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Lenders back off subprime car loans

Threat of massive losses seems in check

WASHINGTON – Lenders are pulling back on extending car loans to consumers with very poor credit histories, reversing a trend that had sparked fears of new financial bubble, according to a report by Moody’s Investors Service.

Robust auto sales have kept lenders busy in the past few years as Americans have opted to trade in their aging vehicles. At the same time, private-equity firms have regained their appetite for securities made up of car loans because of the cash flow and minimal risk – cars are easily repossessed and resold. 

In the face of all of this demand, more lenders began making loans to would-be car buyers with low credit scores, charging them double-digit interest.

There are now reports of lenders placing subprime borrowers into loans they can’t afford, which has drawn comparisons to the subprime mortgage fiasco and led the Justice Department to launch a series of investigations. The surge in subprime auto lending has also caused bank regulators to warn that an overheated market could spur high default rates to the detriment of bank balance sheets.

It turns out, however, that banks, credit unions and the finance arms of the car companies, or captives, have slowed their efforts to court borrowers at the low end of the credit-score spectrum, Moody’s said.

That change has eased the pres­sure for smaller finance companies to move further down the credit spectrum to remain competitive. 

As a result, average credit scores of subprime borrowers have edged up over the past two quarters.

Analysts at the credit rating agen­cy also noted that the rate of late payments on subprime car loans, though on the rise, remain be­low their levels at the height of the financial crisis. They suspect the performance of these loans will hold up in the near term unless lenders again court consumers with very weak credit.

“Lenders are beginning to show some caution in lending to riskier borrowers. That caution, if it continues, could help rein in subprime auto loan losses,” Moody’s analysts wrote. “Subprime loan volumes are still high, although they have flattened somewhat over the past year.”

Credit scores for subprime auto loan borrowers peaked in 2010. At the time, the average credit score on used vehicles, a popular choice among subprime borrowers, hovered around 653; by the fourth quarter of 2013, it had fallen to 646, according to Moody’s.

As lenders began accepting lower scores, they also be­gan extending the length of the loans, which allows peo­ple to buy more expensive cars. Longer-loan terms heighten the risk of borrowers defaulting during the extended period. It can also lead to higher losses on repossessed cars because smaller monthly payments mean the borrower will have paid less principal before defaulting on the loan, Moody’s said last week.

In June, the Office of the Comptroller of the Currency pointed to extended terms and the overall explosion of subprime lending as “signs of increasing risk.” The bank regulator said lenders on average were issuing loans for new and used cars that were higher than the value of the cars, what’s known as loan to value. 

That means car prices are climbing as dealers tack on more extended warranties and aftermarket accessories, such as sound systems, into the car financing, the OCC said. The high loan-to-values and longer terms, the regulator said, were causing banks to lose money on loans over the past two years.

Although the Moody’s re­port highlighted the risks that the OCC documented, an­a­lysts said, “Rising credit scores for used vehicle loans and higher loan interest rates underscore lenders’ growing ca­ution.”

Nevertheless, the credit rat­ing agency warned about the risks of securities backed by subprime auto loans from small­er lenders. Analysts said “smaller, inexperienced lend­ers with limited financial re­sources” would have trouble servicing loans if losses skyrocketed, and the agency cautioned them to staff up just in case.

But it’s the large lenders that have attracted government attention for their subprime securitization prac­tices. Federal prosecutors have launched investigations into the subprime underwriting stand­ards and securitization at the financing arm of General Motors and the consumer-lending unit of Spanish bank­ing giant Santander, according to securities filings.

The investigations have raised concerns that investor de­mand is leading lenders to relax their standards too much, which could lead them to suffer big losses that would rock the financial system just like subprime mortgages did.

But housing finance is much larger than the auto-lend­ing market, and cars are much easier to repossess and sell than homes. That limits the damage subprime auto loans could do to the economy, though not to investors and consumers.

For now, the threat of massive losses on subprime car loans appears to be in check. Defaults in the subprime auto market crept up last year but have retreated in the past six months, suggesting that the market may be correcting itself, according to another report from Moody’s Analytics.