Why more used car lending is being financed in ABS market
Fed up with the high cost of new cars, more Americans are buying used. And increasingly, these older vehicles are being financed in the securitization market.
That’s not necessarily a bad thing.
Used vehicles have historically been associated with higher risk in bonds backed by auto loans because borrowers have defaulted at higher rates and recoveries on repossessed cars have been lower.
But with average new vehicle prices topping $36,000 and average monthly new car payments nearly $540, more consumers with good credit are opting instead for recent-vintage used cars. And this, in turn, is boosting prices of used cars.
The combination of stronger borrowers and stronger used-car prices is encouraging lenders, and in particular subprime lenders, to increase concentrations of used-car loans in pools of collateral for deals.
“The major trend is that the used-car segment is a bigger portion of the subprime collateral pool,” said Tracy Chen, the portfolio manager and head of structured credit for Brandywine Capital. And the higher prices on those vehicles “definitely makes the investor a little bit more comfortable,” she said.
A main factor in that comfort is that investors can (for now) count on higher recovery rates from lease returns, or resales of vehicles taken back after borrower defaults, due to the elevated used-car prices that the market has sustained for nearly the entire year – and potentially into 2019, according to market observers.
In August, two major indices tracking used-car pricing trends hit two-year highs as many car buyers fleeing from the sticker shock-and-awe of new-car prices continued their yearlong trek to pre-owned lots.
In July, the commonly used vehicle remarketing service Manheim (a unit of Cox Automotive) reported used-vehicle prices were up 2.01% month over month in August, bringing the Manheim Used Vehicle Value Index to 139.7 – a 6.4% year-over-year increase, “which raises the series to the highest level in its history,” according to S&P.
For September, another industry resource for dealers, lenders and also auto ABS investors – the Black Book used-car retention index – hit a two-year high of 116, up 1.9% month over month on a data point baseline of 100. The index measures retained values of two-to-six-year-old used vehicles compared to the original manufacturer suggested retail price, based on wholesale auto auction results across the country.
“When our index goes up, that means the market is very strong,” said Anil Goyal, executive vice president of operations for Black Book, a division of Hearst.
Some deep subprime lenders have always predominantly financed used cars; what's new is that more older vehicles are being financed by subprime lenders who cater to slightly stronger borrowers. In the third and fourth quarters, issuers including American Honda Finance Corp., Ford Motor Credit, Exeter Finance, Santander Consumer USA and AmeriCredit boosted the levels of used cars in asset-backeds, all without any decrease in the overall credit quality of the collateral pool.
The largest increase was in Santander’s fourth deep subprime securitization of the year in September on its three-year-old Drive Automobile Receivables Trust platform (DRIVE). An issuance from DRIVE, for the first time, had a 50%/50% split on new and used cars, compared to the 60%/40% ratio of new cars to used vehicles in deals from a year ago.
Exeter increased the used-car concentration to 27% in the subprime loan pool in its October securitization, compared to 23% in its prior deal in July. The AmeriCredit Automobile Receivables Trust 2018-2 transaction by the General Motors affiliate in August raised the used-car mix to 46% from 43%, compared to AmeriCredit’s 2017-4 transaction.
In each case, the increased exposure to used cars did not result in either a lower credit rating or higher credit enhancement for a given rating.
So far, only a few prime securitizations by captive-finance firms have slightly elevated used-car exposures in recent deals. In Honda's upsized $1.3 billion Honda Auto Receivables (HAROT) 2018-3 transaction in August, the used-car concentration increased to 10.18% from 9.45% in its HAROT 2018-2 in May. Concentrations had been rising since early 2017, however, initially from 7.92%.
In Ford Motor Credit's most recent transaction Ford Auto Owner Trust 2018-B slightly increased its used-vehicle collateral concentration to 13% exposure vs. 11.66% in its previous auto-loan transaction in May. Other captive lenders such as Nissan North American Acceptance Corp. (5%), GM Financial (12%) and Toyota Motor Acceptance Corp. (20%) show no increase in used-car exposure in recent pools. GM's latest deal in October actually declined from 15% in its first ABS in January.
The influx of used-car loans is part of a pipeline of collateral into subprime loan securitization that JPMorgan expects to rise by $5 billion this year to $30 billion.
Used cars make up 75.1% of all subprime collateral pools, the highest mark since 2010, but are being financed by borrowers with improved credit from three years ago. The average subprime FICO of 586 compares to 572 in 2015, and LTVs have shrunk to 110.9 from 114.8% in 2014, according to Amy Martin, a senior director and structured finance research analyst with S&P Global Ratings.
Another factor boosting investor confidence is the reduction in cumulative net losses for certain issuers since last year, thanks to growing recovery expectations on recent-vintage deals. In August, S&P revised downward loss expectations for subprime transactions for the United Auto and American Credit Acceptance platforms.
The higher average prices for used cars has been “very supportive” of auto ABS recovery rates this year for both prime and subprime securitization issuer, according to Kayvan Dariouian, a director and lead analyst on US ABS research for Deutsche Bank.
That includes outstanding ABS portfolios, which are benefiting from conservative resale value estimates issuers placed in deals during the used-car pricing slump from 2015 to 2017 when the Black Book used-vehicle retention index “came down pretty steeply,” he said.
“Now we’re starting to see a pickup back where there’s more gain to be had on those ABS deals where residual was more conservative,” said Dariouian. “But the values have come out stronger, so we expect to see a gain on the ABS side.”
Sliding used-car prices in recent years have presented auto ABS portfolios with higher risks in both recovery rates and exposure to greater net cumulative losses over the life of a deal.
But this year, S&P Global Ratings reported improved recovery rates from higher vehicle prices across the board in both prime and subprime auto ABS sectors. According to S&P, the prime recovery rate rose to 57.79% in August 2018 from 55.26% in August 2017. Subprime recoveries are up to 41.06% (August 2018) from 40.33% last year.
“We had been seeing declines in recovery rates [in the 2014-2015 vintages],” said Martin. “But beginning with the 2016 and 2017 vintages, we’re finally seeing some stability in recovery rates. And that’s a positive.”
Total recovery percentages for 2018 subprime deals midway through the year was 37.05%, compared to 31.12% for 2017 vintage deals and 33.1% for 2016, according to S&P.
Why the surprise?
The strong performance of recovery rates counters the pessimistic expectations most auto ABS market analysts shared at the end of 2017.
S&P felt heading into the year that used-car values would decline up to 5% as an expected record supply of off-lease vehicles (according to Edmunds.com) flooded dealer lots and auction houses – with passenger sedans suffering the most depreciation because of their ongoing decline in popularity.
But market forces – and Mother Nature – brought a surprising strength to used-car prices at the start of 2018. Ford and General Motors, for example, adjusted to consumer demand by curtailing passenger vehicle production for 2018 in favor of trucks and SUVS.
With fuel prices rising, fewer new passenger cars on lots, and dealers not offering the deep price cuts made last year to move off excess inventory of the models, the uptick in market demand for sedans has had to be fulfilled by the used-car market, according to Goyal.
And the demand is surprisingly across all types of passenger cars, he said. Mid-size sedans are up 0.64% on the index over the past year, for example, and compact cars up 0.89% - “which is very substantial” on the Black Book index, said Goyal.
Hurricanes Harvey and Irma in the Southwest/Southeast U.S. in August and September 2017 created a replacement demand for 700,000 vehicles destroyed in the storms, and “[t]he majority of that replacement was from used vehicles,” said Goyal. “A lot of excess inventory that had been built up was pretty much set back because of that replacement activity. We started year pretty fresh, so as the demand continued to be strong with strong economy, the market has done very well.”
Whether replacing a car out of necessity or choice, many buyers heading to dealers for the first time in a few years were in for surprise when checking out new models. Last December, Edmunds.com stated the average price of a new car was at an all-time high of $36,848.
Used-car demand is not surprising given the obvious driver, said Goyal: They are excellent values.
"There’s actually a supply of three-year-old used cars of models which got refreshed and redesigned fairly well after the recession," he said. "There’s fairly good product out there you can get for half the price" of a new car.
By the second quarter of 2018 dealers were seeing record numbers of used-car transactions. Certified used-car sales were over 700,000 for a quarterly period for the first time – boosted, ironically, by the off-lease supply of vehicles leased in 2015 (4 million) that were originally expected to depress used-car values, according to Edmunds.com.
It’s unclear how long new-car demand will be suppressed, keeping used-car prices on an upward trend, however.
Goyal noted that the fall launch of new-year models typically whets car buyers’ appetites, and end-of-year promotions kick in with dealers trying to clear inventory. “It is unlikely for the [Black Book index] to maintain this upward momentum,” he said. “As we get to the end of the year when typical depreciation patterns are expected to set in.”
But like last year, a lot of wild cards may be in the mix. Hurricane Florence offers a scaled-down repeat of the replacement demand spurred by the Irma/Harvey storm damage from the end of 2017, Goyal noted.
And the threat of auto-industry tariffs imposed by the Trump administration could add to manufacturing costs of new vehicles, including “domestic” cars, trucks and components that U.S. automakers produce and assemble in Mexico and Canadian plants.
Under the modified North American Free Trade Agreement in August, the U.S. federal government could impose tariffs of up to 25% on imported vehicles from Canada and Mexico. General Motors, for example, imports 40% of its pickup trucks from plants in Mexico, on which tariffs “could result in a decline in sales and/or an increase in costs,” according to a recent Fitch presale report for an October dealer floorplan securitization sponsored by GM Financial.
Fitch added that while the “substantial progress” in $6.5 billion in cost-cutting by GM could “help to blunt part of the impact of tariffs on metals and components, but broader tariffs or an all-out trade war would be especially concerning.”
That also could perhaps extend the trend of elevated used-car prices, and ongoing potential benefits to auto securitizations, as well, noted Fitch in its second-quarter auto ABS index published in August.
“With the increasing likelihood of auto-based tariffs overshadowing the new vehicle market, buyers could shift toward the used market as new vehicle costs increase,” Fitch wrote. “The Center for Automotive Research noted that new vehicle prices could increase by $1,000-$4,000 on average, which would push buyers looking for affordability to the used market and, thus, potentially benefit recovery rates and contain loss severity in auto ABS.”