Wall Street's Next Toxic Product - Auto Loans

Back when the Great Recession hit, much of the near collapse of Wall Street and its banking system were laid at the feet of those imaginative financial products like collateralized debt obligations (CDOs) which were basically bundled loans (mainly mortgages) containing subprime loans that were sold to unsuspecting consumers.  Well, eight years later, it looks like "they're baaaack" but in a slightly different form.

Let's start this posting with a definition.  "Securitization" is the practice of bundling various types of debt including mortgages, consumer loans or auto loans and selling their cash flows to third party investors as securities.  Prior to the Great Recession, the brilliant minds of Wall Street got the idea that they could make billions of dollars by bundling residential mortgages into mortgage-backed securities (MBS) which were secured by what turned out to be a significant percentage of subprime loans that were granted to less-than-creditworthy borrowers and selling them to anyone who wanted what appeared to be a risk-free, bond-like investment.  

Now, let's focus on the subject of this posting.  Here is a graph from FRED showing the growth in securitized loans for motor vehicles:

Here is a graph showing the year-over-year growth in auto loans since 2000:

By the fourth quarter of 2015, securitized motor vehicle loans had reached a high of $1.039 trillion, up by $213.8 billion or 25.9 percent from their pre-Great Recession high of $825.2 billion in the third quarter of 2005 and up by $340.6 billion or 48.8 percent from their post-Great Recession low of $698.4 billion in third quarter of 2010.  

Concern is growing over the significant growth in lending for motor vehicles.  While the volume of collateralized auto loans aren't approaching the massive volume of mortgage-backed securities, at over a trillion dollars, these speculative investments that present themselves as a "sure thing" are starting to show signs of weakness.

Here is a graph from Wells Fargo showing how the Americans with poorer credit ratings (i.e. subprime borrowers) are having trouble paying their monthly auto loans:

According to Bloomberg, the default rate on auto loans is currently at 12.3 percent, the highest rate since 2010.  Some of this may be related to the collapse of oil prices which have negatively impacted household incomes of families in Texas, Colorado, Oklahoma and North Dakota. What is even more concerning is that, according to Equifax for the first four months of 2015, 23.5 percent of auto loans were issued to subprime consumers for an average amount of $18,200.  In total, 2.12 auto loans were made to consumers with an Equifax Risk Score below 620 (considered subprime), up 9.6 percent over the previous year.  

Here are some comments from U.S. Comptroller of the Currency, Thomas Curry, back in October 2015 about the securitization of auto loans:

"Auto lending is another area of credit risk that we’ve had our eye on for several years. It’s good news for automakers and for the economy as well that sales are rolling along at record levels. It’s also good for banks, which have supplied a significant amount of the financing that makes this activity possible, either directly to purchasers or indirectly through car dealerships. At the end of the second quarter of 2015, auto lending represented more than 10 percent of retail credit in OCC-regulated institutions, up from 7 percent in the second quarter of 2011. And, increasingly, banks are packaging these loans into asset-backed securities rather than holding them in a portfolio. These securities are being greeted by strong demand from investors, who no doubt remember that securities backed by auto loans outperformed most other classes of asset- back securities during the financial crisis.

But what is happening in this space today reminds me of what happened in mortgage- backed securities in the run up to the crisis. At that time, lenders fed investor demand for more loans by relaxing underwriting standards and extending maturities. Today, 30 percent of all new vehicle financing features maturities of more than six years, and it’s entirely possible to obtain a car loan even with very low credit scores. With these longer terms, borrowers remain in a negative equity position much longer, exposing lenders and investors to higher potential losses. Although delinquency and losses are currently low, it doesn’t require great foresight to see that this may not last. How these auto loans, and especially the non-prime segment, will perform over their life is a matter of real concern to regulators. It should be a real concern to the industry.

Neither auto loans nor home equity loans are inherently unsafe. That’s true for most asset classes. However, what is inherently unsafe are excessive concentrations of any one kind of loan. You don’t need a very long memory to recall the central role that concentrations—whether in residential real estate, agricultural land, or oil and gas production—have played in individual bank failures and systemic breakdowns. It’s an old movie that’s been reprised on a regular basis. That’s why we’re closely watching growing exposures in commercial real estate loans, especially in the construction and multifamily housing sectors, as well as in loans to non- depository financial institutions." (my bold) 

And, it looks like trouble in the sector has already started as shown on this release from Asset-Backed Alert about Skopos Financial's most recent securitization of subprime auto loans:

"The collateral for Skopos Financial’s most recent securitization of subprime auto loans is performing worse than expected, feeding fears of an impending liquidity crunch in the asset class.

At issue is a $154 million transaction that Skopos completed on Nov. 9 with Citigroup running the books. That issue’s top class earned ratings of A/AA from DBRS and Kroll, but already has experienced enough collateral defaults to approach a “cumulative net loss ratio trigger event” set by Kroll.

Should losses reach that level, Skopos would have to stop collecting excess cashflows and redirect the money to bondholders.

Such an event would make it difficult for the Irving, Texas, company, founded by former Drive Financial executive Mark Gallas, to continue doing business as usual — and would make it virtually impossible for Skopos to raise additional capital through securitization. Sources said other deep-subprime lenders including Go Financial and United Auto Credit face similar pressures due to rising losses among the loans underpinning their securitizations.

“For these smaller firms, securitization is their only source of funding in this space,” one source said. “It only takes one deal of theirs to go sideways in terms of performance and they can impact the whole subprime-ABS market.”” (my bold)

Once again, whether they want to admit it or not, the Federal Reserve's near zero interest rate policy comes home to roost.  With interest rates on no-risk 5 year CDs looking like this:

...in the search for reasonable yield, investors have taken on far more risk than they normally would.  With the default rate on auto loans rising, there could be a lot of tears among small retail investors that thought that they were buying a sure thing.  On top of that, with auto loans at near-zero levels, consumers are being lured into borrowing money to buy cars that they simply cannot afford.