Subprime Securitization
Hits the Car Lot
Are fears of a “bubble” in auto lending overstated?
By Jessie Romero

T

he car dealers deliberately inflated borrowers’
incomes — sometimes without the borrowers’
knowledge — to ensure the loan applications would
be approved and they’d make the sale. The lender knew
the applications were fraudulent and the borrowers were
likely to default, but it didn’t care because it could package
the loans into securities and sell them off to investors. At
least, that’s the version of events described in an action
brought by the attorneys general of Massachusetts and
Delaware against Santander Consumer USA, a subsidiary
of the Spanish bank Banco Santander that specializes in
auto financing. In March 2017, Santander agreed to a $26
million settlement that includes $19 million in relief to
more than 2,000 borrowers.
To many observers, Santander’s alleged lending practices look alarmingly similar to those that contributed to
the housing boom and bust a decade ago, lending weight
to broader concerns that rising delinquencies indicate an
auto lending “bubble” is about to burst. “Auto Loan Fraud
Soars in a Parallel to the Housing Bubble,” proclaimed one
headline. “Are Car Loans Driving Us Towards the Next
Financial Crash?” asked another.
Regulators and policymakers also have expressed
unease. In the fall of 2016, for example, the Office of
the Comptroller of the Currency warned that auto lending risk was increasing and that some banks did not
have sufficient risk management policies in place. Fed
Gov. Lael Brainard pointed to subprime auto lending as an
area of concern in a May 2017 speech; her concerns were
repeated — and amplified — the next month in a speech
by then-Gov. Stanley Fischer.
While it’s not obvious whether the increase in subprime
auto lending is a significant departure from past cycles, it
has raised eyebrows coming so soon after the mortgage
crisis — especially as delinquencies have begun to rise.
In addition, an increasing share of those loans have been
securitized and spread through the financial system, much
like mortgages before the housing bust. Still, even if the
auto finance industry were poised for a fall, the effects on
the financial system could be limited — although the auto
industry itself might take a hit.
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Buy Now, Pay Later
In 1919, General Motors (GM) had a problem. The innovation of the assembly line a half-dozen years earlier by
Henry Ford had made it cheaper and easier to build cars,
but that meant GM needed its dealers to buy in bulk —
and the dealers needed people to buy more cars. The solution was credit, but banks were leery of making loans for
a relatively new invention they didn’t know how to value.
(Around the same time, the Federal Reserve warned banks
against financing “automobiles that are used for pleasure.”)
So GM launched its own financing company, the General
Motors Acceptance Corporation (GMAC), to enable
dealers to stock more inventory and consumers to buy
more cars. Other car manufacturers eventually followed
suit, and today, every major auto manufacturer has its own
“captive” finance company.
The next major innovation in auto finance arrived
half a century later. Banks and credit unions had entered
the market by this point, but loans generally were only
available to borrowers with strong credit histories. That
began to change in 1972, when Detroit businessman Don
Foss founded Credit Acceptance, an independent finance
company, to finance sales at his network of used car dealerships. Credit Acceptance was the first company to specialize in auto loans to borrowers with limited or poor credit
history, known today as “subprime” loans, and its success
spawned numerous competitors.
One of those was Ugly Duckling, an Arizona-based
used car dealership that expanded quickly during the
1990s. (The company is now known as DriveTime.) Ugly
Duckling mainstreamed the “buy here, pay here,” or
BHPH, dealership format, in which the dealer is also the
lender, typically to borrowers with very poor or no credit.
BHPH dealerships often require borrowers to make their
payments in person, hence the name; interest rates may be
as high as 30 percent.
Today, roughly 86 percent of all new cars in the United
States are purchased via financing; about two-thirds of
those transactions are loans and one-third are leases.
Captives and banks issue the majority of new car loans and
leases; as of the second quarter of 2017, they had 53 percent

 Motor Trends
Household auto debt fell during the Great Recession, as
did all types of household debt excepting student loans,
but has rebounded more quickly than other types. Between
the second quarter of 2010 and the second quarter of 2017,
outstanding auto debt increased nearly 70 percent, from
$700 billion to $1.2 trillion, according to the New York
Fed’s Quarterly Report on Household Debt and Credit.
In contrast, credit card debt increased just 5 percent, from
$7.4 billion to $7.8 billion. Auto loans are now the
third-largest form of debt behind mortgages ($8.7 trillion)
and student loans ($1.3 trillion).
Subprime auto debt contracted sharply during the Great
Recession but growth resumed soon after. While there is
no legal definition of prime or subprime, a credit score of
620 is generally the cutoff in auto finance; credit scores
range from 300-850. Between 2010 and 2015, average quarterly originations to subprime borrowers more than doubled, from $15 billion per quarter to $31 billion per quarter
(albeit still below the high of $34 billion per quarter in
2005), according to New York Fed data.
With the mortgage crisis fresh in many people’s memories, the increase in subprime auto lending garnered considerable attention. But the growth was comparable to growth
in other credit categories. Loans to borrowers with a credit
score between 660 and 719 increased from an average of
$17 billion per quarter to $31 billion per quarter. Loans to
“super prime” borrowers, those with a credit score above
760, grew less in percentage terms but have surpassed the
pre-recession peak. (See chart.) “The subprime pipe was
turned off after the financial crisis,” says Melinda Zabritski,
the senior director for automotive finance solutions at
Experian. “When the pipe got turned back on, the increase
looked dramatic, but we were coming out of a trough.”

Subprime Revs Up

The return of subprime auto lending has garnered considerable attention

Credit Score

<620

620-659

660-719

720-759

Q1 2017

Q1 2016

Q1 2015

Q1 2014

Q1 2013

Q1 2012

Q1 2011

Q1 2010

Q1 2009

Q1 2008

Q1 2007

Q1 2006

Q1 2005

50
45
40
35
30
25
20
15
10
5
0
Q1 2004

AUTO LOAN QUARTERLY ORIGINATIONS
($BILLIONS)

and 29 percent market share, respectively. Credit unions
currently finance around 13 percent of new cars, with the
remainder financed by independent finance companies,
BHPH dealerships, and other lenders. In the used car market, about 55 percent of cars are financed, the vast majority
via loans. At present, banks make 35 percent of used car
loans, slightly more than their share of the new car market. Credit unions, independent finance companies, and
BHPH dealerships play a much larger role in the used car
market than they do in the new car market, with 27 percent, 17 percent, and 13 percent market share, respectively.
While a consumer can work directly with a lender and
shop for a car with a pre-approval in hand, about 80 percent of car financing is arranged through dealerships. The
dealer sends the loan application to a number of lenders
with whom it has a relationship, and a lender who is willing
to make the loan will respond with a “buy” rate. The dealer
then has some discretion to either lower the rate and absorb
the difference in order to make the sale, or to charge the
purchaser a higher rate and keep the difference as compensation for serving as middleman.

760+

SOURCE: Federal Reserve Bank of New York, “Quarterly Report on Household Debt and Credit,”
Second Quarter 2017   

Some of the growth was fueled by competition, particularly among captives and independent finance companies,
which have originated about 75 percent of outstanding
subprime loans. As the demand for auto loans grew during
the recovery, new finance companies entered the market
and existing finance companies sought to expand. In an
effort to reach new customers, these companies “started
buying a little ‘deeper’ and taking on more subprime
borrowers,” says Zabritski. Even GM, which had sold a
majority stake in GMAC to a private equity firm in 2006,
got back into the financing game by purchasing subprime
specialist AmeriCredit in 2010.
Subprime auto lending might already have peaked for
now, however. Beginning in 2016, bankers reported tightening auto lending standards in the Fed’s Senior Loan
Officer Opinion Survey, and even some traditional subprime specialists have taken steps to tighten credit. Overall,
average credit scores increased by four points for both new
and used cars between the second quarter of 2016 and the
second quarter of 2017, according to Experian. Average
quarterly subprime originations also decreased in 2016, for
the first time since 2009, to $30 billion per quarter.
The retreat is potentially a response to rising delinquencies. Between 2012 and 2016, average annual subprime
delinquencies increased from 2.5 percent to 4.3 percent — a
higher rate than in 2008, according to S&P Global Ratings.
Researchers at the New York Fed calculated that the share
of subprime loans that were 90 days or more delinquent
increased nearly 40 percent from the beginning of 2013
to the third quarter of 2016, for a total of about 6 million
consumers.
One reason for the rise in subprime delinquencies,
despite improvements in the economy and labor markets
overall, may be a change in the composition of subprime
borrowers. The foreclosure crisis affected both subprime
and prime borrowers, so consumers who may otherwise
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 Subprime Securitization

Subprime

Other

2017

2013

2015

2011

2007

2009

2003

Near Prime

2005

2001

1997

1999

1993

1995

1991

1987

1989

100
90
80
70
60
50
40
30
20
10
0
1985

PERCENT OF TOTAL

As a share of all auto ABS, subprime has surpassed its pre-crisis peak

Prime

NOTE: “Other” includes ABS backed by leases, fleet sales, rentals, dealer floorplan loans, and
motorcycle/RV loans. Data for 2017 are from the third quarter.
SOURCE: Securities Industry and Financial Markets Association   

have been low risk could have seen their scores drop to subprime levels. Many of those borrowers’ credit scores have
since recovered, however. (See “The Missing Boomerang
Buyers,” Econ Focus, First Quarter 2017.) As a result, the
remaining pool of subprime borrowers may be riskier.
It’s also possible that increased competition led lenders
to lower their underwriting standards in other ways, such as
not requiring proof of income. In at least one batch of loans,
for example, Santander Consumer verified just 8 percent of
borrowers’ incomes. Lenders also have been increasing the
length of loans. In 2002, 36 percent of subprime loans had
an original loan term longer than 60 months. In 2016, more
than 83 percent had a term longer than 60 months. Some
lenders even offer 84-month — seven-year — car loans.
These loans are attractive to some buyers because they offer
a lower monthly payment, but they are also much more
likely to end in default.
Securitizing Subprime
Like other types of loans, including student loans and
credit card receivables, auto loans can be packaged into
securities and sold to investors. These “asset-backed securities,” or ABS, provide the lender with the cash (and an
additional incentive) to make more loans. ABS made up of
auto loans — “auto ABS” for short — are mostly issued by
independent and captive finance companies.
Auto loan securitization increased rapidly in the early
2000s, as did securitization in general. Between 2000
and 2005, the annual issuance of auto ABS increased from
$70 billion to $106 billion; total ABS (excluding collateralized debt obligations, which comprise multiple securities types, including mortgages) grew from $185 billion to
$280 billion. Issuance of auto ABS contracted sharply
during the Great Recession, but afterward, between 2010
and 2015, it grew from $58 billion per year to $96 billion.
Currently, auto ABS makes up about 45 percent of ABS
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issuance, according to data from the Securities Industry and
Financial Markets Association (SIFMA).
An increasing share of those ABS are backed by subprime loans. In 2009 — the financial crisis trough — subprime loans accounted for just 11 percent of auto ABS. As of
the third quarter of 2017, the share had more than doubled,
to 22.5 percent — 4.5 percentage points higher than the
pre-recession peak. (See chart.) Moreover, many of those
loans were made to the riskiest borrowers; the share of
securitized subprime loans considered “deep subprime” —
to borrowers with a credit score in the mid-500s or below
— soared from 5 percent in 2010 to 33 percent in 2017.
The increase in subprime and deep-subprime securitization has continued despite worsening performance.
Subprime securitization net loss rates have increased
steadily since 2010; in June of that year, the average net
loss rate was 3.5 percent, according to market analytics
firm S&P Global. In June 2017, the rate was 6.2 percent.
The cumulative net loss rate — total losses since the security was issued — also has increased for successively later
“vintages” of security issuances.
Lower performance in part reflects more loans being
made to borrowers with lower credit scores and their usually
higher delinquency rates; if average credit scores continue
to improve, performance might improve as well. But higher
loss rates also reflect lower recovery rates, meaning that
lenders are recouping less from the sale of repossessed cars.
Longer loan terms bear some of the blame, because they
make it more likely the loan’s outstanding balance exceeds
the car’s value if the buyer defaults in the early years of the
loan. In addition, record-high rates of vehicle leasing in
recent years have swelled the number of used cars on the
market, lowering the value of repossessed collateral. If those
trends continue, they might be a drag on subprime ABS
performance even if delinquency rates stabilize or go down.
Toil and Trouble?
Higher loss rates don’t necessarily translate into higher
losses for investors, however. Some amount of loss is
built into issuers’ projections, and subprime issuers typically offer “credit enhancements,” such as establishing
a reserve fund or holding extra collateral, to cover those
expected losses. And since the Securities and Exchange
Commission issued a rule in 2014 requiring ABS issuers to
release loan-level detail about their bond packages, potential investors have substantial information with which to
evaluate the adequacy of those enhancements. Problems
are more likely to arise when the actual losses exceed the
expected losses.
That’s what happened in the mortgage market a decade
ago; in hindsight, market participants underpriced the
amount of risk present in mortgage-backed securities
(MBS), perhaps in part because they had some expectation
the government would step in to protect them. There’s
little evidence of a similar expectation in auto lending;
although the U.S. Treasury purchased a large stake in

 GMAC in 2008, the move was widely regarded as an
attempt to protect auto manufacturers rather than lenders
or investors. All else equal, the absence of government
support, explicit or implicit, would make the auto lending
industry more responsive to risk.
Other factors could contribute to lenders and investors
underpricing risk, however. For example, a car is a relatively easy asset to repossess compared to, say, a home.
Laws vary from state to state, but in general, lenders are
allowed to repossess a vehicle as soon as the borrower is in
default without providing any prior notice. Actually towing the vehicle takes just minutes, and some lenders and
car dealers even install so-called “kill switches” to prevent
a car from starting if the borrower misses a payment. In
contrast, in many states, a home foreclosure requires judicial action; even in nonjudicial states, the process can take
months or even more than a year to complete.
Cars depreciate rapidly, which means there’s likely to
be a gap between what the borrower owes and what the
lender can recoup. But in nearly every state, lenders are
allowed to sue borrowers for the difference. A lender who
obtains such a “deficiency judgment” is able to garnish a
borrower’s wages or seize other assets. Some states also
allow mortgage lenders to sue foreclosed borrowers, but
there are greater restrictions on obtaining a judgment
than in auto lending.
Even if subprime auto ABS performance does deteriorate beyond current expectations, there are reasons to
think it’s unlikely the effects would spill beyond the auto
finance sector into the broader financial system.
“People who say, ‘This is just like the subprime
mortgage crisis!’ are missing the boat,” says Christopher
Killian, managing director and head of the securitization
group at SIFMA. First, auto loans are a much smaller portion of consumer debt than mortgages: $1.2 trillion versus
$8.7 trillion in outstanding mortgage balances. And the
volume of auto ABS is dwarfed by the volume of MBS:
Mortgage-backed securities in the United States total
more than $9.1 trillion (including both residential and
commercial), compared to $201 billion in outstanding
auto-loan-backed securities. Perhaps most important,
Killian notes, auto ABS aren’t turned into collateralized debt obligations, the highly complex securities
that helped transmit MBS losses throughout the entire
system.
“Let’s imagine the subprime auto market craters,”
Killian says. “There will be losses, but there won’t be cascading losses.”

History also offers some reassurance; this is not the first
time investors have been enamored of subprime auto loans.
In the early 1990s, the securitization market contributed
to hundreds of new subprime lenders opening their doors;
between 1991 and 1994, there were more than 20 initial
public offerings. Just a few years later, a combination
of accounting irregularities, overleverage, and fraud had
contributed to massive stock price declines and numerous
bankruptcies. Stockholders and investors lost money, but
the effects on the broader financial system were nil.
The Effects on Detroit
Still, past performance is no guarantee of future results.
As Fischer noted in his June speech, the potential for
subprime auto lending to cause broader financial distress
seems moderate at first glance. But, he cautioned, “[O]ne
should remember that pre-crisis subprime mortgage loans
were dismissed as a stability risk… and not take excessive
confidence.”
The industry most likely to feel the pain from a decline
in subprime lending is the auto industry itself, which
accounts for about 3 percent of U.S. GDP and supports
nearly 4 percent of private employment. Vehicle sales
have been a bright spot during the relatively tepid recovery from the Great Recession, doubling from a nadir of 9
million sold per month in early 2009 to about 18 million
per month at the end of 2016. But during the first eight
months of 2017, monthly sales fell by about 2 million and
many manufacturers began cutting jobs. (Vehicle sales
spiked in September of 2017, in part because consumers were replacing hurricane-damaged cars.) Numerous
factors influence vehicle sales, including energy prices
and trade policy. But many observers noted the correlation between the decline in sales and tightening credit
conditions.
The availability of credit played a large role in the drop in
vehicle purchases during the Great Recession, according to
a 2017 article in the Quarterly Journal of Economics by Efraim
Benmelech of Northwestern University, Ralf Meisenzahl
of the Federal Reserve, and Rodney Ramcharan of the
University of Southern California. The authors concluded
that lenders’ lack of liquidity accounted for nearly one-third
of the decline in auto sales in 2009.
Barring other developments, it’s doubtful a pullback
from subprime auto lending and securitization would result
in an auto credit crunch as extreme as that experienced
during the financial crisis. Still, manufacturers are keeping
their fingers crossed the subprime pipe stays open.   EF

Readings
Benmelech, Efraim, Ralf R. Meisenzahl, and Rodney Ramcharan.
“The Real Effects of Liquidity During the Financial Crisis: Evidence
from Automobiles.” Quarterly Journal of Economics, February 2017,
vol. 132, no. 1, pp. 317-365.

“Semiannual Risk Perspective for Fall 2016.” Office of the
Comptroller of the Currency, Jan. 5, 2017.
“Quarterly Report on Household Debt and Credit.” Federal Reserve
Bank of New York, August 2017.

Fischer, Stanley. “An Assessment of Financial Stability in the
United States.” Speech at the IMF Workshop on Financial
Surveillance and Communication, Washington, D.C., June 27, 2017.
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