The subprime consumer sector has come a long way since the dark days of the financial crisis. Borrowers, lenders and issuers have made improvements, but still subprime can’t seem to exorcise its reputational demons.
I’ve seen a lot of news coverage recently that reinforces investors’ worst fears. Several articles have warned that consumer debt and loan delinquencies are rising, particularly in the auto space. But this doesn’t mean a crisis is brewing. Delinquencies and losses are only part of the story for subprime autos. My analysis of borrowers, lenders and auto asset-backed securities (ABS) deals indicates the subprime auto sector is in better shape than it gets credit for. Let’s see why.
Borrower wage gains – worth the wait
Subprime borrowers tend to be lower-income earners. For this group, wage gains usually don’t materialize until late in the economic cycle. This has certainly been the case with the current cycle. A decade into the recovery, lower-income groups are only now enjoying strong income growth. But higher wages are worth the wait. Recent earnings relative to expenditures can have an impact on borrowers’ payment and default behavior. And compared to other workers, wage increases are especially meaningful for subprime borrowers, many of whom live paycheck to paycheck.
The chart below illustrates the late-recovery bounce in wages for retail workers (a proxy for lower-income earners).
Lenders and issuers adjust with the cycle
Borrowers aren’t the only group that influences loan performance. Lender and issuer trends vary throughout the economic cycle, which can affect credit patterns. But these aspects of subprime auto ABS get much less attention than the consumer angle.
In the middle of the cycle, as the benefits of monetary stimulus spread, lenders tend to “broaden the credit box.” This means extending capital to non-prime borrowers. For the current cycle, this happened from 2015 into the first half of 2017. As the share of higher-risk borrowers grows, increased delinquencies and losses typically follow with a lag, which we saw in 2017 and 2018.