Bonds Backed by Auto Loans Look Toxic

(Bloomberg View) -- You might think we were headed straight for Carmaggeddon. Car sales are at their lowest level in more than two years; subprime delinquencies are nearing their crisis-era highs. Deep subprime -- loans accessible to the least creditworthy borrowers -- represent a third of the subprime car-loan backed securitization market. Seven-year loan terms are now the norm as borrowers stretch themselves precariously thin to make their paychecks match their payment capacity. The New York Fed says 6 million debtors have fallen behind, with many more to come. And of course, used car prices are crashing, devastating the collateral lenders can recoup at auction.

So why aren’t investors in the auto-loan backed securitization market a wee bit alarmed? If anything, pricing in this market indicates performance of auto ABS is expected to improve: According to investors in this arena, a year ago, buyers of the riskiest slices of these bonds were demanding yields that were 7.50 percentage points over comparable four-year maturity swaps, the fixed-income instrument against which they are priced. As of the end of the first quarter, that premium had been cut in half.

Auto dealers in this deep subprime space reinforce the pricing environment -- demand for these loans remains robust and underwriting standards have not tightened in recent months despite the obvious deterioration in the sector. In fact, car loans led the rise in consumer credit in February; excluding mortgages, household debt now stands at a fresh record of $3.34 trillion. What gives?

It all comes down to the composition of the market. Go back to the fact that deep subprime is but a subsector of the subprime auto ABS market. Granted, it’s grown to be a third of subprime, up from a tenth in 2010. This will present challenges, but not just yet because of one key and missing ingredient -- recession.

That is not to say the decline in sales has gone unnoticed. Auto manufacturing and car sales have been robust sources of growth for the broad economy throughout the current recovery. By some estimates, 4 percent to 5 percent of all U.S. jobs, including services, touch the auto sector in some way. That was fine as the sector expanded, but it is concerning today. March incentives of 10.3 percent of sticker price and inventories of 70 days were both the highest since 2009.

The preponderance of data has prompted Bank of America Merrill Lynch Chief Economist Michelle Meyer to ask in a report, “Are we heading into a car crash?” She said first that falling sales and swings in dealer inventories tend to be erratic when the business cycle is turning as manufacturers maneuver to ratchet back production to match falling demand.

To arrive at the potential hit to growth, Meyer conducted a sensitivity analysis against assumed annualized sales rates in 2017 of 15, 16 and 17-million units. Economic growth should be fairly immune to both a 16- and 17-million unit rate. It’s the “What if March’s 15.3-million unit pace was not an aberration?” scenario that things get dicey. To put this pace into context, it’s about where sales were in the mid-2000s when the population was appreciably smaller.

“Under the more extreme scenario of 15 million, real GDP growth would be dragged down by 0.4 percentage points,” Meyer wrote. “Of course, this only accounts for the direct hit to the economy. There would be incremental pain from spillovers into auto-related parts production, transportation and trade. Moreover, such weakening in auto sales would be an indication of broad-based deterioration in consumer sentiment, which could ripple through the economy.”

The true unknown is how the overall ABS market will fare when recession does hit. According to Wells Fargo’s John McElravey, in 2011, two big players, AmeriCredit and Banco Santander, made up for 44.8 percent and 45.3 percent of the subprime auto ABS index, respectively. Today their shares of the index have shrunk to 24.5 percent and 27.8 percent, respectively. Filling the gap are what he terms "non-benchmark issuers" whose share has risen from 12 percent in 2011 to 48 percent today.

Many of these new entrants are backed by private equity, which is a concern for dealers. Will the money backing these lenders, who tend to offer looser underwriting standards, flee as quickly as it poured in? More to the point, how does one stress-test a market that for all intents and purposes didn’t exist six years ago?

In the aggregate, this market didn’t exist during the last downturn. Moreover, student loans were not as abundant or widespread during the last recession; they are sure to add an extra element of risk to households’ future capacity to keep current on their payments.

The onus is clearly on the new administration and Congress to expedite deregulation and legislation that catalyze short-term economic growth. The current economic expansion, the third-longest on record, is clearly one fender-bender away from the repair shop.

This column does not necessarily reflect the opinion of the editorial board or Bloomberg LP and its owners.

Danielle DiMartino Booth, a former adviser to the president of the Dallas Fed, is the author of "Fed Up: An Insider's Take on Why the Federal Reserve Is Bad for America," and founder of Money Strong LLC.

To contact the author of this story: Danielle DiMartino Booth at Danielle@dimartinobooth.com.

To contact the editor responsible for this story: Max Berley at mberley@bloomberg.net.

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