Winter is Coming. Subprime Auto Participants’ Worst Fears May Come True in a Recession

The phrase “winter is coming” was more than just a motto to House Stark in “Game of Thrones.” It was both a warning and a call to vigilance – the honor in readiness and preparation that was the key to victory. Subprime ABS participants should heed that call. With uncertainty swirling about the economy, even the most sure-footed optimist should be concerned for what lies beyond the seemingly safe path that subprime auto has followed in the past.

With the recent stock market drop and the inversion of the yield curve in the bond market, the word “recession” is on everyone’s lips. The declaration of a recession happens retroactively, so the question on many folks’ mind is, “are we there yet? And if not, is our arrival inevitable?”

Our market study revealed that participants’ greatest concerns related to credit quality were less about underwriting standards, and more about the ability of subprime borrowers’ ability to ride through an economic storm. The concerns amplify our past reports on the rise of subprime auto delinquencies, noting that weak performance exists despite the backdrop of a benign economic environment. If people are struggling with car payments in a time of stability, how much worse will it get if there is an economic crisis?

Yet troubling news keeps coming. The most recent New York Fed Quarterly report on Household Debt and Credit shows a severe uptick in transition into severe delinquency for auto loans. These second quarter results demonstrate that “[a]uto loans are now 21 percent of the outstanding severely derogatory balance, a larger share than what we’ve seen historically.” In its blog, the NY Fed also pointed out blog that “auto loan delinquencies have been increasing for subprime borrowers in the past five years.”

Wolf Richter at Wolf Street has noted that second quarter serious delinquencies (90+ days or more past due) show a 47 basis point increase year-over-year, which is “the largest year-over-year jump since Q1 2010.”

This turbulence spans out to the broader environment as well. The bad news out of Germany of an economic slowdown, China’s industrial production falling, and the United Kingdom with its Brexit woes have all cast a pall on the overall global, and US economic, outlook. By certain accounts, auto makers are preparing for a recession coming out of the trade war with China, as well as a drop-off in market demand. Even with the Trump White House delaying additional Chinese tariffs, confidence is being chipped away day by day.

Although there’s a counterpoint that fundamentals are fine and the numbers are not so dire, the latest news is a caution flag given participants’ serious concerns about the subprime borrower’s ability to survive an economic shock. Credit enhancements largely continue to protect investors from poor performance, but the forecasts on which those enhancements are based could move in an unexpected direction.

It’s best to remember that, as was pointed out several times in GOT, the Starks were always right.

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