Subprime Auto Lending: Should we Fear for Another Recession?

October 5th, 2017

In August 2017, the U.S. woefully celebrated the 10-year anniversary of the financial crisis that sent the nation into a complete shock. The crisis led to the Great Recession, during which the unemployment rate peaked at levels not seen since the early 1980s. Additionally, mortgage-related delinquencies decimated investors’ assets and the U.S. was left pondering what caused such widespread economic disaster in such a powerful and resilient economy. Subprime mortgage lending and its ensuing delinquencies were deemed a major catalyst which sent the rest of the economy into a downward spiral. Unfortunately, the auto loan industry appears to be experiencing a potential subprime lending problem, causing memories of the Great Recession to return. However, severe delinquencies within this industry aren’t nearly as consequential as those in the housing market, and may actually lead to increased opportunities for the accounts receivable management (ARM) industry.

Subprime borrowers are individuals maintaining substandard credit scores and thus retain a higher probability of defaulting on their debts. However, creditors demand greater interest rates in return for loans to compensate for the added risk, potentially leading to massive profits when subprime borrowers don’t default. The above graph titled Auto Loan Originations by Riskscore illustrates that subprime auto loan originations have grown significantly since 2010, approaching their pre-recession highs in 2005-2006. This suggests that in the post-recession era of historically low federal interest rates, creditors may be attempting to offset the safer, minimal-return loans to super-prime borrowers with more lucrative, albeit riskier, subprime loans. However, we also see that auto loan originations to prime and super-prime borrowers (riskscores greater than 660) has grown even more, which indicates that although subprime lending increased, it’s been potentially more than offset by extremely safe loans.

As shown in the above graph titled Auto Loans Delinquencies, new (seriously) delinquent auto loan balances, increased over the past four years. Although this may appear consistent with the auto loan originations trend discussed previously, these data actually reveal current auto loan delinquency trends pale in comparison to levels during the Great Recession. This suggests that despite a growing value of subprime auto loans, borrowers simply aren’t going delinquent nearly as often as before. Of course, total delinquent auto loan debt has risen simply due to the sheer growth of the market, but these data imply there’s not much to worry us yet.

While subprime lending has once again come into play, the real question is, will the market experience a similar shock as it did in 2007? As alluded to previously, we don’t believe so. First off, auto debt only accounts for 9% of total outstanding debt, whereas, mortgages account for 68%, so if there is a problem, it won’t be nearly as large. Additionally, it’s much easier for creditors to repossess automobiles from defaulted borrowers than it is for them to foreclose upon a house. Considering the rising levels of aggregate auto loan debt and subprime originations combined with the moderate increases of new delinquencies, we anticipate greater first- and third-party collection opportunities in the auto loan segment. However, the data suggest that first-party work may be more lucrative if ARM participants are able to contract with major auto loan financiers.

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