Auto lenders could face lower credit ratings

Standard & Poor’s Ratings Services is warning that it could lower ratings on some auto lenders this year, over concerns about lower underwriting standards and inadequate pricing for residual risk on leased vehicles.

In a report entitled How Looser Underwriting Standards and Rising Competition Could Dent US Auto Lenders’ Credit Quality, the ratings specialist says that “despite the robust performance of the auto sector in the past few years, we believe bumpier roads may lie ahead.”

The company says a rebounding economy and easy credit have fueled a surge in auto purchases and leases over the past few years, while the strong performance of the asset class has attracted many lenders eager to differentiate in order to grow.

It argues that as lenders compete for market share, they have extended loan terms and increased the average financing amount, while yields have declined. Lenders have also increased their exposure to leases, which it says leaves them vulnerable to falling residual values of cars.

As a result, the report states that Standard & Poor’s Ratings Services does not expect to upgrade many nonbank auto lenders in 2015 and 2016. In addition, it could lower ratings if increased competition, combined with looser underwriting standards, ultimately leads to significantly higher credit losses and weakened profitability.

In its analysis, Standard & Poor’s says it expects 2015 light vehicle sales to reach about 16.8 million units. It predicts that there is likely to be slower auto sales growth in 2016 as the US Federal Reserve is expected to raise interest rates in September, although this may be balanced by continuing low gas prices.

Looking at the auto lenders it currently rates, Standard & Poor says auto loan receivables for sub-prime specialists Drive Time Automotive Group and Credit Acceptance Corp have increased by 40% and 30%, respectively, over the last three years.

The agency highlights strong performance by GM Financial, which reported that, in the first quarter of 2015, for the first time, more than 50% of its originations in North America were to prime borrowers. This is more than double the level for the same period last year and is a result of a sharp increase in new-vehicle lease volume (mostly to prime-risk borrowers) since GM switched all its lease incentives to GM Financial from Ally earlier this year.

Ford Motor Credit and Hyundai Capital America have also continued to grow, with a focus on prime borrowers, the agency says.

The report states: “We believe the captives will continue to maintain discipline on both credit and pricing on loan structures, although we are not as confident that other finance companies will do the same.”

Standard & Poor’s says that although losses and delinquencies have remained relatively flat even as loan volumes rise, it is concerned that companies that ineffectively manage their underwriting could be exposed to higher losses down the road.

It says increased competition among lenders could further support the shift toward longer-term loans with lower monthly payments to purchase higher-priced vehicles with increased amenities and capabilities. While this is attractive for consumers, at the same time, these changing loan standards expose lenders to greater credit risk.

The report also flags up a potential oversupply of used vehicles as current leases mature over the next few years, which will result in lower prices, leaving lenders–in particular, captive auto finance companies that are major participants in the auto leasing market–exposed to potential losses on residual values.

Another risk is heightened attention the auto lending industry has received from regulators, including the Consumer Financial Protection Bureau (CFPB). Standard and Poor’s anticipates new CFPB rules for the sector to be announced this year, and says that, over the next two years, compliance costs will increase and the operating environment may change for many finance companies.

Lastly, in August 2014, the US Securities and Exchange Commission approved Regulation AB II (Reg AB II), which aims to provide securitization investors with greater transparency into loan-level data and will require companies to comply with new rules and disclosures.

The agency expects that Reg AB II rules will increase the costs related to public issuance of auto securitizations. It says that as a result, lenders may shift temporarily to private transactions, which are not covered under these rules, if they need additional time to comply with the asset-level disclosure requirements.