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Trade-Ins Represent Growing Risk for Auto Lenders

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Many Americans are accustomed to trading in their cars after a few years for a new model — a habit that lenders have generally been happy to accommodate. But that cycle is drawing fresh scrutiny amid rising fears about the risks building in the U.S. auto lending market.

In a new report, Moody’s Investors Service warned Monday that auto lenders face the prospect of outsize losses as a result of easy lending practices on vehicle trade-ins.

Moody’s noted that many borrowers owe far more than their cars are worth — by late 2016, the average negative equity on a vehicle at trade-in was over $4,800, an all-time high. In recent years, nearly half of all new-vehicle sales have come with a trade-in, according to the report.

Trade-ins can push borrowers deep into negative equity because lenders often take steps to maintain the monthly payments from their previous loan. Loan terms of 72 months or longer have become common as lenders seek to avoid charging borrowers more per month. The problem is bigger in situations where borrowers owned their old cars for a relatively short period of time.

“The effect of the trade-in treadmill is increasing lender risk, with larger and larger loss-severity exposure,” the Moody’s report states.

The report is the latest red flag from Moody’s about the U.S. auto lending sector. Late last year, the credit rating agency downgraded its outlook for the industry from stable to negative.

“Lenders are providing loan terms which have not been time-tested. So you don’t have a lot of data that really shows how an 84-month loan is really going to behave when the economy goes into a downturn,” Jason Grohotolski, senior credit officer at Moody’s, said in an interview.

Recent declines in the value of used cars, in addition to rising late-payment rates on auto loans, are contributing to lenders’ rising anxieties. Some banks — including JPMorgan Chase and Wells Fargo — have responded to the growing risks in the sector by reducing their exposure.

“This is probably a good decision from a risk-adjusted return standpoint,” analysts at Barclays wrote in a research note last week. “We think rising auto delinquency trends and ongoing declines in used vehicle values deserve careful monitoring.”

Moody’s flagged an additional concern in its new report: The firm predicted that an expected decline in new-vehicle sales in 2017 will lead lenders to accept riskier loans in order to remain competitive in the market.

And the credit rating agency’s concerns regarding vehicle trade-ins are not confined to the subprime segment, which has drawn considerable scrutiny in recent years.

“We think of this as being an issue that cuts across all credit spectrums,” Grohotolski said.

The best-case scenario for lenders might be for auto manufacturers to start taking steps to lower the prices being paid for new vehicles. Such moves would help reduce borrowers’ negative equity.

In a grimmer scenario, lenders continue to take actions designed to keep borrowers’ monthly payments affordable, and their risks keep rising.

“If lenders continue to be accommodative to car buyers, asset quality will weaken, with negative implications for lenders’ profitability,” the Moody's report stated.

This article originally appeared in American Banker.
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