Title: “The Perils of Subprime Auto Loans: A Deep Dive into the Risky World of Asset-Backed Securities”
Subprime auto loans have once again garnered attention in the news, reminiscent of their notorious past. Frequently associated with financial troubles, subprime borrowers are categorized as such precisely because of their higher likelihood of default. However, it is important to note that subprime auto loans only account for approximately 14% of total auto loan balances outstanding, and the majority of these loans have been securitized into Asset-Backed Securities (ABS) to attract yield-hungry investors. This article delves into the world of subprime auto lending, explores its impact on the market, and sheds light on the risky nature of this business.
The Rise of Subprime Auto Loans:
Subprime auto loans primarily serve borrowers who are unable to qualify for prime-rated loans. These borrowers often opt for older, used vehicles, usually more than a decade old, due to limited eligibility. It is crucial to emphasize that subprime auto lending has a minimal influence on the market for new vehicles, as those are predominantly reserved for prime-rated customers and cash-buyers. In fact, new vehicle unit sales have witnessed a robust 20% year-over-year increase, with higher average transaction prices. The subprime auto loan delinquency rates remain minuscule for prime-rated borrowers, further highlighting their reliability.
The Subprime Quandary:
While the prime-rated auto loan segment remains stable, it is the subprime sector that poses inherent risks. Troubles within this corner of the used-vehicle market consistently make headlines as a substantial percentage of subprime auto loans tend to default. This high-risk, high-profit market segment has witnessed a surge in delinquency rates, hitting a record high of 6.1% in September. This figure surpasses previous records, underscoring the unstable nature of subprime lending.
The Role of Government Support:
Government intervention during the pandemic has provided a temporary lifeline for subprime borrowers. Stimulus packages, mortgage forbearance, and eviction bans infused cash into the economy, enabling many borrowers to stay afloat and catch up on their auto loan payments. Consequently, subprime delinquency rates reached multi-year lows of 2.6% in May 2021. However, when coupled with the hunt for yield in a low-interest-rate environment, the perception of invincibility led to increased aggressive lending practices by specialized subprime dealer-lenders.
The Downfall of Greed:
The lure of sizable profits, driven by exorbitant interest rates and substantial profit margins on vehicles, entices companies to engage in subprime lending. However, when subprime dealer-lenders adopt overly zealous lending practices and loosen their underwriting standards, the resulting bubble is unsustainable. Recent examples, such as the closure and subsequent Chapter 7 bankruptcy filings of US Auto Sales and American Car Center, both owned by private equity firms, illustrate the perils of overreach in this industry.
The Mechanics of Subprime Auto Loan-Backed ABS:
Specialized subprime lenders and dealer-lenders often follow a similar modus operandi. They grant high-risk, high-interest loans to subprime-rated borrowers to finance the purchase of older, inflated-priced used vehicles, knowing that a significant portion of these loans will default. These pools of subprime auto loans are periodically securitized into ABS, comprising various tranches, ranging from equity and deep-junk tranches to investment-grade rated tranches. The highest-risk tranches experience the highest yields but also bear the brunt of the initial losses. As losses escalate, the losses gradually shift to the higher-rated tranches.
Normalization of Subprime ABS Losses:
Fitch Ratings closely monitors net losses for the auto loan ABS it rates, providing valuable insights into the long-term performance of subprime-backed ABS. Notably, prime-rated auto loans showcase net losses well below pre-pandemic levels, demonstrating their resilience. On the other hand, subprime-rated ABS losses have now normalized, showing seasonal patterns similar to the period before the pandemic. However, the demise of PE-owned specialized subprime dealer-lenders, once the era of easy money concludes, serves as a reminder of the inherent volatility in this sector.
Subprime auto lending, though risky and marred by occasional unscrupulous practices, continues to be a profitable avenue due to its high interest rates and substantial profit margins. Nevertheless, investors should approach this market segment with caution, considering the underlying risks involved. The world of subprime auto loans and securitized ABS provides a stark reminder of the complexities and vulnerabilities that lurk beneath the surface of the seemingly lucrative proposition it presents. As the industry strives to strike a delicate balance between profitability and responsible lending, monitoring the lessons from the past remains imperative to avoid future disruptions.