Wednesday , 17 October 2018

Used Vehicle Market Problems Could Affect the Economy Bigtime – Here’s Why

Let’s hope that the problems piling up in the used vehicle market — andcars their impact on new vehicle sales, automakers, $1.1 trillion in auto loans, and auto lenders — are just a blip.

The comments above & below are edited ([ ]) and abridged (…) excerpts from the original article by Wolf Richter (

State of Subprime Auto Loans

Loans that originated between 2013 and 2015 have been particularly hard hit as that was when the proportion of subprime loans with loosey-goosey underwriting standards began to surge amid the exuberance of the greatest credit bubble in history. “Bad deals are made in good times,” says the old banking law.

Auto lenders package their loans into asset-backed securities (ABS) and sell them as bonds to yield-hungry institutional investors. Fitch Ratings, which rates auto lenders and auto-loan ABS, just reported on the state of the industry:

  • 60+ day delinquencies were relatively low for prime auto loans at the end of Q4, but subprime loan delinquencies surged to 5% of outstanding balances, the highest since at least 2008, during the depth of the Financial Crisis!
  • Net Charge-offs from prime loans ticked up to a still low 0.75% of outstanding balances but net charge-offs from subprime loans surged to 10.5%, the highest since at least 2008!
  • Average loan terms have reached a record 67 months for the overall market but, for subprime borrowers, they’ve jumped to over 72 months…Longer loan terms:
    • make payments more affordable for cash-strapped consumers…
    • pump up sales volume [for the dealerships] and
    • allow finance companies (and dealers) to make higher profits…
    • cause depreciation of the vehicle to outrun the amortization of the loan principal for longer, and
    • cause borrowers to have negative equity for longer, which raises the risk of loss, particularly for subprime loans. This, says Fitch, will:
      • pressure recovery values on defaulted loans and
      • also hurt customer trade-in values,
      • which could negatively affect future new car sales/financings.

Effect on Auto Industry & Lenders

…The above is important for the industry as a whole, not just lenders and their investors because:

  • Lenders are starting to feel the bite of those losses that are made worse by extended loan terms, higher loan-to-value ratios, a higher proportion of subprime loans, more negative equity for longer, and hence subprime defaults and net charge-offs that are soaring to crisis levels.
  • This spiral is made worse by dropping wholesale prices of used vehicles when they’re sold at auction, which is where lenders unload repossessed vehicles. This deterioration in used vehicle wholesale prices came to the fore in the National Association of Auto Dealers’ gloomy report on February in which it reported that:
    • used vehicle price index plunged 8% from a year earlier
    • and 13% from the peak in 2014, to hit the lowest level since September 2010.

To tamp down on future losses, lenders began tightening underwriting standards, particularly in the subprime segment, in 2016: pricing, minimum down payment and minimum credit were all tightened BUT they continued to lengthen the maximum loan maturityWhy? Because shortening terms, in face of high prices, and hence unaffordable payments for stretched consumers, would strangle sales volume and profits.

 They’re Getting Nervous:

  • Fitch expects lease turn-ins to surge by 50% between 2015 and 2018. These are the vehicles that customers turn in at the end of the lease and that are then sold at auction. Dealers buy them and retail them.
  • This surge in supply comes as rental car companies are “rightsizing” their fleets, and their units are flooding the auction
  • and it comes as automakers are piling on incentives to sell down bloated dealer inventories of new vehicles and keep plants open, thus making new vehicles more competitive with late-model auction units.
    • New vehicle demand is “believed to have plateaued,” says Fitch and this lack of demand, in face of surging supply, pushes vehicle values lower, which adds “downward pressure on lenders’ recovery values and lease residuals.”

Lease Residuals

“Lease residuals” is a term that has started to crop up in earnings warnings. When you lease a car, the lender puts an estimated value on the vehicle at the end of the lease term. This is the part of the vehicle that you never pay for. The higher this “residual value,” the lower the monthly payment. At the end of the lease, you turn the vehicle in, and it is then sold at auction. As wholesale prices drop, residual values are under water, and lenders are taking losses on them. This is starting to happen.

How big is leasing? It’s huge. Leases account for 30% of total auto financings. Hence the earnings warnings – and Fitch “anticipates” that this chorus will get worse.

Then there are knock-on effects. Bleeding lenders lower residual values on new leases. This causes monthly payments to rise, making the vehicle less affordable for stretched customers, and thus more difficult to sell, just when demand has already peaked, and when subprime is getting crushed.

Let’s hope that the problems piling up in the used vehicle market — and their impact on new vehicle sales, automakers, $1.1 trillion in auto loans, and auto lenders — are just a blip.

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