Is the Auto Loan Securities Market Headed for the Same Fate as the Residential Mortgage Backed Securities Market of 2008?

By:  Julie Rodriguez Aldort and Albert E. Fowerbaugh, Jr.

August 13, 2018 - Americans’ appetite for larger cars with expensive upgrades is pushing up the cost of purchasing or leasing a new or used vehicle. To afford these cars, consumers are borrowing more and taking longer loan terms to reduce their monthly payments.[i]  In the U.S., approximately 86% of new cars (including leased vehicles) are purchased with financing.[ii]  According to the Federal Reserve Bank of New York, auto loan originations hit a record $568.6 billion for 2017.  As of March 31, 2018, the New York Fed reported American consumers owed $1.229 trillion in auto debt.

Auto loan lenders are loathe to keep all of those loans – especially with their longer terms – on their books. It ties up capital and exposes them to both interest rate and credit risk. To avoid these risks, lenders bundle and securitize their auto loans. Investors purchase a stake in exchange for a steady stream of interest and principal paid by the auto loan borrowers over the life of their loans.

With the low interest rates that have prevailed since the Great Recession in 2008, auto loan securitizations with their higher yields have attracted significant attention from investors. More than $70 billion in auto backed securities were sold in 2017.[iii]  At the same time, auto loan delinquencies are on the rise – as of the end of March 2018, 4.3% of auto loan balances were 90 or more days delinquent.[iv]  With memories of the Great Recession still fresh, fears that the auto loan securitization market is headed for a crash similar to the ill-fated residential mortgage backed securities (RMBS) market are on the rise.  Below we compare the auto loan securitization market to RMBS to see if those fears are justified.

BUCKLE UP: A PRIMER ON AUTO LOAN SECURITIZATIONS VS. RMBS

The Structured Auto Loan Transaction 

Here’s a simplified description of the process:

First, an auto loan is originated by a lender pursuant to underwriting guidelines. The lender could be a bank, a credit union, or an auto finance company.  The robustness of the origination process varies by lender and is often based on the borrower’s credit profile.  For example, one analyst reported that in most cases borrowers with credit scores above 750 did not have the income stated on the loan application verified, whereas those borrowers with credit scores below 660 (generally referred to as “subprime” borrowers), sometimes had their income subjected to at least a minimal level of verification. [v]  Even so, subprime borrower income was verified less than 50% of the time.[vi]

Second, the lender bundles a pool of loans from a particular time period, i.e. all loans originated from January 1, 2017 through December 31, 2017, and assigns them to an entity created specifically to house the loans, i.e. a special purpose entity, which in turn places the loans into an asset-backed trust (ABS).  The trust maintains control of the pool as collateral for the bonds that are then created.

Third, the issuing entity divides up the securities into various classes or “tranches,” based on characteristics such as payment priority and maturity date. The tranches are then reviewed by rating agencies, and the rated securities are sold to investors.  The proceeds of the bond sales are then paid to the lender in exchange for the loans that had been transferred to the trust.

Finally, the borrower makes monthly payments on the auto loan to the lender, which typically acts as the loan servicer and handles the customer interface. The funds flow to the trust, which then uses the monthly payments to pay the bond investors.  The lender receives the net interest margin, i.e. the difference between the amount paid by the customer and the amount paid to investors.  For example, if the average interest rate charged to the customer is 11% and the amount paid to investors is 5%, the net interest margin paid to the lender is 6%.  That amount is reduced by operating expenses, credit losses and any other securitization fees.

Are Auto Loan Securities Actually Similar to Residential Mortgage Loan Securities?

The basic structure of auto-backed and residential-mortgage-backed securitizations is largely the same. Both involve asset backed loans that are transferred into special purpose vehicles, placed into a trust as collateral, and the securities are sold to investors.  In both instances you may see the following players:  (1) the loan originator, which originates the loan pursuant to prescribed underwriting guidelines; (2) the sponsor, which is often the parent entity or affiliate of the originator, drives the securitization transaction and transfers the assets to a special purpose vehicle; (3) the depositor, which is usually an affiliate of the sponsor and is the special purpose vehicle that acts as the repository for the assets to be securitized; (4) the issuing entity, which is also usually an affiliate of the sponsor and which issues the securities for sale to the securities underwriter; (5) the securities underwriter, which is typically an investment bank that evaluates the securities, purchases them from the issuing entity, and then offers them to investors; (6) the trustee, which, among other things, administers the trust that holds the securitized assets, makes payments to the investors, and typically subcontracts the administration and servicing of the assets; (7) the servicer who processes billings to and payments from the borrower; and finally (8), the investor, who purchases the securities.

ABS v. RMBS: Differences in Credit Enhancements

Despite the similarities, the markets differ in significant ways. One key difference is the form of credit enhancement used for the securitizations, i.e., some method for reducing the risk of default on the payments to investors, to increase investor confidence and limit risk to investors.  RMBS transactions typically have at least two types of credit enhancements.  The first is mortgage insurance.  Mortgage insurance may be purchased by the borrower to protect the lender in the event of default (borrower paid mortgage insurance) or it may be purchased by the lender (lender paid mortgage insurance).  In RMBS transactions, the trustee is usually the named insured under these policies.  Assuming compliance with the terms of its policy, the mortgage insurer steps in and pays a percentage of the amount outstanding, subject to those policy terms, in the event of a default.  Second, RMBS transactions are often structured with credit wrap insurance, under which a financial guarantee insurer agrees to pay all or a portion of the amount due investors in the event of the pool’s inability to pay.

In contrast, auto loan securitizations do not have the equivalent of mortgage insurance credit enhancement. Credit wrap insurance was sometimes used for auto loan securitizations prior to the Great Recession, but due, at least in part, to the subsequent drop in ratings for the financial guarantee insurers, it has not been used much since that time.  Rather than relying on insurers, the most common type of credit enhancement currently employed is over collateralization.  The securitizations bundle more loans than needed (based on projected default estimates) to ensure the timely flow of payments to investors.  Thus, if a certain percentage of the loans in the pool default, payments received on the remaining loans should sufficiently cover payments to investors.  Auto loan securitizations also achieve credit enhancements with reserve funds, where they put funds aside to ensure investors are paid in the event of borrower defaults.

ABS v. RMBS: Differences in Collateral

There are also differences between RMBS and auto loan securitizations with respect to collateral characteristics. Auto loans are generally smaller and for shorter terms than residential mortgage loans, e.g., a $20,000 auto loan for a six year term versus a $100,000 mortgage loan for a thirty-year term.  Generally the value of the collateral for an auto loan (the car) is also easier to assess than for a residential mortgage because it is easier to find a comparable for a car than a house.  In the aftermath of the Great Recession, we saw many reports of homes being overvalued due to erroneous or fraudulent appraisals.  Inadequate valuations can result in a loan-to-value ratio that is much higher than the lender (or in this case, the investor) bargained for and result in a higher likelihood of default.  If a borrower defaults, however, obtaining the collateral is far easier and quicker with a car than with a home.  While the latter can result in years of foreclosure proceedings, some financed vehicles are even outfitted with kill-switches that disable the vehicle if the borrower defaults, making it even easier to collect the vehicle in the event of default and providing an added incentive for the borrower to pay on time.  No equivalent exists in the housing market.

ABS v. RMBS: No GSEs in the Auto Loan Market

Another key difference is the absence of a government player in the auto loan market. Government sponsored entities (GSEs) like Fannie Mae and Freddie Mac have a major influence on the residential mortgage loan market by providing a ready market to purchase loans from originators where those loans meet set criteria established by the GSEs.  There is no equivalent player in the auto loan market.  The existence of the GSEs may impact risk assessment in the lending market.  As one author explained, the auto loan securitization market may be more responsive to risk than the RMBS market because the auto loan market is less likely to anticipate government intervention in the event of a severe economic downturn such as the Great Recession.[vii]

ABS v. RMBS: Differences in Default Patterns

Aside from the structural differences between auto-backed and mortgage backed securities, there are also differences in default patterns. With mortgage loans, borrowers historically assumed their homes would rise in value over time, allowing them to refinance or sell the home to pay off the loan.  In the Great Recession, borrowers found themselves “under water” with loans greater than their homes were worth, leading to strategic defaults.  In contrast, with auto loans, borrowers do not necessarily expect the value of their car to increase over time.  Rather, consumers generally understand that as the car ages, its value drops, and they are unlikely to count on being able to sell it at a higher price to pay off their loan balance. [viii]  Indeed, a new car drops in value the moment it is driven off the lot, and consequently, the owner who financed the full value is “under water” almost immediately. The borrower probably pays the loan nonetheless because she needs the car to get around.  Because of this common scenario, we may be less likely to see the strategic defaults that we observed in the housing crisis.  This may change as borrowers continue to take on longer term auto loans and more frequently find themselves obligated to make payments on loans for cars they are no longer driving.  The CFPB reports that longer-term auto loans have higher rates of default – loans with terms of 6 years or more have default rates in excess of 8% in contrast to loans with shorter terms that have default rates closer to 4%.[ix]

Is A Crash Coming?

Many fear that the auto-backed securities market is headed for a crash like that suffered by the RMBS market in the Great Recession.  There are some commonalities that cause concern; in particular, the presence of fraud in the origination process.  In the subprime auto loan market there are reports of auto-dealer originators and certain subprime auto lenders inflating borrower incomes.  The most well-known of these is the recent action brought by attorneys general of Massachusetts and Delaware against Santander Consumer USA, which focuses on auto financing in the subprime market.  Santander settled the action in late 2017, agreeing to pay $26 million.  It has been reported that one in five subprime auto loans may have resulted from fraud by the dealer, the borrower, or both.[x]  Dealers do have an incentive to get loans approved and make the sale, and unscrupulous originators have little incentive to control fraud because the loans are being sold off to banks or to investors.

In addition to fraud, credit risk has also been increasing. Lending standards for auto loans reportedly loosened as demand has grown for more securitizations.  This is especially true for auto finance companies, which have increased their subprime shares, as compared to traditional banks, which have begun decreasing their portfolios of the riskiest loans.[xi]  Underwriting vigor also appears to be on the decline.  It has been reported that Santander investigated income in less than 1 of every 10 securitized loans.[xii]  In contrast, AmeriCredit (a unit of GM Financial) and Ally Financial Inc. each checked income in about 65% of their subprime car loans.[xiii]  At the same time that underwriting standards appear to have loosened, the market has seen increasing levels of delinquency.  The New York Fed reports that 90+ day delinquencies have been slowly trending upward since 2012, with 4.3% of auto loans 90+ days delinquent as of March 31, 2018.  One analyst reported that borrowers defaulted on their very first bill in 3% of subprime auto loans, which is eerily comparable to the mortgage market before the Great Recession.[xiv]

Auto loan delinquencies are still low, but that could change quickly with the next economic downturn. The health of the market will depend on the adequacy of the market’s risk assessment and pricing.  The auto loan securitization market may not suffer if interest rates are high enough, repossessions are efficient, and the collateral holds at least some of its value.[xv]  The question will be whether those higher interest rates and credit enhancements, like over collateralization and reserves, are sufficient to cover what could be massive defaults.  If fraud is as rampant as we saw in the mortgage market and if deteriorating credit quality explodes into massive defaults, the auto-backed securities market could be in for a serious shock, leading to a multitude of fights over who bears what share of potentially enormous losses.  We explore that question in our recent Law360 article, linked here: https://www.law360.com/automotive/articles/1071517/what-if-the-auto-loan-securitization-market-crashes- (subscription required).

[i] Consumer Financial Protection Bureau, CFPB Report Finds Sharp Increase In Riskier Longer-Term Auto Loans (November 1, 2017), available at https://www.consumerfinance.gov/about-us/newsroom/cfpb-report-finds-sharp-increase-riskier-longer-term-auto-loans/.

[ii] Jessie Romero, Subprime Securitization Hits the Car Lot: Are fears of a “bubble” in auto lending overstated?,  Econ Focus (Q3 2017), at 12.

[iii] Joe Rennison, Securitised auto loans hit post-financial crisis high,  Financial Times (Dec. 29, 2017), available at https://www.ft.com/content/37390b14-ec86-11e7-8713-513b1d7ca85a.

[iv] Federal Reserve Bank of New York, Quarterly Report on Household Debt and Credit 2018:Q1 (May 2018).

[v] David Snitkof, Auto Loan Securitizations – Mid-year Update (Oct. 4, 2017), Orchard Platform blog, https://www.orchardplatform.com/blog/auto-loan-securitizations-mid-year-update/.

[vi] Id.

[vii] Jessie Romero, Subprime Securitization Hits the Car Lot: Are fears of a “bubble” in auto lending overstated?  Econ Focus (Q3 2017), at 14-15.

[viii] Matthew DeBord, Everyone’s totally overthinking an auto-loan ‘bubble’, Business Insider (May 20, 2016), www.businessinsider.com/were-over-thinking-auto-loan-bubble-2016-5.

[ix] Consumer Financial Protection Bureau, CFPB Report Finds Sharp Increase In Riskier Longer-Term Auto Loans (November 1, 2017), available at https://www.consumerfinance.gov/about-us/newsroom/cfpb-report-finds-sharp-increase-riskier-longer-term-auto-loans/.

[x] Gilad Woltsovitch, What the auto loan crisis really means, Lending Times (August 1, 2017), available at https://lendingtimes.wpengine.com/2017/08/01/what-is-the-auto-loan-crisis/.

[xi] Losses slow within subprime ABS space, SubPrime (Mar. 26, 2018), https://www.autoremarketing.com/subprime/losses-slow-within-subprime-abs-space.

[xii] Gabrielle Coppola, New U.S. Subprime Boom, Same Old Sins: Auto Defaults Are Soaring, Bloomberg Businessweek (July 17, 2017), available at https://www.bloomberg.com/news/articles/2017-07-17/new-u-s-subprime-boom-same-old-sins-auto-defaults-are-soaring.

[xiii] Id.

[xiv] Gilad Woltsovitch, What the auto loan crisis really means, Lending Times (August 1, 2017), available at https://lendingtimes.wpengine.com/2017/08/01/what-is-the-auto-loan-crisis/.

[xv] Tony Dutzik, What Comes After the Auto Bubble?, Streetsblog USA (May 1, 2017), https://usa.streetsblog.org/2017/05/01/what-comes-after-the-auto-bubble/.