In recent years, signs of weakness have crept into the leading indicators for the three key consumer finance sectors—mortgages, auto loans and student loans. It’s true that indicators, such as delinquency rates for average consumers, have come off their post-crisis lows. But context is essential for understanding the real story, and whether these data points are a cause for panic, blips on the radar, or something in between.
Take, for example, subprime auto lending: Delinquency rates have been ticking up in this space for several years (see chart below for data on delinquency rates and market share in subprime auto lending market), unnerving some investors and leading to recent headlines like “Consumers Are Skipping More High-Rate Auto Payments than during Crisis.” However, context is key. It’s important to understand how the rapid growth of higher-risk lenders is skewing the data on delinquency rates.
In any lending market, there is a mix of responsible lenders and pockets of higher risk. Subprime auto is no different. The segment’s benchmark lenders, all owned by General Motors or Santander Bank, are experienced underwriters and generally maintain strict lending standards. In 2012, these lenders controlled nearly 90% of the subprime market, and since then they have kept a lid on default and delinquency rates.
Today, their market share is much smaller—benchmark lenders now only control about 50% of the subprime market. It’s not because they are shrinking; rather, it’s because new, aggressive entrants who see a high-risk, high-reward opportunity are growing rapidly. These new issuers often extend loans at high rates to the weakest borrowers. Many of them lack operating experience and do not have proven business models; in some cases, their alignment with bondholders is questionable. Their default rates are higher than more “traditional” subprime lenders and rising more quickly; because they are gaining in share, they are having an increasing impact on the aggregate credit profile for the overall segment.
THE RISE OF RISK
The subprime auto loan market has changed markedly since the financial crisis, with a host of new, aggressive lenders coming on the scene, driving market growth and gaining share. Benchmark issuers have kept default rates below 10%, while default rates for this new class of issuers are climbing back toward 15%.
Source: Wells Fargo. As of Mar. 31, 2018.
Even though the data suggests that risk is somewhat concentrated in this higher-risk segment, rising delinquency is still meaningful. After all, one could say that the subprime mortgage crisis also started with looser underwriting among a subclass of lenders. But we also see a good deal of positive consumer data to counter concerns about consumer credit. Current consumer debt as a percentage of income sits near 10%, its lowest level since the 1980s. The economy is essentially at full employment, and consumer sentiment is near its post-crisis peak. Importantly, the Fed’s Senior Loan Officer Survey indicates that auto loan and credit card lending standards are tightening, not loosening. While caution in the subprime auto space is certainly warranted, a deeper dive beyond the headlines can help investors direct their caution more precisely and target their credit investments accordingly.
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