Subprime Auto: There’s No "There" There, Is There?

As history bears out, "honest disagreement is often a good sign of progress." We’ll take it as a positive sign then that, when taking the pulse of the subprime auto market lately, the discourse surrounding risk levels is becoming more fact-based than we’ve seen in the past.

Nothing to See

S&P has noted that better collateral is leading to lower losses for prime ABS. Since 2016, subprime ABS cumulative net losses have been stabilizing. Numerous deals have received ratings upgrades, which is to be expected as deals pay down and downgrades have been few and far between. Aside from the challenges posed by the state and federal consumer protections, and the uncertainty of the upcoming Presidential election, some participants we’ve spoken to do not see major risks ahead.

Is It Because the Risks Are Hidden?

Recently, at the AFSA conference, a wise woman summed up her view colorfully, "when the water recedes, you can see who’s been skinny dipping." I hadn’t heard that one before, but it’s much more pleasant than the old cockroach analogy. It aptly reflects the concerns expressed by some who are familiar with certain practices that could broadly be categorized by fraud and layered risk.

As to the fraud issue, it comes in many flavors, but the Wall Street Journal recently shed light on the unsavory practice of "kick the trade," where a dealer recommends to borrowers who are underwater on their vehicle loan that they let the lender repossess the vehicle, but only after taking out a new loan on a new vehicle. Escalating the risks, dealers may also misrepresent the income of those borrowers to assist them in getting the new loan.

The trend of letting unpaid balances of prior vehicles get rolled over into new car purchases has also been an increasing problem, leading to more borrowers with negative equity. Edmunds reported that people trading in cars with negative equity has grown from 19% ten years ago to 33% today. Likely culprits are both the cost of cars rising and the length of repayment terms gradually extending.

Regarding layered risk, Experian reported the average loan terms for:

  • Used cars – 65 months, with 20% having terms of more than 72 months.
  • New cars – 69 months, with 33% having terms of more than 72 months.

Over such a long period, there is a greater risk of events that will disrupt loan performance.

While some have seen positive signs in the market, others have noted a 15.5% "surge" in serious delinquencies year-over-year, estimating that it’s likely that 23% of all subprime auto loans are seriously delinquent. This is impacting subprime ABS with the January 2020 60+ day delinquency rate for auto loan ABS, which have reached the highest rate for any January at 5.83%, and higher than delinquency rates during the Financial Crisis. Most of the blame is placed on aggressive subprime lending to meet strong investor demand.

Global Capital reported on caution raised at SFVegas 2020 around deep subprime consumers and the rise of revolving auto ABS structures. Given the vulnerability of subprime borrowers experiencing an economic pinch to their wallets and lack of robust performance history for longer loan terms, investors should be watching closely for signs of strain.

Looking Ahead

While the debate over subprime risk may have entered a quieter, gentler phase, we see the controversy heating up, especially now that the coronavirus spreading across the globe has economists raising estimates of a global recession. It’s the perfect time for our Second Annual Subprime Auto Market Study, which will take a 360-degree view of the market to reveal market participants’ expectations related to credit ratings, credit enhancements and credit quality. The survey has just closed with nearly 150 originators, servicers, trustees, investors and service providers sharing their valuable insight. Keep an eye out for the full report when it comes out at the end of May, which may reveal, with respect to participant’s expectations of increased losses, whether there is truly any "there" there.

Nicole Serratore, an attorney in the Insolvency, Creditors’ Rights & Financial Products Practice Group of Davis & Gilbert, contributed to this post.