Auto Lenders Are Taking More Risks: Extending Terms, Higher Debt, Lower Quality

We have already reported extensively on the subprime auto market, which is somewhere in between topping out and completely imploding, over the last couple of weeks. It should come as no surprise to anyone that lending in the auto space has been redlining aggressively over the last few years, as the "recovery" that started in 2008 by manipulating lending standards (read: lowering interest rates) has now used and abused the auto space in every which way possible.

This leaves auto lenders, including those that aren't just lending to subprime, with little to no choice but to continue to take on more risk to keep the lending business open and running. This includes issuing more loans that are longer than 5 years and extending credit to borrowers who, in laymen's terms, can't afford it. The Wall Street Journal reported this week about the new risks that automakers are taking on:

As loan growth slows, banks and other lenders have been tinkering with loan terms in an effort to gain more consumers. They are originating a greater share of loans with repayment periods of more than five years and, in some cases, extending loans to consumers who are stretching further to afford their purchases. Banks such as TD Bank,Santander Consumer USA Holdings Inc. and BB&T Corp. , meanwhile, have said they are increasing their loans to riskier applicants.

Their moves come at an unsettled time for auto lending. Sales growth has been choppy and missed payments are up from a year ago. Also, used-car prices are under pressure, raising the risk of higher losses for lenders when vehicles are repossessed. Faced with these headwinds, many lenders shunned applicants with low credit scores and have been looking for ways to make up the lost volume.

The latest underwriting efforts show that lenders, faced with conflicting signals about the health of the U.S. consumer, are engaged in a delicate balancing act to boost lending and profit without taking on overly risky customers. Though unemployment has reached an 18-year low and wages are creeping higher, some households are sliding deeper into debt and falling behind on their credit cards and other debt payments.

And what would taking on more credit risk be without a token excuse for doing so? Here's a gem from TD Bank's Chief Executive:

"[If] you only took on the financing for the top echelon of the super prime... [it’s] very, very hard to make money in and of itself,” TD Bank Chief Executive Greg Braca said at an industry conference this year.

The article notes that the timeline of most loans has been extended significantly, naturally yielding a higher interest rate for the bank. 

Many auto lenders, including banks, nonbanks and the finance arms of car manufacturers, have been offering more loans with longer terms. Generally, these terms allow borrowers to make lower monthly payments, but usually at a higher interest rate. That, combined with the longer payment period, means that borrowers can end up paying thousands more for their cars than if they opted for a shorter loan.

In the first quarter, the average loan term for a new car exceeded 69 months, the second consecutive quarter it had ever been above that level, according to credit-reporting firm Experian. Also in the first quarter, new car loans originated with repayment periods of between 73 and 84 months represented more than a third of total new car loans, up from 7% of loans in late 2009.

In addition to blaming the lack of creditworthy borrowers, banks are all blaming the rising prices of vehicles as a reason for their disintegrating lending standards. Not only that, but consumers seem to be convinced that taking on longer term loans with higher interest rates gives them more flexibility:

Lenders say borrowers need flexible terms because new vehicles are getting more expensive. Despite the longer repayment periods, average monthly loan payments continue to rise, hitting a record $523 for borrowers who bought new cars in the first quarter, according to Experian.

Zac Craft wanted a three-year loan when he bought his 2012 Chevy Cruze this year but opted for a five-year loan despite its slightly higher interest rate. Mr. Craft plans to pay off the loan in three years to cut down on interest but wanted the option to make lower monthly payments when money is tight.

“There’s some security in that,” said Mr. Craft, who lives in Hawaii.

Of course, as the article notes, these loans are actually more susceptible to eventually being defaulted on:

Loans with longer repayment periods are more prone to default, according to Moody’s. Loans of five years or longer extended to borrowers in 2015 with high credit scores had a cumulative net loss rate of 1.29% as of spring 2017. For shorter-term loans, the loss rate was 0.28%.

And if you don't want to call it "subprime", just call it "non-prime". This is the term that the article says banks are usually to describe those who borrow and are less creditworthy than prime borrowers. Banks are swooning over this newly-discovered-group of borrowers who, just years ago, would have been called "subprime" because they're - well, literally sub-prime.

“When you can kind of operate in the belly of credit and generate 7-plus-percent yields on new originations, that’s pretty attractive business,” Ally Financial Inc. Chief Executive Jeffrey Brown said at an industry conference this month. Ally, one of the largest U.S. auto lenders, does business with borrowers across the credit spectrum, including subprime.

Lenders say they typically make the longest loans to prime customers who can afford them and understand the risks. A report last month by Moody’s Investors Service, however, found that borrowers who sign up for loans that last six years or longer have lower credit scores and owe a larger share of the vehicle’s price than consumers with shorter loans. The loan payments also account for a larger share of their income, said Moody’s, which reviewed loans securitized since 2017 and that were mostly comprised of prime borrowers.

At Ally, for example, borrowers with loans stretching six years or longer owed on average around 100% of the car’s purchase price when those loans were originated, according to Moody’s. Borrowers with a shorter repayment period owed 83%. Credit scores for borrowers with the longer loans averaged roughly 725, compared with about 760 for borrowers with shorter-term loans.

As we pointed out just yesterday, investors in auto loan bonds are getting used to the crappier paper that's being sold off. 

The longer an expansion lasts, the crappier its paper becomes.

That may seem like a baseless assertion, but it’s actually just simple math. Early in recoveries, borrowers and lenders are both shell-shocked by the last recession, so only high-quality deals get done. But as time passes, all the good borrowers get their loans and if banks want to keep the deals flowing, lower-quality borrowers must be found and financed. Eventually the deals become shockingly speculative and start blowing up en masse, bringing on the next downturn.

For a more sophisticated explanation of this process, see the work of the late/great Hyman Minsky, as described here:

Hyman Minsky has become famous in the aftermath of the financial crisis for his characterization of the three phases of markets – hedge finance, where the borrower can repay interest and principal out of cash flows; speculative finance, where cash flows can repay interest but not principal, and therefore need to roll over any financing; and Ponzi finance, where cash flows cannot pay either principal or interest and therefore must either borrow more or sell assets to support those costs.

The Minsky moment in a crisis is when Ponzi finance becomes the most common. My colleague John Rooney aptly compares these to a fully amortizing mortgage, an interest only mortgage, and a negative amortization mortgage – images from the housing collapse, which was the most recent Minsky moment.

Where are we in this cycle? Based on the following, it’s Ponzi time:

Sub-prime auto puts more junk in trunk

Car finance companies have pushed into fresh territory this year by selling Single B rated debt backed by loans made to sub-prime borrowers.

Selling Double B bonds was a bold trade not so long ago but as demand has grown for riskier assets, auto sellers are now able to sell further down the capital structure.

“It would appear that investors have grown comfortable with this collateral,” S&P auto ABS analyst Amy Martin told IFR.

“But some investors who are buying this class stand to lose principal if losses are just mildly higher than expected.”

American Credit Acceptance, First Investors, Foursight Capital, United Auto Credit and Westlake have each sold Single B bonds this year, according to Intex data.

By migrating to Single B from Double B, investors can pick up a bit of the spread that has vanished from less risky classes.

Last summer Double B spreads sank to a post-crisis low of around 300bp. But by last month, Westlake had cleared its Double B notes at 205bp, according to IFR data.

Its Single Bs fetched 325bp to yield 6.1%.

“It will be one area to watch,” a senior ABS banker told IFR this week. “We used to say that the Double B window was not always open. Now multiple companies are selling Single Bs.”

Already – with the economy growing nicely and interest rates still historically low – subprime auto loan defaults are trending upward, and are now above their Great Recession levels. So it’s reasonable to assume that when the next recession hits, hundreds of thousands of Americans who bought cars they couldn’t afford with money they didn’t have will find those never-ending payment terms more than they can handle. The sector will become a high-profile casualty and today’s “comfortable” investors will be a lot less so.

God forbid we should have a slowdown in lending when creditworthy borrowers disappear. 

Hey, maybe this time it's different...