Vadim Verkhoglyad, vp and head of research publication at dv01, argues that challenges in the subprime auto market are not as significant as they seem

Many view the US subprime auto market as a ‘canary in the coal mine’, equating facts like rising delinquencies to an indication of a looming financial crisis. This perspective is false and its adoption could decrease subprime activity and exclude borrowers from a critical market. It is crucial that market participants acknowledge the broader context of subprime auto loans to understand why the issues aren’t as significant as they may appear.

Concerns about the subprime auto sector are predicated on several factors. Delinquency and charge-off rates in subprime auto ABS are increasing: delinquencies 60-plus days overdue hit a seasonally adjusted record high of 5.6% in July. Additionally, interest rates and used car prices are rising, causing affordability challenges for potential borrowers. Moreover, wholesale poor underwriting by a select number of auto lenders has been detrimental to sector performance and perception. 

However, these challenges are not as significant as they seem and are certainly not signals of a looming crash. Increased delinquencies during periods of rising interest rates are not unusual and do not necessarily imply long-term increases in defaults, repossessions or widespread risk to consumer markets.

On top of this, delinquency rates for public issuers remain relatively contained. These delinquencies can also be managed effectively by lenders: they have significantly increased interest rates on new loans, which - while leading to higher delinquency rates - also provide a bigger return and a cushion for existing losses. 

Furthermore, the subprime auto market represents only a small portion of the consumer universe and is a self-contained market. As reported by the Federal Reserve, auto loans make up just 9.3% of total outstanding consumer debt, while SIFMA reports that auto ABS makes up less than 15% of outstanding auto loans.

Moreover, the aggregated performance of auto loans has fared significantly better than subprime auto ABS indices. Fluctuations in the auto market have not historically had a substantial impact on the broader consumer sector or the economy at large. The rates for delinquencies 90-plus days overdue in 2019 were equal to 2008 levels and did not spill over into the broader US economy, as noted by the Federal Reserve.  

Acting on overblown fears is dangerous, as it has implications on subprime auto market activity at large and impacts underlying borrowers. Due to fears of the issues presented above, some lenders have been scaling back their loans to subprime borrowers and are instead targeting higher-quality borrowers.

At the end of June this year, the 12-month rejection rate for auto loans hit a new high at 14.2%, according to the Federal Reserve. This negative sentiment may deter investors from a valuable market, decreasing market activity. It also impacts the many Americans for whom the subprime auto market is the only avenue to access the car they need to get to work and maintain their income. 

Given the vital importance of the subprime auto market for many Americans, we must have a comprehensive understanding of sector performance. Issues in the sector - such as rising delinquency rates - in this self-contained and small market, while noteworthy, are not indicative of a looming credit crisis. By recognising the broader context, we can ensure the market is not negatively impacted and continue to make critical loans available.