Through the course of our research, we’ve seen a significant increase in media coverage surrounding the U.S. auto loan market. Headlines highlight an increase in delinquency and default rates, a prevalence of deep subprime auto loans, lower vehicle deliveries and higher inventories. Reminiscent of the financial crisis, many investors are asking whether this is the next bubble and what they can do to manage related ESG risks.
The rapid growth of the U.S. auto loan market has been fueled by investors seeking yield in a low interest rate environment. Consumers also play a role in the market’s growth. Wealthier drivers tend to trade-in their cars for newer models sooner to access the latest technological features – see Automakers Smarten Up (gated content). As a result, a greater supply of high-quality second-hand vehicles, which appeal to lower income consumers, is created.
After the financial crisis, sales volumes in the U.S. auto market reached a peak in 2016, but have since slowed down. This slowdown is partially driven by subprime households struggling to make loan payments. This problem is exacerbated by higher used car inventories that are depressing prices, which makes it harder for subprime borrowers to sell their cars.
Some comparisons have been made between the subprime auto loan market and the pre-crisis mortgage market. The auto loan market is, however, only around 8% of the size of the mortgage market and deep subprime loans represent only 3.9% thereof. Large banks, such as Wells Fargo and JPMorgan, represent a significant portion of the auto loan market and have prudently started to reduce originations. They also appear to be tightening their lending standards. However, a few financial services companies and specialist subprime lenders remain highly exposed to these types of loans and not all of them are adequately prepared to manage related ESG risks.
The Prevalence of (Subprime) Auto Loans in the U.S.
Auto loans made up 9% of the total household debt in the U.S. in Q1 2017. This amounts to about USD 1.16 trillion out of USD 12.73 trillion – the highest value in more than 10 years since the 2007 financial crisis.
U.S Debt Composition in Percentages as at Q1 2017
Source: New York Fed Consumer Credit Panel/Equifax
Rating agencies, regulators, financial institutions and industry analysts have warned about increasing losses from subprime auto loans, which reached 9.1% in January 2017 compared to 7.9% in 2016 (according to data from S&P Global Ratings and Bloomberg). Delinquency rates (i.e., payments that are more than 90+ days overdue) were at 3.8% at of the end of March according to a report from the Federal Reserve Bank of New York. This would suggest that 2-3 million Americans may be at risk of having their cars repossessed.
1. ESG Issues Associated with Subprime Auto Loans
1.1 Discriminatory and Predatory Lending Practices
Late last year the Office of the Comptroller of the Currency raised concerns over discriminatory and predatory lending practices. For example, Ally Financial was found to be charging higher fees to minority borrower, compared to Caucasian borrowers. Santander Consumer USA, in turn, engaged in predatory lending when it worked with dealerships that it knew falsely inflated borrowers’ income on applications. In other words, they knowingly provided loans to individuals who were at risk of not being able to afford payments. The U.S. captive financing arms of Toyota and Honda reached settlements of over USD 20 million each for discriminatory lending practices and customer lawsuits related to vehicle repossessions and debt collection.
1.2 Inadequate Financial Product Governance and Controversial Repossessions
Unlike mortgage lenders, car dealers are not legally required to assess whether potential buyers can afford their payments. This and other more relaxed regulatory standards have enabled dealers to extend the duration of auto loans from the standard 60-months period to 72 months, for both new and used cars, and to increase loan-to-value (LTVs) and debt-to-income ratios to record levels. LTV ratios are either stagnant or increasing, leading to a higher risk of negative equity for borrowers. This has contributed to an increase in defaults and repossessions, especially for vulnerable groups.
2.Legal and Reputational Risks
Both financial institutions and auto makers, through captive financing arms, face serious legal and reputational challenges related to (subprime) auto loans. In 2014, Ally Financial paid a record USD 98 million to settle discriminatory lending charges and, more recently at the end of March 2017, Santander Consumer USA Holdings paid USD 26 million. The captive financing subsidiaries of Ford, General Motors, Toyota, Honda and BMW have been subject to investigations, lawsuits and penalties with settlements reaching USD 20 million and more.
Implications for Investors
Investors may be at risk through their exposure to securitized auto loans as well as investments in auto manufacturers and financial institutions with high auto loan concentrations. Companies such as Santander Consumer USA Holdings, Ally Financial, Huntington Bancshares and Capital One Financial Corporation may be at great risk. In addition to having a high exposure to auto loans, our research indicates that they do not appear to have robust policies and programs in place to manage associated ESG risks. Investors may also want to engage with major automakers to understand how they are managing risks related to subprime auto loans. These loans may further increase their exposure to customer-related controversies.
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