Momentum changes everything – it’s hidden, but you know it when you feel it. It has the power to shift markets, so if you find where it’s headed, best to get there first. As we near year end, we’ve identified clues as to where momentum will take subprime auto in 2020, and in subprime auto, the 2019 numbers tell the story.
Performance is (almost) Everything
Subprime auto origination volume revved up slightly this year and accounted for 21% of all auto loans originated in the first half of 2019, according to Federal Reserve Bank of New York data. Auto ABS issuance reached $91.5 billion through September 2019, up 12% versus a year ago, according to SIFMA.
2019 has been a record year for subprime auto delinquency rates. 60+ day delinquencies for subprime auto ABS tracked by Fitch hit 5.93% in August 2019 – the highest level since 1996. S&P also observed high delinquency levels, which it attributed to a greater percentage of deep subprime loans in securitizations.
S&P Global Ratings reported that subprime losses increased in August by 13 basis points from the previous year, although recoveries have improved. The rating agency raised its loss expectations for a number of transactions this year, including First Investors Auto Owner Trust deals. As we noted previously, higher-than-expected losses led S&P to downgrade recently the Class E notes in four CPS Auto Receivables Trust deals. This brings total year-to-date downgrades to five, up from two in 2018. Prior to that, S&P had not downgraded an auto ABS since 2011.
Meanwhile, auto loan terms reached “record highs” this year and averaged 72.90 months for subprime new vehicle loans, according to Experian, and we are seeing more loans with 84 month terms. Loan amounts are also increasing as new car prices continue to rise. On average, subprime borrowers took out a loan of $29,795 for a new vehicle in Q2 2019, which is 5% more than in 2018. Used car prices, on the other hand, fell by 1.6% in September – the greatest decline in a year, reflecting a high volume of vehicles coming off lease.
Reports earlier this year that Santander Consumer verified income on less than 3% of loans in a $1 billion subprime auto bond was another sign that underwriting standards may be loosening. It has since been revealed that Santander’s subprime auto loans are defaulting at the “fastest rate since 2008,” prompting yet more comparisons to the lead-up to the housing crisis. Santander’s repurchase of offending loans has so far shielded bondholders from losses. In fact, the lender is now required to buy back certain loans following a 2017 settlement agreement with Delaware and Massachusetts over predatory lending allegations, and has repurchased nearly 7% of loans in a 2018 offering.
In the wider bond market, yield curve fluctuations have sparked fears that an economic downturn may be on the horizon. Last month, S&P increased its odds of a recession in the next 12 months to 30-35%, and noted that the U.S. auto industry “faces ongoing negative pressure” from global economic uncertainty and declining used car prices.
As S&P has noted, downgrade potential has increased this year, and 32% of the 41 auto issuers it rates are currently on negative watch. The agency even predicts that falling demand will lead to a 3% decline in light vehicle sales in 2020, and also cautioned that long term loans, which are becoming more prevalent, can “weaken auto-bond performance when credit conditions sour.” Similarly, DBRS found that in a recession scenario, an increase in cumulative net losses reduced credit enhancement coverage and left lower tranches more vulnerable to downgrade.
What’s Around the Corner for 2020?
Just as subordinated notes are closest to the fire, so too are lenders dipping into the deep subprime market. Investors may exercise more caution around smaller lenders with limited securitization histories, but exuberance will likely remain high for junior tranches among investors in search of higher yields.
Lending practices may start to be affected by the Current Expected Credit Loss (CECL) accounting standard. The new model, which will require financial institutions to increase their loss reserves, is due to come into force in 2020, but implementation has now been delayed to 2023 for small and private companies. As reported by Bloomberg, Ally Financial expects to double its loan loss reserves in order to meet the new requirements. CECL was intended to bolster reserves to protect against an economic downturn, but with a three year delay for most banks, this may not come soon enough to protect against a more imminent threat of a recession.
These trends – higher delinquencies, longer terms, and greater-than-expected losses – may not, on their own, trigger a subprime auto crisis in 2020. But, in an economic downturn, credit enhancements may not be able to withstand weakened performance, causing losses to intensify and bubble over. Subordinated tranches are already feeling the impact, and we expect to see more warnings and downgrades in the near future if market conditions continue to deteriorate.
Further, an economic downturn could cause latent market risks to be seen more clearly. For example, a combination of slumping sales and worsening economic conditions could result in more auto dealer bankruptcies, and in any dealer bankruptcy, it would not be too surprising if fraud by consumers or the dealer (or a combination of both) is uncovered, creating doubts in the market.
Emily Hatchett, a paralegal in the Insolvency, Creditors' Rights and Financial Products Group, assisted with this post.