Like a car on a bridge buffeted by strong winds, subprime auto lending will be challenged on several fronts as it approaches the other side of the pandemic. Turns out, the anticipated “new normal” may involve a new framework with subprime borrowers under severe financial pressure and regulators watching underwriting, servicing and collection practices. It’s difficult to know if a market change is temporary or represents a trend, but areas of risk can be identified. We talked with some industry leaders regarding their reactions to the state of the market.
Origination and Performance
Overall, auto origination for both prime and subprime auto lending has been declining in 2022, mostly because 2021 levels were historically high. Also, lower inventory has resulted in fewer transactions. The NY Fed has attributed increases in auto origination dollars in Q1 2022 to higher vehicle prices. According to NY Fed data, subprime (<620) origination has been gradually declining for the past four quarters following a peak in Q2 2021 of $35 billion. Now, at $27.7 billion, originations are close to pre-pandemic levels (in Q1 of 2020 they were at $28.4 billion).
Though the “average balance of new auto loans reached $28,415 in Q1 2022 — a YoY increase of 15.2%,” according to Transunion — we’re now beginning to see a little drop off. The Manheim Used Vehicle Value Index declined 1% from March to April.
Higher prices have resulted in higher loan amounts and payments, but, through the pandemic, there have been enough countervailing factors in the market to warrant “staying the course and not making changes to underwriting standards,” notes Sean Morgan, Senior Vice President of Finance at Westlake Financial.
In February, Equifax reported an all-time high for delinquencies on subprime loans and leases. But some have questioned whether Equifax’s delinquencies data is overinclusive (by including charge-offs which overstate the severity of late payments) and TransUnion has reported subprime auto 60+ delinquencies as actually falling from 12.01% in February to 11.19% in March. This leaves a question of whether there could be a weakening across consumer credit sectors that may persist as inflation heats up.
Credit extensions are often an early warning sign of this weakening. According to Standard & Poor's March 2022 U.S. Auto Loan Tracker, the subprime extension rate has declined month-over-month from 2.62% in February to 1.87%, and it has also declined year-over-year. Tax refunds do have a seasonal impact, but, even with inflation, S&P is not seeing “stress” in the extension numbers.
Lowell Sandell, Corporate Counsel at Westlake Financial notes that Westlake is seeing more routine extensions at this time akin to “normal maintenance on a loan in its path to maturity.”
Moving Toward a New View of Subprime?
With the end of government stimulus and rising inflation, properly identifying credit risk may require rethinking the factors that go into determining prime and subprime status. A LendingClub study said 64% of people report living paycheck-to-paycheck and nearly a quarter of them have FICO scores above 750.
Alternative data and artificial intelligence are available to help lenders understand these anomalies and make better credit decisions. According to Morgan, “Third-party data augments lending decisions and adds a ton of value when it can factor in more aspects of a borrower’s spending and payment habits.”
William Fife III, Chief Compliance Officer and General Counsel at Arivo Acceptance LLC, sees additional benefits from alternative data since “it can help weed out dealer fraud and can even get borrowers a lower rate because the lender has a better picture of the risk factors.”
Subprime Auto ABS Volume
The market view is that rating agencies protected investors well on auto asset-backed securities (ABS) throughout the pandemic. “Credit enhancement has been healthy,” according to Sean Morgan. But he points out that now “interest rates will be the thing to watch.”
Based on Finsight data, there were 15 subprime auto ABS deals in Q1 2022, on par with Q1 2020. With 67 deals, 2021 reached a historic high in volume. For comparison, there were 57 deals in 2019.
But this level of activity is not expected to proceed through 2022. Fitch Ratings’ prediction for 2022 was “a neutral performance outlook” for ABS, expecting “losses and recovery rates to stay relatively flat in core sectors such as auto and credit cards.” Fitch specifically expressed concern about subprime auto as being among the sectors that would “remain more susceptible to performance volatility given generally weaker borrower profiles.”
The Wall Street Journal has already reported on some pullback in the sector due to pricing and wider spreads.
While the CFPB has taken an increasingly aggressive tone in its bulletins, market participants we’ve talked to have suggested the CFPB does not always fully understand the practices they are critiquing.
Regarding the Consumer Financial Protection Bureau’s (CFPB’s) recent concerns about repossessions, William Fife says he has not seen any rush in the space to repossess. “The CFPB may be using this heated language to support their regulation by enforcement approach.”
Further, Sean Morgan says that “there’s no benefit for the servicer/lender with repossessions because you are locking in a loss.”
Fife suggests a shift in collectors’ perspectives. “For Arivo, we want to take the word repossession out of the vernacular of collections. We want to be working to problem solve to prevent repossession.”
With the approach to collections modernizing under Regulation F, Morgan says that this change “helps to limit antiquated servicing practices and transition to communication mediums that are more frequently used by borrowers.”
To help participants prepare for and succeed in the new normal, I’ll be moderating a panel discussion at the National Automotive Finance Association’s Non-Prime Auto Financing Conference with Sean Morgan and Lowell Sandell of Westlake Financial and William Fife of Arivo Acceptance. We’ll discuss the risks and opportunities resulting from economic uncertainty, available technology and regulatory enforcement. ABS structures have historically protected investors, but there must always be sound fundamentals in origination and servicing. An informed discussion of the state of the market by these leaders will help identify best practices for maintaining success going forward.
Nicole Serratore, an attorney in the Insolvency + Finance Practice Group of Davis+Gilbert, assisted with this post.