Subprime auto loans have once again come into the spotlight, with delinquency rates reaching record highs and leading to the closure of specialized subprime lenders. While subprime-rated borrowers make up only 14% of total outstanding auto loan balances, they tend to face difficulties repaying their debts, as reflected in their subprime rating.

The majority of subprime auto loans have been securitized into Asset Backed Securities (ABS) and sold to investors who are attracted by the higher yields. These loans are typically used for the purchase of older vehicles, such as 10-year-old or older models, as subprime borrowers often do not qualify for loans to purchase new vehicles.

However, subprime auto lending does not significantly impact new vehicles, as these are predominantly reserved for prime-rated customers and cash-buyers. The demand for new vehicles has been strong, with a 20% year-over-year increase in unit sales in the third quarter of this year. The Average Transaction Price (ATP) for new vehicles has also risen to $47,420.

While interest rates for financing new vehicles have increased, captive auto lenders like Ford Credit have been reducing interest rates, and automakers are subsidizing leases. As a result, inventory levels have rebounded, and new-vehicle unit sales have experienced significant growth.

Delinquency rates for prime-rated auto loans remain minuscule, holding 86% of auto-loan balances outstanding. According to Fitch Ratings, the delinquency rate for prime auto loans in September was a mere 0.27%, lower than pre-pandemic levels. The real concern lies in subprime auto loans, where a substantial portion of borrowers consistently faces challenges with repayment, reinforcing the high-risk nature of these loans.

In September, the delinquency rate for subprime-backed ABS tracked by Fitch Ratings reached 6.1%, surpassing previous records set in 1996 and 2019. This segment of the market represents a relatively small but profitable corner of the used-vehicle market, often drawing attention with its volatility.

During the pandemic, government assistance provided relief to subprime borrowers. The infusion of cash, coupled with mortgage and student loan forbearance measures, helped many individuals catch up on their auto loans. Consequently, the subprime delinquency rate dropped to a multiyear low of 2.6% in May 2021.

However, as subprime lenders became more aggressive with their lending practices, some businesses suffered significant setbacks in 2023. The temporary decline in delinquency rates, combined with investors searching for higher yields in a low-interest-rate environment, led to specialized subprime dealers and lenders adopting loose underwriting standards and offering high loan-to-value ratios. Unfortunately, this excessive risk-taking has resulted in the collapse of several national chains.

Subprime lending can be a risky business with slimy aspects, but it remains attractive to companies due to the potential for high-profit margins on vehicles and substantial interest rates. Investors are enticed by the promising yields it offers. However, when subprime dealer-lenders become overly greedy and loosen their lending standards, it often leads to financial collapse.

In 2021, two prominent subprime dealer chains, US Auto Sales and American Car Center, both owned by private equity firms, filed for Chapter 7 liquidation after experiencing insurmountable challenges.

The success of subprime auto lending is largely dependent on securitizing subprime auto loans into ABS with varying tranches. While the highest-yielding equity tranches and deep-junk tranches absorb the initial losses, as losses escalate, higher-rated tranches also face consequences.

Fitch Ratings also monitors net losses for auto-loan ABS. The Annualized Net Loss (ANL) Index for prime-rated loans remains below pre-pandemic levels at 0.36%. On the other hand, the subprime-rated Annualized Loss Index stood at 9.23%, slightly below previous years. These numbers indicate that prime-rated auto loans remain resilient, while subprime loans have normalized within the seasonal patterns of the industry.

In conclusion, the surge in delinquency rates for subprime auto loans has triggered the closure of specialized subprime lenders. While the majority of auto loans are prime-rated and remain in good standing, subprime loans continue to pose challenges. The risky nature of subprime lending, combined with loose underwriting standards and excessive risk-taking, can result in financial turmoil for both lenders and borrowers.