Auto Loans

Time to Buckle Up: The State of Subprime Auto Risks

Apr 05, 2020 | By JOSEPH CIOFFI

2019 seems far behind in the rear mirror. Way back then, in our 2019 year-end review, we warned that an economic downturn could cause latent market risks to be seen more clearly. Higher delinquencies and longer terms were among the trends that were intensifying beneath the surface, causing cracks to form on the road ahead.

With that as a backdrop, we conducted our second annual subprime auto survey with broad participation from nearly 150 market participants of all types, including originators, investors, trustees, servicers and others in the field. We had just closed the survey on March 6 and then . . . the world changed.

Early Survey Results

The survey results indicated some pessimism surrounding loan performance and an expectation of some deterioration. While many did not see credit enhancements failing to protect senior tranches, general concerns persisted that credit enhancements could become insufficient. There was an expectation among servicers that they would need to grant more credit extensions versus last year, though these same respondents didn’t expect others to necessarily follow suit.

Similar to last year’s survey, participants cited macroeconomic changes as one of the largest risks to deal performance – the biggest fear being the vulnerability of subprime borrowers to economic shocks. But no one saw what was around the curve.

Now, with a recession being a “near certain” probability, we are shifting our focus to whether the cracks we saw ahead will be able to withstand an economic shock of a severe magnitude. We are re-opening the survey (which you can take here) so that we will be able to compare market sentiment in the pre-coronavirus world versus where we stand today. It’s time for participants to adjust their mirrors, buckle up and realistically consider whether a subprime auto crisis is imminent.

Auto Market Risks

Consumer Impact

With the economy grinding to a halt, one of the most immediate concerns has been financial implications for consumers. U.S. unemployment claims reached 10 million in March (with 6.6M in the last week alone) – the highest level ever recorded. Auto manufacturers and banks have been offering temporary payment relief options for struggling borrowers, for example - Honda and Ally Financial are allowing existing customers to defer payments for 60 and 120 days respectively. With all the focus on conducting triage today, there is little talk about tomorrow. It’s foreseeable that consumers who remain subject to shelter in place orders or unemployed long after the relief runs out will give less priority to their vehicles and consequently their auto loan payments as their vehicles become less necessary for everyday life.

Nancy Pelosi recently introduced a bill that, if passed, would temporarily prohibit creditors from pursuing consumers who fall delinquent on their auto loans. In fact, federal regulatory agencies including the CFPB and FDIC have been encouraging banks to work constructively with borrowers, and clarified that loan modifications will not automatically be categorized as Troubled Debt Restructurings (TDRs), which will relieve banks’ reporting requirements and concerns about having to increase their loss reserves. For the most part though, while mortgage loans and student loans have received the lion’s share of the government’s attention, subprime auto has been left out of the discussion.

Decline in vehicle sales

Vehicle demand had been falling even before the pandemic, with S&P last year predicting that 2020 would see a 3% decline in light vehicle sales. Now, with fewer customers going to dealerships and automakers temporarily halting production, the industry is braced for an even sharper decline. The rating agency revised its projection in light of the outbreak, and now estimates that U.S. auto sales could drop by as much as 20% this year, which would represent the lowest volume in a decade.

We are seeing a number of incentives for new buyers, including payment deferment options and interest-free financing. Companies including Hyundai and Ford are giving new buyers the option to defer payments for 90 days, and Ally Financial is doing the same for new borrowers. Interestingly, 90 days is the timeframe after which a loan is often considered to be in default.

While short term measures will be aimed at providing immediate relief to consumers who have been affected by COVID-19 and incentives are being used to spark consumers to action, these moves are pushing up against consumers’ changing attitude toward vehicle ownership. As lifestyles adapt to the new normal where mobility is less of a necessity, there may be even further pressure on vehicle demand that outlasts the current crisis. The counterpoint to this is that in the future, consumers may place a higher demand on having their own vehicles in which they can control their health, safety and distancing, rather than rely on ridesharing services.

Solvency concerns

Automakers are having to respond quickly to manage liquidity and minimize the impact of falling sales. Even though many factories have closed, manufacturers are finding creative ways to help with the crisis. Ford, General Motors (GM) and Tesla are among the makers that are switching their production from vehicles to ventilators.

Despite this, the financial pressure is starting to take its toll, as reflected by S&P’s recent downgrade of Ford’s credit rating to BB+ and its placing of GM on credit watch. Morgan Stanley is confident that Ford will be able to withstand the economic shock, citing the company’s $30 billion in liquidity as a factor. However, smaller automakers and dealers that do not benefit from as much liquidity protection could be at risk of suffering more severe financial distress, which could, in turn, expose fraudulent practices by consumers and dealers.

Lending Practices and Factors

2019 year-end recap

Recapping what the market looked like before the current crisis started to unfold. Total auto loan debt increased to $1.33 trillion in Q4 2019, up from $1.27 trillion in 2018, and accounted for 9.4% of the $14.15 trillion in national household debt, according to Federal Reserve Bank of New York data. Subprime origination volume (FICO <620) remained steady in 2019 at $121.7 billion, comprising 20% of all auto loan originations, but is likely to shrink this year due to reduced demand. 4.94% of auto loan balances were 90+ days delinquent in Q4 in 2019 – up 10.5% versus a year ago and representing the highest level since 2011.

Longer terms

The initiatives outlined above will increase the time it will take for borrowers to pay off their loans, creating greater scope for disruption to loan performance. Experian reported that loan terms reached “record highs” in Q4 2019, with subprime new car loans averaging 73.19 months, up from 72.85 months in 2018. GM is now offering 0% interest on 84-month loans, and we may see even more of these risky loans going forward as lenders attempt to increase affordability.

ABS Practices and Factors

2019 recap

Overall auto ABS issuance increased to $117.8 billion in 2019, up from $107.3 billion in 2018, according to SIFMA. Although falling vehicle sales may exert downward pressure on securitization volume this year, we would expect this to be counteracted to some extent by the re-introduction by the Federal Reserve of the term asset-backed securities loan facility (TALF), which will create $100 billion in loans for investors to purchase auto and other ABS.

Subprime 60+ day delinquencies continued to climb and hit 5.93% in August 2019 for deals tracked by Fitch – the highest level since 1996. Subprime auto ABS loss rates also increased year-over-year to 9.43% in August 2019, up from 8.32% the prior year. In its 2019 year-end auto ABS tracker, S&P noted that while subprime performance improved, “collateral credit quality weakened slightly compared with 2018,” and the surge in unemployment may cause borrower creditworthiness to deteriorate further still. Higher-than-expected losses led to five downgrades in 2019, up from two the previous year.

What the rating agencies are saying now

In a recent report on the potential effects of COVID-19 on U.S. auto loan ABS, S&P said that auto ABS performance is likely to weaken, and predicted that “higher losses will follow a period of elevated extensions and delinquencies.” The report noted that the subprime sector is most at risk of ratings disruption, as subprime borrowers are more likely to be impacted by unemployment. S&P believes that speculative-grade subprime auto ABS (rated ‘BB+’ or lower) will be particularly vulnerable to downgrade, as these tranches do not benefit from as much credit enhancement. As a result of this, S&P is increasing its loss expectations and stress testing for the lower tranches in new auto deals.

Investor concerns

Investors have been expressing concern that payment deferment options will jeopardize their principal and exacerbate losses. Reserve funds in subprime auto ABS are usually only designed to cover short-term payment interruptions (typically 5 months of interest coverage) and are not likely to be sufficient to cover extended periods of delinquency.

The delay in implementation of the Current Expected Credit Loss (CECL) accounting standard, which will require financial institutions to increase their loss reserves, was encouraged by banks, as it will allow them to sustain lending in these challenging times. Similarly, the clarification regarding TDRs will be a relief for financial institutions as it will enable them to preserve capital. But these measures could obscure the true likelihood of losses.

Looking Ahead

While consumers and auto companies are immediately feeling the effects of the economic uncertainty, it may be some time before we start to see the damage to the secondary market. S&P cautioned that it is too early to be seeing any worsening auto ABS performance, but once Q1 2020 market data is released later this month, we should have a better idea of the impact.

In the coming months, we can expect to see higher levels of delinquencies and extensions, reflecting job losses and borrowers falling behind on their auto loan payments. In the longer term, as defaults mount up, bonds may be increasingly at risk of not being repaid, and rating agencies may look to increase their loss expectations. Until now, ratings expectations for deals were often based on “moderate” stress scenarios. This unprecedented economic crisis may subject deals to far more extreme economic conditions than could have reasonably been foreseen, and consequently, existing credit enhancement coverage may no longer be sufficient. Damages may not be limited to the lower tranches and may bubble over. Ultimately, higher losses and more downgrades could be on the horizon.

How do you feel about the risks?

As we face an impending recession, it appears the cracks that were forming in the subprime auto market are likely to be eroded further. But, of course, the story isn’t over. There’s a shadow hanging over us, but government fiscal and monetary policies will soon influence the market. It’s a shifting landscape in which participants’ expectations will now need to reflect their confidence in the government to do the right thing (or do things right). Does it look as though the market’s troubles are here to stay? Or do you have a feeling everything is going to be alright? Take our updated survey and look for our updated market study in May.

Emily Hatchett, a paralegal in the Insolvency, Creditors’ Rights & Financial Products Practice Group of Davis & Gilbert, assisted with this post.