Subprime auto loans – the next bubble?

Subprime auto loans, which finance the used car purchases of buyers with the lowest credit score, are on the rise. Dubious lending practices in the space have led the U.S. media to compare the growth in this segment of the credit market to the subprime housing mortgage bubble that caused the financial crisis in 2008.  

The New York Times featured an article in July that was highly critical of subprime auto lending. The piece named cases of customers who overstretched themselves due to excessive interest rates of 20 percent or more for cars that were often massively overvalued. 

Other borrowers had unwittingly signed up for unnecessary insurance products adding to the burden of making monthly payments. 

Part of the problem is that the car dealerships, keen to sell their stock of cars, have an obvious incentive to arrange the credit to purchase a used vehicle. Not surprisingly nearly everyone in the United States qualifies for a car loan. 

And when a borrower does not, providing false employment and income information can overcome this obstacle in a similar way many subprime mortgages used to include incorrect and falsified borrower income figures to arrange more risky mortgages during the housing bubble.  

The larger issue, The New York Times suggested, is that when many of the risky car loans are bundled together to back asset-backed securities and sold to investors, the hidden risks are transferred to the financial markets.  

Potentially, the effect could mirror the bursting of the subprime mortgage bubble which led to the financial crisis and subsequent recession, albeit on a somewhat smaller scale, the Times article argued. 

This theory is also compelling to regulators who are already getting involved.  

In July, the Justice Department subpoenaed subprime auto lenders General Motors Financial Co. and Santander Consumer USA asking for documents relating to the origination and securitization of subprime automobile loan contracts since 2007 to determine if the loans are riskier than they are professed to be and part of complex financial products held by investors. 

But could subprime auto loans really lead to a repetition of the crisis caused by subprime mortgages? 

There is no doubt that car loans are growing and subprime auto loans are growing faster than the rest of the market.  

The quarterly report on household debt and credit by the New York Federal Reserve found that auto loan balances in the U.S. are up by $30 billion, boosted by $101 billion in auto loan originations. Auto loan balances, including leasing, have increased for 13 straight quarters and reached the highest volume of originations since the third quarter of 2006. 

The subprime segment, auto loans made to customers with the worst credit score of below 620, is growing the fastest. In 2013 about 23 percent of auto loans were originated by borrowers with the lowest credit scores and the highest risk.  

According to consumer credit reporting agency Equifax, that number is even higher and the share of subprime in auto loan origination reached 27 percent last year, up from 20 percent in 2009. Yet prior to the financial crisis this share was as high as 36 percent in 2006. 

For researchers at the New York Fed, these figures are worth monitoring but no reason to ring alarm bells. The authors of the report “Looking under the Hood of the Subprime Auto Lending Market” say subprime auto lending is certainly on the rise in absolute terms but the general increase in auto lending “makes the relative increase in the subprime share less pronounced.” 

The New York Fed researchers say lending to the lowest credit score borrowers was hit hard after 2006 and had dropped by two thirds by the end of 2009, which is why during the economic recovery subprime auto lending bounced backed more significantly than other car loan categories.  

They point out that the car loan market is split into two segments: auto finance companies which are typically associated with a car manufacturer and banks. 

Auto finance companies represent 53.7 percent of new auto loans and are also the main originator for subprime loans compared to banks, which are much more conservative and risk averse in their lending. 

As a result, 30-day delinquency rates for bank car loans have been lower at around 1 percent than loans by auto finance companies (2.5 percent). Overall, the percentage of auto loan debt that is 90 days or longer delinquent remained flat at 3.3 percent.  


Subprime auto asset-backed securities  

There are currently no signs that unrecognized risks have been transferred to the capital markets. 

Auto lenders use asset-backed securities to finance their business and make out new loans. The securitization process consists of bundling loans and transferring them to a bankruptcy remote special purpose entity, which then moves the loans to an asset backed security trust. 

The trust uses loans as collateral for bonds that are sold to investors, and investors get paid as the loans are repaid. Investors are fully aware that a certain percentage of loans will default and they are compensated for the risk. 

Despite the risky subprime loans that back the securities most subprime auto loan ABS are structured relatively conservatively with excess loans and reserves covering for initial losses so that they are safer than the complex multi-asset securities that were sold before the financial crisis. There are also no synthetic derivatives related to subprime auto loans which would amplify losses should the market turn sour. 

So far, subprime auto ABS are not exhibiting any unusual behavior that would suggest auto lenders are unduly stretching their loan terms making the underlying loans riskier than they appear to be. Credit rating agency Moody’s says the performance of subprime auto ABS is in line with the perceived risk profile.  

And Standard & Poor’s Ratings Services said in July asset-backed securities overall, including those back by auto loans, remain adequately protected against increasing credit risk. The recent increase in expected losses is more a sign of a functioning market after an unsustainable period of overly restrictive loan terms following the financial crisis, the rating agency noted.  

Cristian deRitis, a senior director at Moody’s Analytics makes the same point. “Vigilance is needed to protect borrowers, but expanded lending activity with some deterioration in performance may be symptoms of a lending market returning to normal rather than overheating.”  

Overall, he writes in the research note ‘Is U.S. Auto Lending About to Bubble Over?’, it is difficult to argue that the wider availability of credit in the auto loan market is not a good thing for the automobile industry and consumers. “While households with less than perfect credit were unable to finance house purchases or other spending during the recession, they could qualify for auto loans as long as they could prove employment and had steady incomes. For some, the ability to purchase a vehicle meant the difference between keeping a job and unemployment,” he writes. 

Another important point to consider is that auto lending is small compared to the mortgage market, in particular relative to the subprime mortgage market before the financial crisis. Car loan ABS represent 12.4 percent of all outstanding asset backed securities and of the $168.3 billion of outstanding car loans $30.4 billion are subprime, SIFMA statistics show.  

In 2006 about $450 billion of subprime mortgages were sold as bonds, a market nearly 15 times larger.  

In fact the subprime auto asset-backed securities market nearly evaporated in 2009, shrinking to less than $1.2 billion, down from $21.6 billion in 2006, according to data by Standard & Poor’s.  

Since then, the volume has recovered to $11.4 billion in the first half of 2014 up from $9.9 billion in the first half of 2013. For the entire year 2013, the volume reached $17.6 billion, down from a recent peak of $18.4 billion in 2012.