The current U.S. subprime auto lending market is developing a resemblance to its condition in the early- and mid-1990s, according to a report released yesterday by Moody's Investors Service.
This was the time when "overheated competition among lenders led to poor underwriting that drove up losses," the rating agency said. Similar to that period, capital is flooding the sector while the issuance of subprime auto ABS is booming.
"It is too early to predict whether today's subprime lending market will deteriorate as it did in the 1990s, but the early similarities between then and now suggest that losses will climb if competition intensifies," said Vice President Peter McNally, who is the author of the report U.S. Subprime Auto Lending Market Harkens Back to 1990s.
In the past two years, given the asset class' profitability, a significant amount of private-equity investment has gone into the subprime auto lenders, many of which are comparatively small, specialty finance companies, the rating firm stated.
The interest of investors from outside the subprime auto market part as well as the possibility for more competition carry the risk that losses can rise if a race for profits and market share lowers underwriting standards. The growth in the market can lead to capacity issues, McNally said.
"When losses rise quickly, inexperienced lenders have trouble servicing a loan portfolio that requires more attention," he noted
In the 1990s, the number of small lenders also jumped, which lead to intense competition for loans that resulted in weak underwriting as well as high losses on securitizations. Net losses in subprime auto ABS rose to over 10% in December 1997 from under 3% in early 1995.
In the past several years subprime auto loan performance has been strong, with the net loss rate now less than 4%. But, the credit quality of pools securitized in 2011 and 2012 showed that credit has loosened since 2010, the rating agency pointed out.
Subprime auto ABS issuance is actually on pace this year to go over the healthy 2011 volume, which made up 24 deals that reached $14.3 billion.
Moody's also noted several differences between the market now and the overheated market of the 1990s.
A credit positive for the market today is that most lenders no longer use gain-on-sale accounting. This is when lenders capitalized securitization gains and credited them to equity, which allowed their balance sheets to seem stronger than they actually were.
The market, according to Moody's, is not yet overcrowded with new lenders. The rating agency counted 13 active securitizers currently versus 34 issuers in 1997.
However, auto deals are no longer backed by monoline guarantors. These bond insurers absorbed losses on offerings that would have otherwise defaulted in the 1990s while also assuming the deal servicing from failing lenders.