangs in the balance.
- Also, we’re watching what happens in the CFPB action against Credit Acceptance Corporation. This lawsuit is the agency’s attempt to bring the ability to repay standard to subprime auto. Credit Acceptance is pushing back hard this time by filing a motion to dismiss. If CAC prevails on its motion, it may put the nail in the coffin of the “ability to repay” concept altogether.
- It is possible the CFPB would attempt to issue rules on ability to repay but that would require a long notice and rulemaking process. That would be open to public comment, feedback and industry resistance and it would probably take years to promulgate.
Nicole Serratore, an attorney in the Insolvency + Finance Group at Davis+Gilbert, contributed to this post.