Subprime Auto: Is the Tank Half Empty?

For the past two years, the subprime auto market has defied expectations, but 2023 is off to a cold start. Normalization is on the horizon, but when we will get there and what it will look like when we do, remains unclear. What is normal in this moment is to ask whether the performance data is a sign of deeper trouble. And if so, will the structural protections in auto ABS continue to protect investors?

As ABS performance weakens, there’s always the risk that investors may seek to investigate potential problem spots and determine if they have claims. Increased regulatory scrutiny will likely accelerate concerns.

Point: Why the Tank is Half Empty

Neuroscience tells us the human brain is biased toward negativity, but it doesn’t take a negative outlook to see the warning signs. 
S&P has noted that performance has been weakening. Per KBRA, 60+ delinquencies in subprime auto in December were at 5.6% – matching pre-pandemic levels. Annualized net losses have been rising for months and reached 8.0% in December. This remains below KBRA’s reported pre-pandemic net loss level (February 2020 was 9.4%), however, S&P’s delinquency figures and extensions for November 2022 exceeded pre-pandemic levels. 

Net losses fell to near historic lows in 2022 which KBRA attributed to the high used vehicle prices and higher delinquency churn rates. Used vehicle values peaked in January 2022 and have been steadily falling for months. December saw a price change decline of 1.9% (non-adjusted) compared to November, which resulted in the largest annualized decline in the Manheim Used Vehicle Value Index series’ history. Yet, KBRA, looking at a decade of auto ABS data, thinks vehicle values will remain higher than in recent years. 

Inflation is putting pressure on consumers from all sides, and subprime borrowers’ wallets are stretched the most. For those who had no choice but to buy during the pandemic (at the top of the market), negative equity may be a real issue, compounded by historically high prices and interest rates. More and more consumers may need to choose between an aging vehicle worth less than they owe, or the increased pressure of new debt on a purchased vehicle inflated by negative equity in the trade and higher interest than their previous loan.  These dynamics may be reflected in tighter underwriting standards, which if tightened too much, will reduce available credit and bring more costs to the market.

Counterpoint: Why the Tank is Half Full

All that being said, history is on the side of subprime auto. 

As market leaders in our past webinars have noted, sequential pay and strong credit enhancements do a great job of creating protective buffers in this sector. Subprime auto has weathered rough markets before.

Just looking at a few 2023 deals some credit enhancement rates have been rising. For instance, a Santander transaction backed by subprime receivables from January increased initial hard credit enhancement over the previous Santander transaction in November, across classes A, B, and C to 52.25%, 42.40%, and 26.50%, respectively, from 45.50%, 36.60%, and 23.35%. Similarly, a CPS subprime transaction in January increased hard credit enhancement over the previous CPS transaction in July for classes A, B, and C to 58.40%,46.35%,and 30.50%, respectively, from 55.20%, 42.85%, and 29.50%.

In addition, S&P recently ran some stress models to test the subprime auto deal structures and found rating upgrades in all three hypotheticals, but the magnitude of downgrades depended on the stress level.

In any event, the number of subprime loans overall is approximately $150 billion of the $700 billion market. Of that, only 29% are securitized. So, unlike the housing market, any subprime auto trouble is less likely to tip the whole market.

The Fine Point: Investors Will Act Earlier Than in Past Downturns

If investors are concerned about losses, there have been two significant legal developments in ABS litigation that should encourage their swift and decisive action. 

First, the Court of Appeals in New York ruled in March 2022 in US Bank N.A. v. DLJ Mortgage Cap. Inc. that based on the repurchase protocol of the RMBS agreements at issue investors would need to do any forensic investigations and specifically identify all claims for all loans prior to beginning suit. Now that loan-by-loan, pre-suit analysis is required, they can no longer assert claims based on post-filing expert findings. This is having a huge impact on these cases and gives reason to auto ABS investors to sure up their claims upfront. 

Second, the materiality standard as developed in RMBS litigation allows materiality to be shown by a “material increased risk of loss”. As a result, investors could arguably assert material breaches of representations and warranties before actually incurring losses. 

Regulatory Concerns May Accelerate Action by Investors

Two areas in particular have the attention of investors: alternative data and ability to pay.

Alternative data is an area that is getting increased attention from the Consumer Financial Protection Bureau (CFPB) and the White House. Although it can shed light on true credit risk and improve performance, the CFPB has expressed concern over how bias could get baked into AI and machine learning algorithms that analyze alternative data. The White House published a Blueprint for an AI Bill of Rights as a framework to provide core values in the use of AI and protect against algorithmic discrimination. 

The CFPB may issue a rulemaking creating more risks around this practice. Given the pitfalls and uncertainty around regulatory action, it is a potential area of focus for breaches of representations regarding compliance with laws. 

We recently discussed the risks around alternative data and provided best practices in this article for Reuters Legal News and Westlaw Today

Regarding the ability to pay standard, the recent complaint by the CFPB and New York AG against Credit Acceptance Corporation (CAC) has renewed attention on the potential for it to be applied to auto lending. You can read our prior post regarding the standard here, which discusses the earlier suit against CAC brought by the Massachusetts AG and my thoughts related to the recent lawsuit in MarketWatch and American Banker

Looking Ahead

Whether or not disruption comes to subprime auto, investors have the impetus and means through recent ABS-related court decisions to act earlier than investors in prior economic downturns. That could spell more litigation activity than anyone has ever expected in the market. 

As attorneys at D+G, we have represented parties in ABS litigation related to breaches of representations, gross negligence, fraud, loan servicing standards, and indemnity and have participated in the very disputes that will shape any battles over loss allocations in subprime auto and other ABS markets. Please contact us if you’d like to learn more. 

Nicole Serratore, an attorney in the Insolvency + Finance Practice Group of Davis+Gilbert, assisted with this post.

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