Subprime Auto Loans: Breakdowns Up Ahead

The overheated subprime auto loan market is heading for a breakdown.  Capital is pouring into this market despite – and driving – its increasingly poor credit characteristics.  This market’s increasingly weakened underwriting standards will result in increased borrower defaults, the collapse of industry lenders, substantial investor losses, and a renewed shortage of credit to potential subprime auto borrowers.

Credit Acceptance Corp. (NASDAQ: CACC), a mainstay lender in this market, provided a clear sign this week that this bubble will end badly, writing in a press release that its 1st quarter volume decreased by 2.9% year-over-year.

CACC’s 1st quarter volume decline might appear to be minor.  But this decline occurred despite the relaxation of its credit standards twice in 2012, a significant increase in its pool of active dealers and a rapidly growing subprime auto loan market.

CACC called the decline, “the result of increased competition.”

With the entry of additional subprime auto lenders in an increasingly crowded space, there is increased pressure on lenders to relax their credit standards and increase their dealer rate participations even further.

Given the rush of capital and increased credit availability that has poured into the subprime auto loan market, and investors’ quest for yield in this environment of scant interest rates and severely compressed risk premiums, some subprime auto lenders and their backers will surely relax their underwriting too far.  This will lead to weaker collateral values, increased borrower defaults, investor losses, and a renewed credit crunch in subprime auto lending.

Lender Risk is Understated

The performance of subprime automobile loans has remained relatively stable.  This will not continue indefinitely, or for much longer.

Subprime auto loan performance has been artificially inflated by sharp rises in used auto values.  This rise has been pushed by a supply imbalance (shortage of used vehicles) due to the impact of the Great Recession on auto sales from 2008 to 2010.  As dramatically fewer vehicles were produced and sold in this period, there simply are many fewer vehicles coming off of lease.

Performance has also been enhanced through consumers’ recovery from the Great Recession.

The performance of subprime auto loan pools originated in 2010 and 2011 benefits from this environment of record high used car values, an improving economy, and stronger underwriting than is present today.

With the increase of vehicle sales towards more stabilized levels in the past 2 years, the used vehicle supply shortage – and corresponding temporary price bubble – will go away.  With less market value in used vehicles, defaults on outstanding related loans will increase and recoveries will decrease.

When the economy softens again, defaults – especially by borrowers who are, by definition, of weaker credit quality – will naturally rise.

With these factors, and the continuing decline in credit standards in subprime auto loans, the performance of subprime auto loans that are currently being originated is likely to be much worse than those originated in 2010 and 2011.

Tread Carefully in This Market

This will not be the first time, nor more than likely the last time, that the subprime auto loan market goes from boom to bust (and back again).

Barring the economy suffering a major and unanticipated plunge back into recession, the collapse of the subprime auto loan market won’t happen in the next 12 months.  It will, however, follow in the not too distant future.

As with all financial collapses, this will result in a credit crunch for lenders.  Even some lenders who will have remained prudent in their lending will fall due to the shutdown of their credit lines and the closing of other financial sources.  The crunch will result in investor losses as well.

Despite these risks, and the poor credit characteristics of the underlining borrowers, subprime auto loans have and will continue to be successfully funded through securitization.

Securitizations, which have a long track record of successfully financing a broad range of asset types, can, through proper structuring (including servicing, payments mechanics, amortization and default mechanics, and other structural elements) and credit enhancement provisions, mitigate the risks of financing subprime auto loans.

Given the lack of large relative returns in subprime auto loan securitizations and the strong likelihood of industry collapse ahead, it would be prudent not to invest too far down the capital structure in subprime auto loan securitizations.

Equity investors in many subprime auto lenders may turn out to be amply rewarded for their investments.  However, the scanty risk premiums offered currently should cause securitization investors to limit their interest to the more senior and shorter weighted average life tranches of securitizations that are originated by stronger originators with more diversified capital strictures.

Judicious Note by Avi Oster, Managing Director, Judicious Advisors LLC





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