High Investment in Subprime Auto Loans Has Some Wary

Inside Subprime: Jan 11, 2018

By Ben Moore

According to some analysts, investors are currently embracing risky auto loans extended to poor-credit borrowers, ignoring market signs that indicate the auto loan industry is heading towards a bubble burst similar to the home loan burst that led to the 2008 recession. Investors have been purchasing subprime auto securitization deals that “offer slices with single-B credit ratings” which are considered “junk territory” and are the lowest grade offered when these types of bonds are sold.

In 2018, auto lenders issued more than $318 million worth of single-B debt, which is more than all prior years combined, a large portion of which was subprime auto loans. Subprime auto deals are often bought by big money managers and other investors. The deals are usually backed by loans that are provided to borrowers with FICO scores below 650. Since borrowers with lower credit scores are also at a higher risk of defaulting on their loans, the bonds tied to these loans can often offer higher yields. These bonds are typically subdivided into different layers with unique levels of risk and return, based on the order in which they receive payments. The single-B layers (the last rated bondholders in line) have been sold in recent months by lenders including American Credit Acceptance and United Auto Credit. In exchange for interest rates of more than 6 percent (which is almost two times what 10-year Treasuries pay), they become the first bondholders “to suffer losses if the underlying loan payments aren’t sufficient to cover all that is owed” which is a trade-off that many investors are hesitant to make.

Essentially, investors are placing bets on the economic health of American consumers – consumers who have racked up record setting amounts of debt, but have yet to show any trouble repaying it. However, the outlook is mixed on securities backed by subprime auto loans. Average credit scores for 2018’s securitization pools have risen to 588 from 2017’s average of 577. But more borrowers (around 80 percent) are signing off on loans that have terms of more than five years, which have a higher chance of default. Additionally, delinquencies higher than 90 days have been growing for all auto loans since 2012.

The subprime loan market has shown recent signs of trouble. One auto lender closed its doors last summer which resulted in bonds backed by the firm’s loans being downgraded to a low double-C rating. Investors are viewing what happened to that firm as a one-off event, but remain vigilant, on the lookout for any signs the bonds issued by other auto lenders are not as solid as they once appeared to be.

In lieu of the risks, bond buyers have become more and more comfortable with subprime auto bonds over the past few years, partly due to the face that these bonds performed well throughout the financial crisis of 2008. Subprime loan borrowers continued to pay their loan payments due to needing their vehicles to get to work, and often skipped paying their mortgage payments to do so. Many analysts claim that if the economy takes a turn and the unemployment rate starts to rise, the inevitable delinquencies on high-risk auto loans could result in a wave of auto lending firms closures, leading to a possible economic recession that hasn’t been seen since 2008.

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