Subprime Auto Lending Shifts into High Gear


A segment on Nightly Business Report the other night noted that car sales exploded in August, and that gleeful auto dealers are expecting the tuned-up buying behavior to last into the fall. A sales executive from General Motors (NYS: GM) stated that the increased activity is due to a healthier housing market, and easier consumer access to credit.

The latter part of his comment is certainly true, but the tie-in to housing seems less about the health of the market, and more about structuring vehicle loans in a similar way to subprime mortgages.

Subprime auto loans are topping pre-crisis levels
A new study by Experian shows that the portion of borrowers with poor credit receiving new car loans in Q2 now sits at 25.41% of all loans, a higher proportion than year-ago levels, and surpassing the pre-financial crisis level of 24.96% back in 2007. For used cars, the percentages were more than twice as high, with subprime borrowers representing 56.46% of all loans in that category. Loan-to-value on new cars dropped a bit from last year, clocking in at 109.55%, while LTV on used vehicles increased by the same amount, with an average of 126.62%.

This phenomenon has been accelerating for some time as lenders look for new ways to make up for poor loan portfolio yield performance. Auto loans have been growing riskier over the past year: The credit rating for the average subprime borrower dropped by nine points from a year ago, while the average size of the loan increased. The monthly payment didn't increase much, however, probably because 77% of these loans have been stretched out for more than five years.

An Experian spokesperson tried to put a positive spin on these numbers, noting that lenders are being cautious, as evidenced by the slightly lower LTV rates on new cars. Also, the statement continues, the lending environment is better, so lenders can safely make these loans available to a greater number of borrowers.

Subprime hits the big time
If the worst case scenario in a default were the repo man taking away the car and calling it even, these low quality loans probably wouldn't pose much of a risk to the economy at large. But the auto industry has taken a page out of the mortgage industry's book, and is bundling and selling these loans to investors as asset-backed securities.

This is nothing new, of course. Auto loan-backed securities peaked at $103 billion in 2005 before dropping to $36 billion in 2008. Since then, the market has been rebounding, and as of late April, auto loans were responsible for nearly 57% of all ABS issuance, amounting to about $34.7 billion.

The sale of subprime auto ABS products has increased this year as well, having reached just over $13 billion as of late August, compared to a little more than $12 billion for all of last year. GM Financial, which specializes in subprime auto loans, recently sold $1.3 billion of these bonds, up from its original estimate of $1.1 billion.

Over the past several months, subprime lenders have been sprouting up like mushrooms, eager to jump-start the type of loans that make up these popular investment bonds. Last fall, the LA Times ran a piece about these lenders, noting that private equity firms have been swallowing subprime auto dealers like J.D. Byrider in order to get in on the action.

The "Buy Here, Pay Here" dealership model trades mostly in used cars, providing on-the-spot financing for customers with iffy credit. The 38% average profit made on each vehicle, in addition to the subprime-loan production line, makes these outfits an investor's dream. Two of these companies, Credit Acceptance (NYS: CACC) and America's Car-Mart (NYS: CRMT) , have seen their stock prices rise over the past 12 months by 39% and 66%, respectively. This past April, J.D. Byrider offered a subprime-backed auto ABS package worth $145 million, marking the lender's entry into the bond market.

Not all lenders are relative unknowns. In addition to General Motors' GM Financial, Capital One Financial (NYS: COF) has been working hard to grab a piece of this pie and has greatly increased its issuance of new car loans.

The next bubble to pop?
These loans are pricey, often sporting exorbitant interest rates for up to seven years. And, despite the fact that the default rate on loans written by the more shadowy subprime lenders is 25%, most of the investment bonds are rated AAA. Why? Because, at this point at least, these loans are bundled together with other, less chancy loans, which ostensibly dilutes the risk.

But, the incidence of these loans is climbing, and, the day may come when they are the dominant loan product in these securities -- mimicking the scenario whereby mortgage-backed securities became dominated by subprime home loans. And, even with the dilution factor, a one-in-a-quarter chance of default on any portion of the ABS seems like enough to lower the overall quality of the bond.

Many are voicing concern about the pervasiveness of these loans, as well as their similarities to the MBS products that helped pop the housing bubble. Investor, beware.

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