Subprime Auto in 2018: Riding a Market That’s All Show and No Go

If the subprime auto loan asset-backed securities (ABS) market collapses, any post-mortem is likely to begin and end with the underlying auto market.  Of course, it won’t all be about sales practices and consumer trends – there would also likely be closely-related contributing factors in lending and ABS practices.  But despite growing concerns, following the 2018 Detroit Auto Show, it appears the auto market is poised for a year of activity centered mainly around “innovations” that are inconsequential to the larger issues that are sure to buffet the industry.

If Detroit is any indication, new hybrids and electric models will get the attention at the upcoming New York Auto Show and other shows this year, but neither the industry nor the environment are going to be saved by an electric car that can go faster than a gas-powered model.  That’s a novelty, not a solution.  These feats of engineering create an upbeat buzz that masks the fact that fundamentals in the market are shaky at best.

A Combustible Mix is Brewing

Sales are steady, but that’s only because of fleet sales and huge incentives.  The deals being offered to consumers mean cars are worth less even before they are driven off the lot, and then values only go downhill from there. The average car (from model years 2007-2016) depreciates one-third in the first year and more than half in four years. To make matters worse, prices continue to be depressed by vehicles coming off leases and the rapid pace of technological advances.  The auto market was always marked by “planned obsolescence” as manufacturers rolled out fully redesigned models every eight years or so, but now it seems the better description is “inevitable replacement” based on technology dependency.

As competition for sales intensifies – both within the auto sales market, and increasingly, car ownership alternatives – lenders become more at risk of aggressive practices at dealerships, and investors become more exposed to loosening underwriting principles. With 95% of vehicles financed or leased (and 70% of that by captives), a combustible mix is brewing in auto finance of negative equity brought about by accelerated depreciation, incentive for dealer misconduct and lower quality loans.  Smaller lenders, which have successfully gained market share, are the most vulnerable, and those that are in the fray of the subprime market could be the first to incur losses.

Subprime Lenders and Their Investors Will Be Most Vulnerable

Investors have remained optimistic that subprime auto lending will thrive, as demonstrated by major investments in Exeter Finance and Flagship Credit Acceptance by well-known private equity firms.

This is not unlike the risks taken by private equity firms pre-financial crisis.  Remember that in 2006 and 2007, just before dozens of subprime mortgage lenders shut down, there were several large investments by private equity firms that publicly declared their optimism for the future of the market.  For example, there was Cerberus Capital Management, L.P., which took control of Residential Capital in 2006 and then sought to buy Option One Mortgage Corporation in the midst of all the bad news in 2007 (though that deal fell apart), and also Lone Star Funds, which bought Accredited Home Lenders in 2007.

As the key driver of future loan performance, the auto industry, including the manufacturers and their captive financing arms, could steer the industry clear of history. And yet, they appear poised to roll on with machinations to prop the market up in ways that put the finance sector at risk.  This could be an industry heading east, looking for a sunset.  Unless the course changes, Dylan’s lyrics seem appropriate here: “It’s not dark yet, but it’s getting there.”


Massimo Giugliano, counsel in the Insolvency, Creditors’ Rights & Financial Products Practice Group of Davis & Gilbert, contributed to this post.

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