Auto loans to customers with subprime credit ratings – FICO scores below 620 – are risky affairs. But during good times and endless cheap money, the high interest rates that can be extracted from car buyers who think they have no other options are just too tempting. Now the losses are coming home to roost.
Big banks have become relatively conservative in this category and are sticklers for things like income verification and other details, which has made room for specialty lenders with fewer such compunctions.
There are scores of these smaller specialized subprime auto lenders, some of them backed by private equity firms. And three of them – Summit Financial Corp, Spring Tree Lending, and Pelican Auto Finance – have now collapsed into bankruptcy or were shut down. Allegations of fraud and misrepresentations swirling through the bankruptcy filings.
These lenders generally borrow from big banks to fund auto loans to subprime customers. The difference between the rates big banks charge those lenders and the rates those lenders obtain from their subprime customers (often in the double digits) is their margin.
These specialized lenders can also package their subprime auto loans into structured asset backed securities (ABS), which are then sold in slices to investors. Each slice is rated separately, with the highest rated slice of an issue often carrying an “AA” or even “AAA” rating. Issuers often retain the riskiest slices that take the first loss. That math works well – until it doesn’t.
And it doesn’t when customers, buckling under these double-digit interest rates and too much car, start defaulting in massive numbers. Subprime loans started to be a fiasco that we have been covering at least since February 2016. This has been a slow-motion wreck.
Fitch, which rates these auto-loan ABS, tracks the performance of the underlying subprime auto loans. The index of its 60+ day delinquency rate of subprime auto loans has now risen to 5.8%, up from 5.2% a year ago, and up from 3.8% in February 2014. It’s the highest rate since October 1996, higher even than during the Financial Crisis. Note the strong seasonality: