Mistakes in subprime auto-loan-backed securities second-worst April ever, behind only Lockdown April: The cost of free money

In the free-money era, subprime auto lenders took on enormous risk amid rising demand from yield-chasing investors.

By wolf richter For wolf street,

Let me start with this chart of subprime auto-loan delinquencies of 60 days and above in asset-backed securities (ABS) rated by Fitch Ratings. In recent years, the worst crime rate in the 21st century was set in August 2019 at 5.93% of total balances, matching the all-time worst of 5.96% in October 1996. Then came the free-money era, when crime sank. When the free-money era ended, delinquencies increased and in January 2023 it was again at 5.93%.

Since then there has been a decrease in crimes every month. In April, they fell to 4.67%. But wait… the fall was totally seasonal. April is usually the month with the lowest crime rate of the year. May is the lowest month if not April. So in April 2023, the crime rate of 4.67% was the second worst April ever, behind only the April 2020 lockdown. Green line connects April;

Reckless Deals of the Free Money Era.

Auto loans are rated “subprime” for several reasons The bond is rated “junk” (BB+ and below): The risk of the borrower not repaying the loan is very high. And in order to make a lot of money, investors take on a lot of risk.

Subprime auto loans account for only about 14% of total outstanding auto loan balances and leases. The remaining 86% are prime rated. Subprime auto loans are typically focused on older used vehicles, which have lower amounts financed.

These subprime delinquencies are not an indication that the overall consumer is in trouble or whatever. According to ABS Rated by Fitch, we can see that prime-rated auto loans are in pristine shape with a 60-day delinquency rate of just 0.2%. In other words, nearly all delinquency is in a relatively small subprime-rated pocket of auto loans, and prime delinquency rates remain near historic lows.

But these subprime delinquencies are a sign that specific lenders had become too lax in subprime lending, with ridiculous loan-to-value ratios and super-lax, often AI-driven underwriting standards. And this happened especially during the free-money era of the pandemic.

Subprime is full of abuses and scams. Some subprime loans come with such high interest rates that they practically guarantee that the loans will default. Sometimes regulators take action, but settlements and fines are part of the cost of doing business.

Risk taking is driven by potentially high profits, and the ease with which the vehicle can be found and sold at auction.

Too often, customers with subprime credit ratings have tried and failed to get financing at regular dealerships, and they end up going to a dealer who specializes in the subprime end of the business, a high-risk, high-margin business. Were.

and from time to time, The collapse of typical subprime auto lenders, as we’ve seen at some dealer-lender chains this year, These dealer chains keep the loans they underwrite, and once a year they securitize large piles of loans into subprime auto-loan asset-backed securities (ABS) and sell them to investors such as bond funds and pension funds. Gave. Equity portion of the ABS.

These ABS are structured where the lowest-rated slices bear the loss first, and are wiped out first, but they are also sold with the highest yield to compensate investors for taking on those risks. As losses increase, holders of higher slices begin to eat them. The highest slices can carry an “A” rating when issued, and they are sold with the lowest yield.

Delinquency rates on these subprime auto-loan ABS fell to lows during the pandemic, when free money was flowing through the system. But then they are back to the high levels of the pre-pandemic years, plus some.

And subprime auto-loan underwriting was very lax because there was heavy demand by bond funds and pension funds to buy subprime auto-loan ABS because of their high yields, in a world where yields were suppressed by central banks. These funds were chasing yield, and these private-equity-backed dealer-lenders made a lot of money supplying those ABS to the yield chasers. Then the loose loans went sour, and the Fed raised rates, and two of those chains collapsed.

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