First, the bad news: used car prices are inevitably headed lower, perhaps much lower.
The good news, according to Fitch Ratings, is that there is unlikely to be much impact on bonds backed by auto loans, even those backed by subprime auto loans. At least not for some time.
Auto ABS investors worry about falling used car prices for the same reason that mortgage bond investors worry about falling (used) home prices: the lower the price, the less likely they are recover all of their principal if a borrower defaults. Same story for investors in bonds backed by auto leases.
Wholesale used vehicle prices (on a mix-, mileage-, and seasonally adjusted basis) actually rose in January for the fourth consecutive month. This pushed the January Manheim Used Vehicle Value Index to a reading of 125.3, which represented an increase of 2.5% from a year ago.
But for several years now, sales and leases of new cars have been surging, and this has led to a rise in the inventory of used cars from trade-ins and vehicles coming off lease. Moreover, even as used car inventories rise, carmakers keep churning out new vehicles at a faster pace, and offering attractive financing. This is steering some would-be buyers away from used cars.
Fitch expects that this shifting balance in supply and demand will lead to a deterioration in used car prices throughout this year and next. Something’s gotta give.
So how will this affect the performance of auto loan ABS? According to senior director Brad Sohl, it won’t.
“Despite expected wholesale market deterioration, auto loan ABS losses are still at or near historic lows,” Sohl said in a report published Friday.
“Auto lease securitizations are also still exhibiting residual gains on the whole, though it is worth noting that certain platforms are seeing more substantial softening,” he added.
Translation: the market values of cars coming off lease are still higher than their residual values, or the prices that lessors expected to get for them.
Rating agencies were roundly criticized for failing to foresee the devastating impact that the housing market bust of the last decade would have on mortgage bonds. Even though auto ABS weathered the financial crisis much better, Fitch and its peers have been careful to broadcast any possible threat on the horizon. All the more so since the subprime auto lending industry has come under intense regulatory scrutiny.
In Friday’s report, Fitch modeled auto ABS performance under two different scenarios. The first, “moderate stress” scenario, is equivalent to a Manheim reading of approximately 108, consistent with average experience through the two most recent wholesale market downturns of 2001−2003 and 2008−2009. The second, “severe stress” scenario is equivalent to a Manheim-indexed level of approximately 98, which is consistent with the short-lived two weakest periods observed in the index’s history: February−May 1995 and November−December 2008.
Under the moderate scenario, which Fitch expects would result in a 20% reduction in the recovery value on auto loans in default, Fitch anticipates no rating deterioration. Under the severe stress scenario, representing an 50% reduction, it might cut the subordinate tranches of some deals, particularly subprime transactions, by one or two notches. But Fitch’s high investment grade ratings would likely remain stable.
This ratings resilience boils down to two things: the credit credit enhancement that the senior tranches enjoy and the relatively short tenors of these notes.
It remains to be seen exactly when used car prices will actually weaken. In its January index report, Manheim says “the fact that wholesale prices are now back to a level last seen when off-lease volumes were at their trough is contrary to expectations of most analysts. Wholesale prices are not, however, in conflict with the continued rise in new vehicle transaction prices (net of incentives) or the strong retail used vehicle results being reported by most dealers.”