Are longer terms to blame for the rapid deterioration in the performance of subprime auto loans?

So says Peter Kaplan, a senior vice president and portfolio manager for Merganser Capital Management in Boston.

The industry has been puzzled by the fact that cumulative net losses have been rising since 2015, despite the fact that nearly every economic indicator suggests that borrowers should be having few difficulties meeting their obligations.

Historically, factors such as jobless claims, low fuel prices and overall consumer confidence have been correlated with the performance in both prime and subprime auto loan securitizations. During good times, people made timely payments.

“You have this backdrop of underperformance in certain areas of the subprime market, but strong performances on macroeconomic trends,” said John Bella, a managing director at Fitch Ratings. 

Kaplan thinks the problem may be that consumer confidence is fueling an overall rise in household debt. This, in turn, may be leading subprime lenders to use tactics such as longer terms to keep monthly payments low, rather than recognize consumers’ limited resources to service their debt obligations.

“Longer term loans are signaling that the consumer is under stress,” he said.

While loans with longer terms have lower monthly payments, they also amortize more slowly, which means the borrower spends more time “underwater,” owing more than the car is worth.  The negative equity results in bigger losses when a borrower defaults and the vehicle is repossessed.

Ben Miller, a senior vice president and treasurer for Irving, Tex.-based subprime lender Exeter Finance, said that his firm and others are tightening underwriting in response to the deterioration in the performance of their portfolios.

 “I don’t see a lot of people out there chasing business,” he said.

Subprime lenders are also boosting investor protections when they securitize their loans. Average levels are up to around 30%, compared with 20% in 2014.

Still, there’s a danger from falling used car prices, which are falling not only because of the number of subprime loans going bad, but because of the large number of cars coming off lease.

“I don’t know how the [used car] market is going to absorb 19 million cars,” Kaplan said.  

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