Government stimulus early in the pandemic put subprime borrowers in the drivers seat and fueled the healthiest auto-loan market ever, but investors in asset-backed securities (ABS) backed by subprime auto loans should be wary about bumps in the road.
"The 2022 [loan] vintage is exhibiting the worst performance," said Bill Awad, head of the global structured finance group of Barings, owned by Massachusetts Mutual Life Insurance. He added that that auto-loan delinquencies of 30-or-more days through 90-or-more days exceed levels seen during the Great Financial Crisis (GFC).
"While some of the subprime auto performance reflects the easing of credit standards coming out of the pandemic, we believe the preponderance of the performance reflects the disproportionate impact inflation is having on lower wage earners," he said.
Government largesse during the pandemic enabled subprime borrowers to pay down debt and boost their credit scores, arguably inflating them. In addition, historically low interest rates and borrowers newly flush with cash prompted lenders to relax their credit standards. Then interest rates rocketed up in 2022, and new subprime auto borrowers quickly felt the pinch.
Noting cumulative losses coming in higher and losses occurring faster, Awad said that Barings believes "this will persist for these vintages, and we have incorporated this view within our cashflow modeling."
Margaret Rowe, head of Fitch Ratings North American auto ABS group, confirmed the troubles in 2022-vintage subprime loans, noting that in October the rating agency's Auto Loan 60+ Delinquency Index hit its highest point ever. She cautioned, however, that investors must consider the composition of the index, since it comprises all public auto-loan transactions—not just those rated by Fitch---and they include those originated by subprime lenders catering to the riskiest borrowers.
Subprime auto provides an accurate reflection of subprime borrowers, Rowe said, a group that is very fragmented, with some bordering on prime and others deeply subprime. Consequently, performance of 2022 vintage auto loans can different significantly, she said, a key factor investors should keep in mind when considering auto ABS deals.
Rowe said that in the GFC, roughly 60% of the Fitch index comprised large auto-loan lenders such as SDART and AMCAR, then numerous new lenders entered the space. Auto ABS deal performance remained relatively benign for several years and then improved dramatically as a result of federal pandemic stimulus, leading to the best auto-loan vintage on record in 2021, with the lowest level of delinquencies and defaults, Rowe said.
By 2022, however, subprime borrowers' stimulus-bolstered savings had largely dried up, their real income fell as a result of persistent inflation and high interest rates, and a number of mid-to-late 2022 vintage deals saw delinquencies and defaults quickly increase.
"For a large cohort of consumers, wage growth has not kept pace with rapidly rising inflation, and borrowing costs have soared for all forms of credit," Awad said, adding that the rapid increase of rates in 2022 was the primary driver of borrower distress, rather than the higher rates themselves.
"We see substantially lower rate volatility picture ahead compared to what we have experienced over the last 18-to-24 months," Awad said.
The rapid increase in loan delinquencies and defaults appears to stem from a certain type of borrower, Rowe said. She noted that subprime lender Exeter Finance, which saw the most junior of its auto ABS downgraded late last year, attributed the increased in defaults to borrowers who had yet to make payments on their loans before they were securitized.
Many of those lenders have since tightened their lending standards. Rowe noted that Exeter limited such loans to 20% of its first deal in 2023 and eliminated them altogether in subsequent deals. Some lenders such as Americredit avoided such riskier borrowers and their 2022 vintage deals have yet to suffer, Rowe added.
"With originators tightening standards, we're starting to see some signs of improvement," Awad said.
