Could Auto Loans Be Problematic for Banks Down the Line?

The coronavirus pandemic has likely resulted in hundreds of billions of dollars in total loan deferrals, in which lenders allow borrowers to skip certain payments and move them to the end of a deferment period or perhaps the end of the loan term. These deferrals have become a big mystery for everyone watching the banking sector, as investors and bankers themselves try and figure out how many of these borrowers will return to good financial footing and how many loans will turn into losses.

There has been plenty of talk about issues in the commercial sector, and credit card loans usually see higher loss rates during a recession. Many of the country's top auto lenders are also seeing high deferral rates. There had already been some signs of trouble in the auto lending segment before the pandemic began, which begs the question of whether banks will see problems in this portfolio down the road.

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Deferral levels

Some of the largest auto-lender banks in the country are Capital One (COF -1.95%), JPMorgan Chase (JPM 0.15%), Wells Fargo (WFC -1.11%), Ally Financial (ALLY -1.56%), and Santander Consumer USA Holdings (SC).

* As of June 30, 2020. Source: Bank earnings materials and SEC filings.

As you can see above, most of these companies and banks had high deferral rates as of June 30, and I think what stood out is that the deferral rates in the auto portfolios were toward the higher end when compared to other loan segments. At JPMorgan, a larger percentage of the auto portfolio was in deferral than in the home lending and consumer and business card portfolios. At Wells Fargo, auto deferrals were at the same levels or slightly below residential mortgage categories but higher than credit card and other revolving credit and installment loans. And at Ally, auto deferral percentages were much higher than in the company's mortgage lending or personal lending businesses.

Another interesting stat that some of these banks offered was how many customers made a loan payment while they were enrolled in the deferral program. At JPMorgan, 34% of customers made a payment while in deferral, which was a much smaller percentage compared to the home lending and business and consumer card categories. At Wells Fargo, only 24% of auto customers made a payment during deferral, compared to 34%, 48%, and 62% in the bank's residential mortgage, credit card, and junior lien mortgage categories, respectively. Capital One seems to have performed better; the company saw 14.1% of auto accounts enter deferral since the pandemic began, but 10.7% of these accounts are no longer enrolled.

When asked by an analyst on the company's recent earnings call about whether higher auto deferrals meant anything for "credit trends" ahead, JPMorgan CEO Jamie Dimon responded with a very simple "no." Capital One co-founder and CEO Richard Fairbank also addressed the higher usage by auto borrowers of the company's deferral program. He said that auto and mortgage customers are more likely to use the programs because these loan payments are much higher than, say, a credit card payment and that the company was seeing a correlation between deferral program usage and higher loan payment sizes. Additionally, he said "the stakes are higher for the customer" to keep their cars.

Capital One CFO Scott Blackley pointed out that actual losses in the card book are typically higher than those in the auto portfolio, primarily because its easier to recover collateral on auto loans if needed.

Trouble has been brewing

Trouble had already been brewing in the auto lending segment before the coronavirus pandemic hit. Americans have piled on auto debt at record-breaking levels. Midway through 2010, total auto loan volume in the U.S. was below $700 billion. At the end of the second quarter of this year, it had reached nearly $1.2 trillion.

Drivers are also taking on larger loans. According to NPR, by late 2019, drivers were paying, on average, close to $38,000 for new cars, up 26% over the past decade. However, in that same time period, the values of those vehicles had not gone up nearly as much.

Americans have also been taking out longer car loans. In the first quarter of 2019, 70% of new and used auto loans ranged from 61 to 84 months (five to seven years), according to a study conducted by Experian in 2019. The problem there is that the car will depreciate heavily and even potentially break down before the loan is paid off.

Cracks in the auto lending market were already beginning to show before the coronavirus hit. Roughly 5% of outstanding auto loans were more than 90 days delinquent at the end of the first quarter of 2020, the highest that rate has been since 2012, according to the Federal Reserve Bank of New York.

Watch it carefully

Auto loans are an asset class that bears some resemblance to home mortgages during the Great Recession. People are taking out bigger loans, and because the loan periods have gotten longer, there might be times during the loan period that the outstanding balance is more than what the car is actually worth.

That's similar to the Great Recession, when homeowners were making the same monthly mortgage payments they always had -- or higher if they had a variable-rate mortgage -- even as their homes were losing value.

While a car loan is much smaller than a home loan, I think the high deferral rates in auto portfolios show us that the car borrower can be very sensitive to economic conditions, so this is one loan segment that should be watched carefully.