Subprime Auto Loans: Ready to Destroy the Auto Manufacturing Comeback?

Auto sales are booming, but is there a dark cloud on the horizon? Some financial analysts think so and it’s because of the way new car purchases are financed.

Auto sales are booming, but is there a dark cloud on the horizon? Some financial analysts think so and it’s because of the way new car purchases are financed. If true, the US consumer is way over leveraged, with the potential for real trouble if employment growth sputters in 2015.

The optimistic view is broadcast widely in the mainstream media. One example is this report from online car shopping site www.truecar.com , who project that the pace of February auto sales will expand to a seasonally adjusted annualized rate (SAAR) of 16.7 million new units on continued strong consumer demand. According to Truecar, new light vehicle sales, including fleet, should reach 1,295,600 units for the month, up 8.5 percent over a year ago. This same increase is expected on a daily selling rate (DSR) basis with 24 selling days this February versus a year ago. “Strong February auto sales signal a very healthy U.S. economy,” said Eric Lyman, vice president of industry insights for TrueCar. “Given this month’s robust demand, the industry remains on track to hit TrueCar’s 17 million-unit projection for the 2015.”

Great auto production numbers…can they last?

Here are Truecar’s forecasts for the 10 largest manufacturers by volume for February 2015:

Unit Sales

Manufacturer

          February 2015 Forecast

                 % Change vs. February 2014

FCA

168,700

8.3%

Ford

193,500

5.5%

GM

234,700

5.7%

Honda

114,300

13.8%

Hyundai

50,500

3.1%

Kia

45,800

11.1%

Nissan

121,300

5.1%

Subaru

40,000

14.6%

Toyota

187,300

17.6%

Volkswagen Group

45,300

9.3%

Industry

1,295,600

8.5%


Market Share


Manufacturer

        February 2015 Forecast

                    February 2014

    January 2015

FCA

13.0%

13.0%

12.6%

Ford

14.9%

15.4%

15.4%

GM

18.1%

18.6%

17.6%

Honda

8.8%

8.4%

8.9%

Hyundai

3.9%

4.1%

3.9%

Kia

3.5%

3.5%

3.3%

Nissan

9.4%

9.7%

9.0%

Subaru

3.1%

2.9%

3.5%

Toyota

14.5%

13.3%

14.7%

Volkswagen Group

3.5%

3.5%

3.4%

What’s the source of this optimism? TrueCar states that GDP expanding for a third consecutive quarter combined with a healthy stock market – the Dow Jones industrial average has gained 12 percent in the past year as of February 20 – the U.S. economy is on solid footing. Additionally, sustained low gas prices continue to buoy consumer confidence and support increased personal consumption expenditures. But what if the stock market gains and low gas prices don’t actually alter consumer confidence?

No money for a new car? Sub-prime to the rescue

Wall Street contrarian Wolf Richter has reported here that the real reason for the explosion of auto sales in an otherwise flat job growth economy has been a subprime lending binge similar to the one which ended in the 2008 banking collapse. Can it be true? There is evidence. According to Richter, “today’s subprime securitization rage is in the auto-loan sector, not mortgages. About 31% of all outstanding auto loan balances are rated sub-prime. They’re the foundation of booming auto sales. There is a lot to securitize. It’s so hot that private-equity firms are all over it. And IPOs are flying off the shelf. These auto lenders – from giants such as Ally and GM Financial to smaller ones – are under investigation by the DOJ (US Department of Justice) and a laundry list of other federal and state agencies for the underwriting criteria they used on securitized subprime auto loans as well as the representations and warranties related to these securitizations.”

In essence, auto lenders are behaving the way mortgage lenders did in the run up to 2008: allowing uncreditworthy and low score customers to take out loans, then bundling them into other securities and reselling them as safe investments. For example, according to Richter, Santander Consumer USA, (one of the targets of the DOJ investigation), is planning a $1 billion securitization of subprime auto loans. It already issued two securitizations since the DOJ subpoenas last summer and surprisingly, $434-million of the current deal is rated triple-A by Standard &Poors. In theory, this subprime market is a healthy financial tool to let credit-damaged yet reliable consumers into new cars…as long as they keep up the payments. Last week, subprime auto lender CarFinance sold $266 million in structured securities. The best loans carried S&P’s single-A rating. Others were rated as low as “BB-.” The underlying loans have an average FICO score of 603, pay an annual interest rate of 15%, have a term of 72 months, and sport an average loan-to-value ratio of a worrying 118%. When it comes to automobiles, the American consumer is overleveraged. But why would investors buy such risky products? Richter puts it simply: “In the zero interest rate environment imposed by the Fed, investors go for anything that has a discernible yield.”

American Banker  took a look at a $500-million securitization that subprime auto lender Exeter Finance sold last August and found troubling numbers: The average APR on those loans was 18.59%. The original term length was 70 months. 75% of these loans had a loan-to-value ratio of over 105%. Eighty-one percent of the borrowers had a FICO score of below 600. Strangely, some of the securities that these loans are packaged into are rated AAA.

Auto manufacturing is at risk is defaults spread

So what happens if there are widespread defaults? Presumably, the same thing that happened when the mortgage market imploded, namely a dramatic fall in the residual value of repossessed vehicles. This may have a knock-on effect on the leasing market [some estimates say it is 30% of the business] since lease rates are calculated on assumptions about the residual value of the vehicle at the end of the term. A significant glut of late-model used vehicles could seriously impact new vehicle pricing as well. Where this pattern differs from the subprime mortgage market however, is in the nature of the underlying assets. Motor vehicles depreciate steadily and rapidly, making it imperative that repossessed vehicles are resold quickly. This is a “good news bad news” scenario. The good news is that the market clears rapidly, allowing the next wave of new car buyers to step forward as the used inventory is rapidly depleted. The bad news is that the same effect can mean highly volatile short-term swings in new vehicle demand, the worst-case scenario for mass production manufacturers.

The other troubling evidence from the statistics is the lengthening term of auto loans, some as long as seven years, and the number of loans that are “upside down”. These loans, where the amount owing exceeds the residual value of the vehicle, not only add risk for the lender, but create a financial penalty for early trade-in for the vehicle owner, suppressing new car demand. For the investors of course, it’s purely a financial risk. According to Richter, “and not a word about the securitization boom and that is stuffing these sliced and diced and repacked triple-A rated subprime loans into bond funds of unsuspecting conservative investors – because that’s where most of these things end up, and that’s where they can quietly decompose.”

Or, as the industry asserts, the subprime market may simply be pricey money that simultaneously puts credit-dinged consumers into new vehicles, while rebuilding their credit ratings. If they are wrong however, automakers may need to speed innovation and bring new models to market faster if they want to push back against a possible glut of late-model used cars and trucks. While subprime is unlikely to blow up the financial markets, the economic recovery in manufacturing is too weak to ignore a 2016 downturn in auto production.

Written by

James Anderton

Jim Anderton is the Director of Content for ENGINEERING.com. Mr. Anderton was formerly editor of Canadian Metalworking Magazine and has contributed to a wide range of print and on-line publications, including Design Engineering, Canadian Plastics, Service Station and Garage Management, Autovision, and the National Post. He also brings prior industry experience in quality and part design for a Tier One automotive supplier.