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 released Tuesday by Moody’s Investors Service.
Robust auto sales have kept lenders busy in the last 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 can be 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 last 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, but fell to 646 in the fourth quarter of 2013, according to Moody’s.
As lenders began accepting lower scores, they also began extending the length of the loans, which allows people purchase more expensive cars. Longer-loan terms heightens 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.
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 and dealers are tacking on more extended warranties and aftermarket accessories such as sound systems into the car financing, according to the OCC. The high loan-to-values and longer terms, the regulator said, was 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.”