Earlier this month, we gave readers a snapshot of the US auto market on the way to explaining why it was that car sales hit a 10-year high in May. To recap:
- Average loan term for new cars is now 67 months — a record.
- Average loan term for used cars is now 62 months — a record.
- Loans with terms from 74 to 84 months made up 30% of all new vehicle financing — a record.
- Loans with terms from 74 to 84 months made up 16% of all used vehicle financing — a record.
- The average amount financed for a new vehicle was $28,711 — a record.
- The average payment for new vehicles was $488 — a record.
- The percentage of all new vehicles financed accounted for by leases was 31.46% — a record.
We went on to note that despite the worrying statistics shown above, optimists (like Experian) will likely point to the fact that the average FICO score for borrowers financing new cars fell only slighty from 714 to 713 Y/Y while the same Y/Y scores for those financing used vehicles actually rose from 641 in Q1 2014 to 643 in Q1 2015. While that's all well and good, there's every indication that those figures are likely to deteriorate significantly going forward. Why? Because Wall Street's securitization machine is involved. in the consumer ABS space (which encompasses paper backed by student loans, credit cards, equipment, auto loans, and other, more esoteric types of consumer credit), auto loan-backed issuance accounts for half of the market and a quarter of auto ABS is backed by loans to subprime borrowers. Put simply, those subprime borrowers are getting subprimey-er.
In other words, the same dynamic that prevailed in the US housing market prior to the collapse is at play in the auto loan market. Lenders are competing for borrowers as lucrative securitization fees beckon, and this competition is directly responsible for loose underwriting standards. Bloomberg has more on the interplay between auto ABS issuance and “stretched” auto loan terms:
Demand for automobile debt in the U.S. is enabling lenders to make longer loans to people with spotty credit, stoking concern that car shoppers are being lulled into debt loads they won’t be able to sustain.
Of the subprime vehicle loans bundled into securities, 73 percent now exceed five years, up from 64 percent during the first three months of 2014, according to data from Citigroup Inc.
Loans as long as seven years are increasingly being put into more bonds as auto-finance companies and Wall Street banks sell the securities at the fastest pace since 2007.
The longer loans make it easier for consumers to afford rising new and used car prices by spreading out and lowering payments. While the securities are attracting plenty of buyers with high loss buffers and AAA ratings, some investors are beginning to question the wisdom of lending at terms that have never before extended beyond five years.
“Everyone has used the argument that borrowers pay car loans because they have to get to work,” said Anup Agarwal, a money manager who oversees $65 billion at Western Asset Management Co. and hasn’t bought a subprime auto bond in a year and a half. “But borrowers only pay loans if the car is working. We have not seen this cycle come through yet.”
A debt offering recently marketed by American Credit Acceptance LLC demonstrates some of the risks. About one-third of the 14,628 loans in the deal are tied to borrowers with credit ratings under 500 according to the Fair Issac Corp. grading system known as FICO -- or with no score at all, according to a prospectus obtained by Bloomberg. The company is charging interest rates of between 27 and 28 percent for almost one-third of the borrowers, and more than half of its loans exceed five years.
While cars are lasting longer than in the past, regulators are concerned that the value of the vehicles will fall faster than borrowers can pay off the debt.
“Because cars depreciate quickly, a borrower is typically upside down or underwater toward the end of a long loan term,” Date said. “If times are tough you might have to sell your car, but you’re still going to owe more than you can get through the sale.”
The riskiest auto bonds offer compensation of up to four times the coupon of comparably dated Treasuries, Bloomberg data show.
History is also on the side of investors. Since 2004, S&P has upgraded 371 classes of subprime auto deals and downgraded none, data from the company show.
Even with the built-in protections, some market participants are starting to caution that buyers may be letting down their guard for the sake of higher yields.
Auto securities sold in 2014 have registered the highest loss rate of any period since 2008, according to data from JPMorgan Chase & Co.
Some finance companies are avoiding the longer terms. Exeter Finance Corp., a Blackstone Group-backed subprime lending firm based in Irving, Texas, isn’t offering them because the risk is too high, said the firm’s treasurer, Andrew Kang.
“At this time we have no intention of going longer than 72 months,” he said. “The risk is that you extend a loan that a borrower cannot afford over its term schedule. Inching out to 75 and 84 months, I don’t think that has been tested yet.”
Here's a visual overview of the auto loan-backed ABS market (note the resurrgence of subprime as a percentage of total issuance post-2009 and the rising net loss rates):
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The takeaway here is simple: under pressure to keep the US auto sales miracle alive and feed Wall Street's securitization machine (which is itself driven by demand from yield-starved investors) along the way, lenders are lowering their underwriting standards and extending loans to underqualified borrowers.
Particularly alarming is the fact that even as average loan terms hit record highs, average monthly payments are not only not falling, but are in fact also sitting at all-time highs.
This cannot and will not end well.