Subprime Auto Loan Defaults Skyrocket

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Easy credit, the high-octane fuel propelling U.S. auto sales to record heights, is beginning to show a downside as delinquencies on the securities backed by subprime auto loans have reached the highest level since 2009, Fitch Ratings reports.

"Weaker performance in the subprime sector is being driven mainly by the weaker credit quality present in the 2013 through 2015 securitized pools, along with marginally lower used vehicle values," wrote Hylton Heard, Fitch's senior director.

Nearly 5% -- 4.98% -- of subprime auto loans were delinquent by 60 days or more, the highest level since September 2009 (4.97%).

Earlier this month Experian Automotive, which tracks the new and used-car finance industry, reported that 20.8% of auto loans are now held by consumers with subprime or deep subprime credit scores -- defined by FICO scores of between 300 and 620.

"Although not yet a cause for concern, the industry should keep an eye on this metric to see how it trends in the quarters to come," said Melinda Zabritski, Experian's senior director of automotive finance.

The annualized net loss rate -- the percentage of subprime loans regarded as likely to default -- was 8.72% in January and is expected to trend closer to 10% by the end of 2016, according to the Fitch report. For perspective the 10-year average annualized net loss rate is 6.24%. The peak from past recessions was 13% in early 2009, according to Fitch's data.

"We have seen this level of delinquencies before. They could be manageable, but we do feel the subprime sector will see some additional softening this year," Heard said.

A contributing factor is the trend of finance companies and other lenders making longer loans, in some cases for 7 years or longer. That means the buyer builds equity in the vehicle more slowly than it depreciates. In a couple years the car is worth less than what the owner owes on the loan.

The average new subprime auto loan is now six years, or 72 months, and carries an interest rate of more than 10%, according to Experian.

"The longer the loan is, the worse the borrower's performance," Heard said.

Unlike the easy credit that triggered the housing market collapse, in which many mortgages carried adjustable interest rates, or only required interest payments initially, most auto loans are made at a fixed interest rate. But the lower one's credit score, the higher the interest rate on the loan. So the loss of a job or an unexpected medical bill could easily cause a missed car payment for a month or two.

Where the risk could grow is when these risky loans are packaged and sold as securities. As anyone who has seen "The Big Short" knows, this was illustrated in the scene where Ryan Gosling uses a tower of Jenga blocks to show how the foundation of these multi-billion-dollar bundles of home mortgages can collapse when enough of the weakest loans go bad.

“What is happening in this space today reminds me of what happened in mortgage-backed securities in the run-up to the crisis,” U.S. Comptroller of the Currency Thomas Curry warned last October.

The securitization, or repackaging, of auto loans has grown rapidly as more people have replaced their aging vehicles. The total of outstanding auto loans reached $1.04 trillion in the fourth-quarter of 2015, according to the Federal Reserve Bank of St. Louis. About $200 billion of that would be classified as subprime or deep subprime.