Subprime Auto Loans: Limited Exposure in Captive Finance Auto ABS

Auto loan delinquency headlines have investors asking questions about auto loan-backed ABS. We discuss how considerations such as originator and credit scores come into play. 

Eric Espeseth, Senior Credit Analyst

A recent article on the New York Fed's Liberty Street Economics blog called attention to the increasing rate of auto loans transitioning into serious delinquency, defined as over 90 days past due. Large media outlets are gravitating to the finding that seven million borrowers are now in serious delinquency - more than during the financial crisis - and concluding this is a red flag for the performance of investments backed by auto loans and the U.S. economy.

We are active investors in the auto loan asset-backed securities (ABS) market through securities issued by the captive finance companies of automotive manufacturers such as Toyota, Honda and Ford. While seven million borrowers in serious delinquency is a large and concerning number given the current strong U.S. economy and low unemployment rate, additional context into the data is warranted before inferring how this will impact the performance of ABS issued by captive finance companies.

To do this, we first look at the breakdown by credit score of loans transitioning into serious delinquency and how this compares to the credit score composition of our auto ABS investments. As the Fed's data show, the increase in serious delinquency has been driven primarily by subprime borrowers - defined as those with a credit score below 620. The percentage of borrowers transitioning into serious delinquency has remained relatively stable over the past few years for those with a credit score above 660 and has declined over the past year for those with a credit score above 720. Captive finance ABS securities typically have strict rules relating to minimum required credit scores for loans to be included in their collateral pools. Our investments over the past few years have had weighted average credit scores of 740-770 - significantly above subprime levels. 

Source: Federal Reserve Bank of New York

Next, we look at the size of subprime auto loans relative to the overall market and the types of financial institutions originating these loans. As of September 30, 2018, subprime auto loans accounted for 23% of outstanding auto loans which totaled $1.25 trillion. Fed data show the subprime market is dominated by auto finance companies, while captive finance company originations are predominately prime borrowers (81%) which continue to show strong loan performance. Despite captive finance companies originating near 20% of their loans to subprime borrowers, these loans are typically not included in the collateral pool of their ABS securities. Most of the captive finance companies we invest in fully exclude subprime loans in their ABS securities and for those that do include them the exposure is relatively minimal, under 10%. 

Source: Federal Reserve Bank of New York

While deteriorating performance of subprime auto loans remains a concern, we believe any losses associated with these loans will be manageable given the size relative to the overall market. We continue to have a favorable view on auto ABS issuance from captive automotive finance companies due to the limited exposure to subprime borrowers and the continued low delinquency rates for prime borrowers. Additionally, these investments benefit from the continued strength of the U.S. economy and initial collateral coverage levels which are structured to exceed projected losses during extreme stress scenarios.

Sources:

Haughwout, et.al., "Just Released: Auto Loans in High Gear," Federal Reserve Bank of New York Liberty Street Economics Blog, February 12, 2019.

Coppola, Gabrielle, "Auto-Loan Delinquencies Are the Highest Since 2012," Bloomberg, February 12, 2019.

Long, Heather, "A Record 7 Million Americans are 3 Months Behind on Their Car Payments, a Red Flag for the Economy," The Washington Post, February 12, 2019