Abacus: Are We About to Burst an Auto Bubble
Remember the huge financial crisis that ruined the economy almost a decade ago? The majority of individuals, the media, and federal agencies placed the greater part of the blame on irresponsible investors and commercial banks, who stretched the terms of subprime mortgage lending to the max. The wicked high returns and profits coming from the securities backing mortgages inevitably led investors to grant a monumental amount of debt disproportionally to those with undeserving credit scores. As subprime mortgages and delinquencies increased, investor’s securities went into a price and liquidity downward spiral, bringing all the sectors attached to it with it.
Recent news in the auto lending sector have led financial critics to draw parallels to the mortgage crisis. The percentage of subprime auto-loan securitizations considered ‘deep subprime’ has risen from about 5% in 2010 to almost a third today. Auto financers have started lending to car buyers with lower and lower credit ratings, and in turn those in the financial industry have started underwriting more dangerous subprime auto-loan asset-backed securities. Could the almost 600% increase in subprime ABSs be assigned to post crisis regulations thrown onto commercial banks by the U.S. Fed, causing them to underwrite high yield subprime securities in other sectors?
Whether that’s true or not, auto loan delinquencies have ascended in the post-crisis world. Since 2012, “[s]ixty-day delinquencies for bonds backed by these loans have risen 3 percentage points”, which is comparable to 2008 data, in which 60+ day delinquencies also spiked, albeit quite a bit more. These increases usually serve as a pretty bad economic signal, but does this mean we’re about to burst the bubble by apparently building in the auto-lending securitization market?
My pops was in the resort real estate business during the crash, where he actually started the first “Destination Club” (he even got credit on Wikipedia!). A destination club works similarly to a country club, wherein you pay a one-time membership fee and annual dues to become a member. But, instead of members paying to play as much golf or tennis as they want at an uppity place, members gain access to an array of vacation homes all over the world. Dad made a ton of money, but when the housing crisis hit, his company lost all funding liquidity and had to file for Chapter 11. Our family lost everything, but the way in which this connects is that he also personally went bankrupt, which entails losing all of your credit.
I recall being shocked last year when he brought home a brand new Chevy Sonic as my sister’s first car. How in the world could he afford this (and why did I have to save up to buy a cheap 1998 Subaru Forester with 200 thousand miles on it)?
Supposedly, in a brief conversation with the salesman at our local General Motors dealership, he was informed that, even with his pitiful credit, he could get awesome financing for the car at super low rates. My dad is one of the typical car buyers being offered very affordable subprime lending by the General Motors Acceptance Corporation (GMAC), who happen to also be experiencing quite the rise in sixty-day delinquency rates on these loans.
I imagine his loan is one of many being underwritten on Wall Street for more security sales. What conclusions can we draw from this one example? Are banks now stretching the terms of debt-obligation securities in the auto industry to replace high-yield profits in the sectors now regulated by the Fed? “At least two dozen lenders have tapped the debt market to sell bonds that hold their subprime auto loans over the last few years”, from smaller lenders to larger lenders. It’s obvious to institutions underwriting these securities that they provide a profitable investment opportunity. Plus, the subprime auto securitization has performed relatively well so far (as they did during the MBS crisis.) This quote from the OCC’s (Office of the Comptroller of the Currency) “Semiannual Risk Perspective” sums up the bank’s situation perfectly:
“Auto lending risk has been increasing for several quarters because of notable and unprecedented growth across all types of lenders. In the last two quarters, delinquencies on auto loans have begun to increase and net losses have also reflected non-seasonal increases. As banks competed for market share, some banks responded with less stringent underwriting standards for direct and indirect auto loans. In addition to the eased underwriting standards, lenders also substantially layered risks.”
While there has been growth in this sector, there are two separate facts that insinuate lenders and investors should be cautious: One, As stated before, 60+ delinquencies are up across both prime and subprime auto loans; and two, there has been a spike in negative equity among borrowers in the auto industry. Both are negative economic indicators for the market, but is it fair to draw parallels of this auto bubble to the housing bubble in 2008?
Don’t jump to conclusions just yet, subprime securitizations of debt in the auto industry may not carry the same weight as in the housing market.
Debt-to-income ratios on consumer balance sheets are still well below their peak levels in 2008, and actually, “with the improvements in the labor markets and decline in borrowing rates, household debt-to-income and debt-service levels have improved significantly since the crisis.”
Also, the notion that underwriting standards in the sector have been deteriorating in the post-crisis world may not be entirely fair; many of these subprime loans may have been made to those in extreme credit situations, i.e. those with unfairly low credit scores after the financial crisis. “As the economy improved, so did the credit scores of such consumers”, and therefore lending to these individuals and furthermore securitizing those loans isn’t as risky as their FICO scores may imply. However, subprime borrowers who did obtain the loans based on this standard, and now are behind, probably will default.
At the dawn of the housing crisis, yield spreads (bond yield over Treasury) among major Wall Street firms, in some cases, increased ten-fold. Increases in bond yield over Treasury spreads are a fairly strong negative economic indicator, and check out substantial spikes (for Goldman Sachs and Morgan Stanley) during the housing crisis below:
Meanwhile, spreads on Subprime ABSs to swaps have actually decreased in the recent years. Implying that risk in securitizing subprime debt in the auto industry may not be as high as expected, and that we haven’t quite stretched out the terms of lending to the max in this market quite yet.
Subprime ABS Yield Spread
The automobile sector isn’t nearly as large as the housing sector, and the implications from a bubble-burst in the former aren’t as alarming as the ones in the latter. Moreover, “[i]t’s also possible that the Trump administration’s pro-growth policies will improve or extend the later stages of the business cycle”, wherein securitization of subprime auto-loans can continue to offer excellent relative value, compared to other fixed-income assets, for longer. Or, it may give creditors and underwriters time to back off a little on stretching the market deeper into and deeper into deep subprime.
In the meantime, dad keeps making his car-loan payments in a timely fashion, which is enough evidence to me that securitization in the auto sector should be just fine in the short-run.