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Buy Here - Pay Here Update: Lenders Continue to Pull Back on Subprime Auto Lending

Posted 12:47 PM by

Note: This article originally appeared in The Showroom.

Some Say Relief Is on the Horizon for BHPH Dealers; Others Say Not So Fast 

Many media outlets have reported about the imminent subprime auto loan bubble burst, warning that the economy is set on a collision course for the next big credit crisis. While some Buy Here-Pay Here (BHPH) operators are bracing for impact, others see this as a sign that the worst is behind them and of opportunities ahead.

Although BHPH operators understand the cyclical nature of their business, many believe the last few years have been one of the worst and prolonged industry slumps they can remember. It has been tough from all aspects – intense competition from non-BHPH sources competing for the best and deep subprime customers, an increasingly watchful regulatory climate, and the shrinking value of collateral have all been contributing factors.

So how did we get to where we are now? Following the credit crisis of 2008 caused by the subprime mortgage collapse, many BHPH operators experienced a short period of record portfolio performance fueled by the dry credit market. Customers had difficulty obtaining financing which allowed BHPH operators to be more selective and reach higher up the subprime credit spectrum. This yielded healthier than normal portfolios and lower delinquency and credit losses.

As the economy emerged from the credit crisis, the combination of steady year-over-year job growth, historically low interest rates, and pent-up demand for automobiles drove the automotive and auto loan industries into rapid expansion. BHPH operators were forced to compete more with traditional lenders for their best customers and often found themselves shifting further down the credit spectrum in order to maintain volume. 2016 was a record year for new car and light truck sales in the U.S. Despite the sustained customer demand for autos, stagnant wage growth throughout the economy resulted in extended customer loan terms and higher loan-to-value (LTV) outcomes as customers looked to manage their monthly payments. According to a recent Forbes article, the fastest-rising class of vehicle loans today is in the 73-84 month category. Eighteen percent of used car loan originations were in this category during Q4 2016. Sustained increases in year-over-year sales, higher LTVs, and longer loan terms caused auto loan balances to reach record levels at the end of 2016.

2017 seems to be painting a different picture. According to Forbes, overall June 2017 auto sales dropped by three percent compared to June 2016. In fact, through June, YTD 2017 vehicle sales hit their lowest levels since the same period in 2014. As sales have dropped off, some BHPH operators have relaxed their underwriting criteria resulting in higher risk portfolios. Additionally, used car values are expected to continue to soften which will result in lower recoveries from future repos.  

All of these factors combined - relaxed underwriting standards, high LTVs, extended loan durations, and shrinking collateral value - have led to high portfolio delinquency and significant credit losses. Many industry leaders fear that the worst is yet to come and that the subprime auto loan industry is on a path to repeat what happened in 2008. Several bank and subprime lenders have begun to cut, or at least cap, their exposure in subprime auto loans as a result of mounting losses. According to Bloomberg, Wells Fargo has implemented a cap that originations of new subprime auto loans cannot exceed 10 percent of all new auto loan originations. Wells Fargo has also made significant cuts to overall new auto loans (29 percent) in Q1 2017. Additionally, JP Morgan is said to have made dramatic cuts in subprime auto loan originations in Q1 2017. 

So with two of the largest subprime auto lenders reducing the exposure of subprime auto loans on their balance sheets and many other lenders following suit, why are BHPH operators not feeling relief? The answer partially lies in the asset backed securities (ABS) market. With interest rates still at historic lows, investors seeking higher fixed income returns continue to turn to subprime auto bonds. Large banks can bundle subprime auto loans into bonds and sell these securities to investors rather than carry these loans on their balance sheet. This effectively shifts the banks’ risk of loss from subprime auto loans from their balance sheet to investors. In fact, as reported by Bloomberg, Wells Fargo and JP Morgan have remained two of the top three subprime auto loan security underwriters even though they have made significant cuts to their own subprime loan portfolios.

This begs the question: if the banks do not want these assets on their balance sheet, why would investors want to buy these securities? Investors are often more willing to accept higher risk for the prospect of higher returns than banks. Further, these loan securitizations often include credit enhancements, such as packaging additional collateral into the securities, which can reduce the impact of credit losses of defaulted loans compared to carrying the loans on the balance sheet outright.

As a result of the continued interest in the ABS market, subprime customers still have many lending choices for used car loans. Combined with the decreased sales volume in 2017, competition in the BHPH industry remains strong for now. As delinquency rates and credit losses stay high, some investors and analysts see relief on the horizon for the BHPH operator. Others, however, believe that competition in the subprime and deep subprime markets will remain difficult for the foreseeable future and operators should buckle up for the continued bumpy road that lies ahead.    

About the Author
Brett Breedlove is a director in Katz, Sapper & Miller’s Buy Here - Pay Here Services and Financial Services Groups. Brett helps clients minimize risk, ensure accurate and complete financial reporting, and maintain compliance with regulatory institutions. Connect with him on LinkedIn.

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