More buyers who borrow to purchase used cars may find themselves overextended with a loan that stretches well beyond their fast-depreciating vehicles’ best years, industry watchers have warned.
These concerns, and a run-up in sales, have placed a lot of attention on the auto-loan market this year. The word “bubble’ has been floated. Could some borrowers get hurt in deteriorating conditions? Yes. Lenders, too. In fact, J.P. Morgan Chase JPM, -0.20% CEO Jamie Dimon has addressed auto-loan risk at least two times in as many months, and as recently as last month he called the market “a little stretched.”
Still, the auto-loan market is far from the powder keg that the mortgage market was when the globe plunged into a financial crisis eight years ago, according to loan and credit experts.
Much of the concern centers around the so-called subprime car-loan market, generally understood as loans extended to borrowers with credit scores below 600.
Investors hear the word “subprime” and “have a little but of a knee-jerk reaction” as they’re reminded of the subprime mortgage market, said Melinda Zabritski, a director of automotive finance at Experian. “But these are not $300,000 homes.”
Reports sounding the alarm on rising subprime auto loans usually compare current levels to the trough at the onset of the last recession, when, Zabritski noted, credit was tight across the board. Moreover, such borrowing is not necessarily a bad thing — for some borrowers, a car is more than just a means of transportation; it can be a gateway to a better job, for instance.
Car loans top $1 trillion
In addition, the car-loan market is a sliver of the size of the mortgage market. Auto loans, including the loans extended to prime and subprime borrowers, topped $1 trillion for the first time last year, according to Experian data, exceeding the outstanding balances on U.S. credit cards. But that $1 trillion is a fraction of the $8.4 trillion mortgage market, based on New York Federal Reserve data.
Moreover, it’s easier to repossess a car than foreclose on a home. There is typically a healthy marketplace for used, and even repossessed, cars; conversely, foreclosed homes, and especially a neighborhood of foreclosed properties, can prove harder to unload.
Subprime loans as a percentage of total auto loans have held steady, standing at about 22% of total auto loans as of the first quarter of the year, said Amy Martin, asset-backed-securities analyst at Standard & Poor’s. That’s well below levels of 25% to 30% pre–financial crisis, as the following chart shows. Instead, the larger debt accumulation has happened for higher-rated superprime borrowers.
Fitch Ratings has predicted a 10% delinquency rate among subprime auto borrowers this year. “The peak subprime (loss) rate was 13% recorded in early 2009 at the height of the financial crisis, so current losses are well below this level. Net losses … are rising marginally, but remain well within Fitch’s expectations,” Fitch analysts said in a recent note.
A portion of auto loans are repackaged, just like mortgages, as asset-backed securities. By design, that frees up more market capacity, presumably getting more people into cars. But memories are long. It was an ABS (and collateralized debt obligation) collapse contagion that spawned the “Big Short” trade of movie fame, and helped feed the Great Recession. As such, financial market sensitivity to another loan bubble may be understandable.
Yet even the proportion of subprime auto loans that are securitized differs greatly from the mortgage market, said S&P’s Martin. Where most mortgages are candidates for securitization, only about 19% of the $125 billion subprime auto-loan originations, or $23.3 billion, were securitized last year.
Auto debt has swelled with strong car and truck sales, fueled by the economic recovery and low gasoline prices. To upgrade to better cars, buyers are taking on longer-term loans, and confident banks increasingly are willing to shoulder the risk. Of course, subprime borrowers sometimes pay as much as double the interest rates of higher-credit-quality borrowers, and so these loans can be more profitable to lenders; the incentive may remain to keep lending to this riskier group.
Of course, massive defaults on auto loans could flood the used-car market, depressing prices for all car types should the bargains among used-vehicle options sway buyers away from new cars.
Growth extends to new- and used-car loans. Experian reported earlier this year that the average amount financed for a new vehicle at the end of last year was $29,551 — a record, and up $1,170 from the end of 2014.
According to Fed data issued earlier this year, about two-thirds of those who purchased a new or used vehicle took out a loan to do so; half of those loans were from the location where the vehicle was bought, and the other half mostly came from a bank, credit union or online lender.
And 12% of car buyers who used loans to pay for a vehicle took out a loan with a longer repayment period than the amount of time they planned to own the vehicle.
For sure, longer-duration loans have increased, extending the time that a car owner begins to realize equity in their purchase. The S&P-provided chart below shows the extended time frame before loans are worth less than the cars they’re funding.
A second chart, covering subprime collateral trends, shows a rise in the loan-to-value percentage in the subprime-car-loan space, although still off pre-crisis levels.
Still, it may be too easy to link the automobile and mortgage markets under the broad label “subprime.”
“Studies show that subprime loans, which have been blamed for the country’s mortgage crisis, are growing at a staggering rate of more than 130% since the financial crisis,” New York Department of Consumer Affairs Commissioner Julie Menin said last year while announcing that office’s probe. “For many families, especially those with low incomes, a car is one of the biggest purchases they make, and, if they are looking to a subprime loan, it’s because they are already struggling financially.”
The new popularity of longer-term auto loans — stretching out as long as 84 months—concerned state and local regulators in reports issued beginning last year.
Even J.P. Morgan’s Dimon repeated his lingering concern for this increasingly “stretched” automotive lending market in an earnings call on July 14, after first mentioning the risk of the subprime auto loans at a June investor conference. Dimon said there could be losers and winners as the auto-loan market stews. But he said he doesn’t think subprime car lending represents “a systemic issue.”
Can sales and prices hold up?
Higher prices and strong sales can help support outstanding loan health. U.S. annual sales of cars and light trucks are on track to hit a record 17.8 million in 2016 before plateauing at 18 million in 2017 and slipping to 17.7 million by 2018, according to the latest outlook by the UCLA Anderson Forecast. (Sales hit a low of 10.4 million in 2009 after peaking at 17.4 million in 2000.)
But used-car sales may be up against some headwinds. In June, Ally Financial said it expects used-car prices to fall by about 5% in 2016 from last year.
Piper Jaffray analyst Kevin Barker, in a June note to clients after an earnings report from CarMax Inc. KMX, -0.15% , the largest used-car dealer in the country, expressed expectations for downside pressure on used-car prices in the coming months.
“The decline in sales from lower-tier borrowers (near-prime to subprime) are a clear signal the market recognizes subprime lending may have been overextended,” he wrote. “These developments continue to confirm our thesis that lower used-car prices and lower auto sales will pressure earnings/revenue for banks most exposed to the auto sector, in particular.” That list includes Huntington Bancshares HBAN, +0.42% , Wells Fargo WFC, -0.33% and BB&T BBT, -0.65% . Wells Fargo announced last year that it would cap subprime auto loans at 10% of its lending business.
And there’s another phenomenon that could stress prices and overall market health. Used-car-market tracker Mannheim has noted the challenge of off-lease vehicles pouring into the market. The expectation for an increase is the result of the U.S. expansion hitting birthday No. 7. Add in expectations that more rental-fleet cars will hit the market and an expected record supply of 7.5 million used vehicles is expected to come on line over the next three years, according to Mannheim.
Kelley Blue Book analysts stressed that they’re not seeing worrisome “bubble” volume.
“Despite what we know about the increase in lease returns for the foreseeable future, it’s interesting to note that Kelley Blue Book Field Analysts are seeing a decrease in auction inventory from last quarter,” said Kelley Blue Book analyst Sean Foyil. “While year-over-year auction volume is up 61%, in the second quarter we saw a 2% decrease in the number of vehicles running through auction lanes from the first quarter of 2016.”
And while historically low fuel prices have added to car fever, that influence may be lessening. Fuel prices continued along an upward trajectory in the second quarter, at a similar pace to that of the same period in 2015, increasing by 13%, or 26 cents, to $2.33 per gallon, Kelley Blue Book said.
As always, context can be helpful in detecting worrisome bubbles.
“The current rate of auto sales looks high but is actually in line with historical norms during positive economic times — and, from that perspective, I don’t believe car sales are in a bubble,” said Dwight Johnston, chief economist for the California and Nevada Credit Union Leagues, in a commentary for the organization.
“We’d be in a bubble if you saw a sudden jump in the annual U.S. sales rate to 19 million or 20 million vehicles without a commensurate surge in the economy. There would also probably be an extraordinary increase in subprime lending.”
Moreover, lenders in the subprime-car-loan space are not becoming more lax in their lending standards, Experian’s Zabritski said. Such lenders usually specialize in riskier borrowers, and they are not lending “without a lot of analysis,” and delinquencies are low, she said.