Subprime auto securitization has been firing on all cylinders lately: The strong financial condition of borrowers, good loan underwriting and a solid market for used cars have all kept investor losses on the 2009, 2010 and 2011 vintages to a minimum.

But it is only a matter of time before the market hits some speed bumps. Demand for bonds backed by auto loans, leases and dealer financing is making it ever cheaper for lenders to fund loans. This will inevitably result in a loosening of underwriting practices as new lenders join more established ones competing for borrowers.

If this sounds a lot like the scenario heading into the last recession, you can see why the credit ratings agencies and other market participants are keen to advertise that they are aware of the potential risks.

At the same time, the ratings agencies are at pains to convey that any deterioration in underwriting will be gradual and is unlikely to affect the performance of auto loan securitizations, thanks to the strong structural support in these deals.

At least not in 2013.

In the Federal Reserve’s latest Senior Loan Officer Survey, conducted between Dec. 27, 2012 and Jan. 15, 2013, domestic banks indicated that they had again eased standards on auto loans over the previous three months. That was in contrast to lending standards for credit cards and other types of consumer loans, which were little changed.

On balance, several banks reported that they had reduced spreads on consumer loans other than credit card loans. A “modest fraction” of banks also reported having increased the maximum maturity of auto loans, on net, while standards on other types of consumer loans were almost unchanged.

Respondents eased many components of their lending standards, including extending the maximum maturity (13.1%), narrowing spreads on loan rates over costs of funds (27.8%), lowering minimum required down payment (6.6%), and minimum required credit score (3.3%).  

This expansion is partly reflective of how much lending contracted during the financial crisis.  It also reflects the facts that auto lending didn’t prove to be nearly as troublesome as mortgage lending.

“Banks didn’t do that badly in the downturn with auto loans, even subprime,” said Jeremy Anwyl, vice chairman of Edmunds.com, the online car buying guide. “If buyers don’t make payments, they pick up the car, turn around and sell it.”

Easier underwriting standards aren’t the only ways lenders are looking to compete for loans.  Chrysler Group is looking to reduce the time it takes to complete auto purchases.

Peter Grady, Chrysler’s vice president of dealer network development and fleet operations, said that the industry-wide average for the approval process is almost four hours, and that this is a “big dissatisfier” with customers, a Chrysler spokesman confirmed.

The U.S. automaker, which is forming an auto-financing venture with Spain’s Banco Santander, may try to cut the time in half, he said.

Grady said that Chrysler was also interested in Santander’s expertise in so-called “automated decisioning,” which uses data modeling to speed the assessment of loan applications and set appropriate terms for the borrower.

Grady’s comments, made at the National Automobile Dealers Association convention on Feb. 9, were originally reported by Bloomberg. Grady declined a request to be interviewed for this article. A spokesman said the company would have more to say once the joint venture with Santander takes effect in May.

Pent-Up Demand

In the third quarter of 2011, approximately 19.97 million borrowers with a VantageScore credit score lower than 700 (on a scale of 501 to 990) carried auto loan balances, according to TransUnion’s Industry Insights database. By the third quarter of 2012, the most recent date for which data are available, this number had increased to 20.66 million.

The total number of consumers carrying auto loan balances also has increased, to 59.27 million in the third quarter of 2011 to 61.68 million in the third quarter of 2012. Auto loan debt per borrower jumped from $12,902 to $13,571 in those same periods.

TransUnion expects that auto debt per borrower will continue to rise this year, jumping from an expected $13,689 in the fourth quarter of 2012 to $14,133 by the end of 2013.

So far, the expansion of lending to higher-risk consumers hasn’t resulted in higher delinquencies. The auto delinquency rate finished 2012 at 0.36%, down more than 50% from its peak of 0.86% in the fourth quarter of 2008. TransUnion expects the ratio of borrowers 60 or more days past due will rise only slightly to 0.37% in the fourth quarter of 2013.

The data include both loans used as collateral in securitizations and loans held on lenders’ books.

Peter Turek, automotive vice president in TransUnion’s financial services business unit, said the favorable forecast is based on macroeconomic factors such as the improving unemployment rate, median household income and housing prices.

The credit reporting agency also reckons that consumers are now valuing their auto loans even more than their credit card and mortgage loans, and that lenders and dealers are putting even more emphasis on placing buyers in vehicles and loans that best fit their financial situation.

Fitch Ratings expects securitizations that come to market in 2013 to include weaker collateral quality than prior years, including extended loan terms and weaker credit tier distributions. Although that won’t translate into losses right away, over the longer term, it is a potential risk to the market, especially if the economy loses steam.

“If another recession or downdraft in the market coincides with this expansion, we would expect a significant challenge to many vintages,” Fitch said in a report released Feb. 12.
For now, Fitch is only predicting that performance in subprime auto ABS, or loans to weaker borrowers, will likely “tail off” for 2012 and 2013 vintages.

Abundant Credit Protection

Why is the ratings agency so unconcerned? There is an awful lot of credit protection built into deals. John Bella, a managing director in Fitch’s asset-backed securities group, said that the coupons on collateral for subprime deals are 12-plus percent. The difference between that and the all-in financing costs of subprime auto ABS is cash flow that can be used for credit enhancement.

Some subprime borrowers pay much more than 12%. Anwyl notes that interest rates on subprime auto loans may only limited by usury laws in the various states. 

“It’s a little sad, in a way – the people who can least afford it pay 16% or 17%” for car loans, he said. “Yes they have a [higher] risk profile, but they also don’t have a choice.”

It is not just auto ABS deals that are structured to withstand losses; ratings are also structured to withstand significant losses.

“Fitch is selective in assigning triple-A ratings to subprime auto deals,” Bella said. “Origination and underwriting platforms, operational concerns, and access to liquidity other than ABS are just a few of the composite risk characteristics within subprime that suggest most attainable ratings in this sector should be more consistent with low investment grade.”

He added, “It is important to note that performance through the most recent recessionary period was mostly as expected and post-crisis credit enhancement levels are structured to support collateral net losses from 40 to 50-plus percent.”

Bella said Fitch that expects to upgrade more subordinated tranches of prime auto ABS in 2013 than it did in 2012.

Standard & Poor’s also does not expect that the anticipated deterioration in collateral performance this year will lead it to downgrade subprime auto ABS ratings.

In a contributed article, Mark Risi, senior director of U.S. ABS surveillance at S&P, notes that the structural features in auto loan ABS transactions typically result in increased credit enhancement levels as the collateral amortizes.

For example, in 12 transactions that S&P rated in the first half of 2012, hard credit enhancement, which the agency defines as credit enhancement from sources other than excess spread, increased by more than 33%, on average, in just the first six months.

S&P has not downgraded a public rating on subprime auto loan ABS due to credit deterioration since it began covering the sector in 1991. That was the case even between 2006 and 2008, when losses nearly doubled. 

Another potential, but not immediate, threat to auto ABS performance is the recent softening in used car prices, which play an important role in recoveries on defaulted auto loans.

Wholesale prices for used vehicles fell 0.6% on a seasonally adjusted basis in January over December, according to Manheim, a remarketing service. Absent the seasonal adjustment, the decline in vehicle values was half that amount. January’s Manheim Used Vehicle Value Index reading of 123.4 represented a 1.8% decline from a year ago.

When the January index was released, Manheim said that the decline was to be expected, because Hurricane Sandy’s impact on the wholesale market was waning and auction supplies from commercial consignors are rising. It said continued strength in the retail market kept the decline in wholesale prices modest, for now, however.

Over the past few years, elevated used-car prices have translated into higher trade-in values, providing incentives for consumers to replace older vehicles and boosting sales.
Meanwhile, subprime issuers also benefit from an active used-car market, as used car loans typically represent the bulk of originations.

Finally, elevated used car prices help boost recovery values on defaulted loans; this helps reduce net loss rates on auto loan pools. And high used car prices improve residual values that also support auto leases.

An increasingly crowded market for autos themselves could put further pressure on used car prices. “Car sales have been climbing, but the production of cars is climbing at a slightly higher pace,” Anwyl said. “Inventory is starting to grow; that means there’s going to be competitive pressure across the board to maintain [sales] volume. Manufacturers will have to sharpen their pencils for incentives or give up share.”

 “Most OEMs [original equipment manufacturers] have fairly good models across the vehicle spectrum,” Bella said. “It used to be that the domestics didn’t have as good a product, particularly in the sedan and compact niches, and they had to heavily incent [sales] with cash on the hood. Today, the U.S. is making just as good cars as the rest of world -- Germany, Japan, Korea.”

“The developing story becomes, with this level of competition, what happens to those models that do not sell as well or turn out [to be] less popular than the industry leaders? At some point, OEMs might need to revert to offering heavier incentives to motivate vehicle sales, which could impact prices for those models in the used-car market,” he said.

“But unless the moves impact the entire wholesale market, the negative recovery impact will be manageable, and should not materially change the auto ABS story.”

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