Vehicle sales have been a bright spot in the economic recovery, largely due to the increase in lending to customers with less-than-stellar credit. But cracks are appearing in the securities created from these dicey loans, and investors may be in for a rude awakening.
Two years in the making
The Office of the Comptroller of the Currency has raised a red flag in its Spring 2014 risk report, noting how lenders have aggressively pursued this loan market by offering loans to consumers with low credit scores. As vehicle prices rise and borrowers purchase extras such as extended warranties, loan terms stretch out further, increasing risk.
Over the past year, charge-offs have increased for all lenders, including banks. The biggest player in auto loans is Wells Fargo (NYSE:WFC), which increased its car-loan activity by more than 11% in the first quarter of this year. One way it has done this is by lending to consumers with credit scores lower than 620, generally considered "subprime" territory.
It wasn't that long ago that subprime auto lending looked like a sweet way for banks to make money, and delinquencies were low. Banks courted subprime borrowers as competition with non-bank lenders grew fiercer, but no problems seemed to be looming on the horizon late in the summer of 2013.
Meantime, asset-backed securities were being stuffed with these subprime car loans, which were then sold to yield-hungry investors tired of piddling returns on less risky investments.
A bubble in the making?
A report by Standard & Poor's earlier this year showed that things were not necessarily as they seemed. Loans contained within those ABSes were showing signs of strain, with 30-day delinquency rates rising nearly 1.5 percentage points to 7.59% from September 2012 to September 2013.
Should investors be worried? Probably, but that isn't stopping them from snapping up these wobbly bonds, even as 60-day delinquency rates rise, too. With interest rates still achingly low, investors have taken a shine to securities that feature loans with interest rates as high as 26.55%. Investor losses are increasing, though, with S&P estimating year over year losses at 4.45% this past March from 3.88% previously.
Though the OCC is concerned about the increasing risk, it states that it will only monitor the situation for now, since loan portfolios at banks aren't in crisis. Wells Fargo isn't worried, either, noting that only 10% of its auto loan portfolio is comprised of subprime borrowers. Meanwhile, with vehicle sales surging this past June to the highest level in over five years, the subprime auto market shows no signs of downshifting just yet.
Amanda Alix has no position in any stocks mentioned. The Motley Fool recommends Wells Fargo. The Motley Fool owns shares of Wells Fargo. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.