Along with taking a longer-term look and investigating how all pools would perform through a credit cycle, S&P Global Ratings reported that collateral performance in the U.S. subprime auto loan asset-backed securities (ABS) sector weakened in 2016 for the fourth straight year.

According to a report published by S&P Global Ratings, both annualized metrics and vintage data — which show performance by year of securitization — demonstrated the decline.

“While the deterioration in the aggregate subprime auto loan statistics had been largely due to deep subprime lenders representing a greater share of issuance (though this is still a factor), about half of the subprime issuers are now reporting higher losses on their 2015 and first half 2016 securitizations as compared with 2014,” analysts said in the report.

S&P Global Ratings explained looser credit standards after several years of low losses (from 2010 through 2013), as well as heightened competition and lower recovery rates on defaulted loans, are contributing to higher losses.

“Some lenders are countering these effects by reducing origination volume and moving up the credit spectrum. Several have also reduced their loan-to-value ratios, especially on their longer-term loans, but we have yet to see a measurable and sustained improvement across the board," said S&P Global Ratings credit analyst Amy Martin.

The report pointed out that another “exacerbating influence” has been the relaxation in collection policies that some companies have adopted in light of increased scrutiny from various regulatory bodies. As a result, S&P Global Ratings said some finance companies have found it more difficult to contact delinquent borrowers and locate their vehicles for repossession and liquidation.

Despite a challenging business environment and the prospect of higher collateral losses, S&P Global Ratings insisted that ABS credit ratings are expected to remain generally stable, especially at the higher investment-grade levels.

“First, for those issuers reporting higher losses, the credit deterioration has been modest, and the transactions' robust structures have generally offset weaker performance,” analysts said. “Auto loan ABS transactions are structured with a sequential-pay mechanism and floors to the reserve and overcollateralization amounts that build credit enhancement for the most-senior classes relative to the declining pool balance.

“In addition, credit enhancement levels have generally kept pace with the higher expected loss levels,” they added.

Examining how auto ABS pools will perform through a credit cycle

As the U.S. economy approaches its eighth year of recovery, S&P Global Ratings acknowledged that the rate of light vehicle sales continues to register at or near record levels. The firm also said the strong pace of sales has benefited ABS issuance, but market participants have started questioning how long auto loans can continue to exhibit solid performance and whether the sector has too much consumer leverage.

Therefore, S&P Global Ratings investigated how these pools would perform through a credit cycle. The firm explained its process.

First, analysts determined the economic factors that would most contribute to loan losses: the national unemployment rate, used-vehicle values, as measured by the Manheim Used Vehicle Value Index, and the household debt service ratio. Then, they created scenarios to forecast losses under different economic environments.

In the base-case scenario, Martin indicated that S&P Global Ratings assumed household debt increases slightly to reflect the trend in worsening credit standards.

“Furthermore, used-vehicle values are likely to decline given the high levels of off-lease vehicles that are expected over the next three years,” Martin said.

Therefore, per the firm’s base-case scenario, S&P Global Ratings’ outlook calls for slightly higher losses. In the base-case, forecast annual net losses drift upward to a little over 1 percent for prime and to an annual average of 6.8 percent for subprime.

“The wide range of outcomes provided in this analysis offer market participants a better understanding of how the three independent variables we examined could affect losses,” S&P Global Ratings said. “However, the analysis doesn't explicitly assume how lenders respond to a worsening employment or used vehicle environment.

“Depending on the success of such lender actions, a potential increase in losses could be mitigated. Again, lender-specific losses would vary depending on individual underwriting and servicing policies,” the firm went on to say.

During the past three years, analysts have noticed credit standards degrade among both prime and subprime finance companies. While this could be viewed as a normalization of underwriting standards, S&P Global Ratings emphasized that auto financing has simultaneously become much more abundant.

Analysts mentioned that outstanding auto finance balances stood at a record level of $1.135 trillion as of Sept. 30, and quarterly originations averaged $140.9 billion for the first three quarters of 2016, up from $138.7 billion for the same period in 2015 and double the 2009 average of $70.5 billion.

In the past six months, Martin indicated some finance companies have tightened their credit standards.

“We view this positively; however, these corrective steps have only helped to offset lower recoveries, she said. “They have not led to a material or sustained improvement in losses. Nonetheless, they are a step in the right direction.

“At present, the competitive environment, prolonged economic recovery of nearly eight years and tremendous availability in auto credit are contributing to higher losses than what we would otherwise see given current low unemployment levels,” Martin went on to say.