“Trade-in treadmill” risk for auto lending

Rating agency Moody’s Investors Service has sounded a warning over what it calls the “trade-in treadmill”.

It argues that the auto lending sector faces increased credit risks because growing numbers of buyers are rolling over negative equity from one car purchase onto the next vehicle loan.

Its report on US auto finance notes that this is achieved with longer loan terms, higher loan to values and higher interest rates.

The agency argues this creates a “trade-in treadmill” where car buyers are in a cycle of regularly renewing their loans at increased negative equity at trade-in. Therefore, each successive loan generates greater risk of default.

The credit rating agency believes lenders are increasingly accepting this choice, resulting in mounting negative equity with successive new car purchases and growing credit risk.

Jason Grohotolski, Moody’s vice president – senior credit officer (pictured above), said: “Now that new vehicle sales have plateaued, the competition for remaining loan supply will intensify, driving increased credit risk for auto lenders.”

The need for auto lenders to be more accommodative to sustain or increase loan volumes is compounding credit risk on their balance sheets at a time when the average dollar amount of negative equity at trade-in is at record levels.

Lenders have also accommodated borrowers by extending original loan terms, slowing principal amortization for the sector at large.

As a result, auto lenders increase the collateral deficiencies in their portfolios, and thereby increase loan-loss severities, upping the pressure on their already thin profitability.

Grohotolski said: “Consumers will have to get off the treadmill and the industry’s response will help dictate how painful it is.”

Lease performance worsening

Fitch Ratings is also predicting that auto loan and lease credit performance will continue to deteriorate in 2017, in its latest quarterly US Auto Asset Quality Review.

The figures show credit losses weakened in the second half of 2016, consistent with seasonal trends, but credit performance versus the second half of 2015 also deteriorated.

Michael Taiano, director, Fitch Ratings, said: “Sub-prime credit losses are accelerating faster than the prime segment, and this trend is likely to continue as a result of looser underwriting standards by lenders in recent years.”

Fitch says banks are starting to lose market share to captive auto finance companies and credit unions as they begin to tighten underwriting standards in response to deteriorating asset quality.

The weaker asset quality primarily reflects the seasoning of vintages originated in a sustained period of looser underwriting standards, particularly from 2013-2015 vintages, and a rising proportion of non-prime lending.

The agency points to the Federal Reserve’s January 2017 senior loan officer survey, which shows 11.6% of respondents reported tightening standards, compared with the five-year average of 6.1%. This trend is consistent with comments made by several banks on earnings conference calls over the past couple of quarters.

Credit tightening

Fitch says it views continued tightening by auto lenders as a credit positive. The tightening to date primarily relates to pricing and LTVs, but average loan terms continue to extend into the 72 to 84-month category.

Fitch believes the extension of loan terms is largely being done in order to help borrowers manage their monthly payments, given the sharp rise in the cost of new vehicles in recent years.

Taiano added: “The tightening of underwriting standards is likely a response to expected deterioration in used vehicle prices and the weaker credit performance experienced in the sub-prime segment.”

Used car price declines have accelerated more recently which will likely pressure recovery values on defaulted loans and lease residuals.

The National Automobile Dealers Association’s Used Vehicle Price Index, which measures wholesale prices of used vehicles up to eight years old, declined more than 6% in 2016 and was down 8% year-over-year in February 2017, marking the eighth consecutive monthly decline.

US light vehicle sales grew to nearly 17.5 million units in 2016 (a 0.4% increase over 2015). Fitch expects full-year 2017 US light vehicle sales to dip slightly to 17 million.

Macro-economic conditions, including the low level of unemployment and growth in household wealth, should help constrain upward pressure on credit losses.

Consumer debt outstanding continues to trend higher, reflecting sustained strong growth in auto, student loans and credit card debt, which could weaken borrowers’ ability to service their debt.

Fitch says it expects deterioration in US auto credit to continue in 2017, with sub-prime auto asset-based securities (ABS) portfolios particularly vulnerable. Conversely, prime and established lenders should be better positioned but will still be affected by the ongoing negative trend in wholesale vehicle values.

Tipping point

Fitch believes that an inflection point has been reached in the US vehicle sales cycle. This follows robust growth for auto lenders in recent years, with smaller sub-prime lenders aggressively pursuing market share. As asset performance slows, rising used vehicle supply from both lease returns and increasing repossessions will drive depreciation higher, putting downward pressure on recovery rates and accelerating loss severity and loss levels.

The decline in used vehicle values in H2 16 and early 2017 should continue given the growth in off-lease vehicle inventory and increasing incentives for new vehicles. According to Black Book USA, vehicle depreciation should rise to 18% in 2017 from 17.3% in 2016. Fitch forecasts a 5-6% overall decline in used values this year.