Auto loan market is shifting back to normal

Auto loan asset-backed security (ABS) delinquency and charge-off rates have increased since the middle of 2021, but don’t call it deterioration. Auto ABS credit continues to perform well, exhibiting no structural problems. A better term, then, is “normalization.” Case in point is that most of the rise in consumer defaults is in the subprime market, and even then, in its weakest participants.

Delinquencies and charge-offs reached historic lows during the Covid-19 pandemic (the latter occurs when an obligor defaults on a loan, and the car is repossessed and sold at auction). That was largely due to support from government stimulus programs and increased consumer savings stemming from the pullback in travel, suspended entertainment and other factors. But the combination of higher inflation, which hit lower income borrowers hardest, and a loosening of underwriting standards has contributed to subprime vintages from 2022 performing worse over the past few years.

The shift has hit less-capitalized subprime issuers the hardest, with these smaller issuers seeing the most significant increases in serious delinquencies and charge-offs. In contrast, larger issuers, typically owned by banks and auto manufacturers, seem to be doing well. They have consistent origination platforms, strong servicing operations and access to multiples sources of financing (debt, equity, bank lines of credit, deposits, etc.), helping them withstand periods of market volatility or disruptions to the ABS marketplace.

But ABS deal structures maintain consistent overcollateralization and ample reserve accounts. Excess spread, which is the first line of defense against charge-offs, remains extremely robust. In some instances, BBB-rated tranches are tested to withstand almost two times the worst-case scenarios experienced during the global financial crisis.

In fact, this year we have seen a huge amount of new auto ABS issuance come to market presenting attractive buying opportunities. Deals are sometimes 10-15 times oversubscribed. So not only are there increased funding needs from issuers implying growth despite the normalization in delinquencies, but there is excess demand from the market for that supply.

A continued rise in unemployment and possible decline in used car prices could lead to a further rise in delinquencies and ultimately in charge-offs, increasing headline risk. But with rigorous credit investment analysis, investors can take advantage of attractive auto ABS deals when they arise.