‘Trade-in treadmill’ causing credit risk for lenders in auto loan market

Last year, automobile loans for new and used vehicles topped $1 trillion. Today, total auto loan debt stands at a little more than $1.15 trillion, and 30- and 60-day delinquency rates have been creeping up for the last couple of years.

Because student loans and consumer debt regularly dominate the news cycle, this area of the economy has been able to fly under the radar for quite a while. Until now…

Moody’s Investors Service published a report Monday (via Reuters) that took a look at how much of a mess and train wreck the auto loan market really is. With U.S. auto sales reaching their peak, it has become imperative to finance car loans, which, at the same time, will boost credit risk for auto lenders.

Since the financial crisis, auto sales have ballooned, and sales of cars and trucks hit a record annual high in 2016 with 17.55 million units – auto debt also soared 48 percent in the same time period. Moody’s, however, projects that U.S. new vehicle sales will decline to 17.4 million units this year.

But that isn’t the worst of it.

Last year, researchers note, approximately one-third of U.S. vehicle trade-ins had outstanding loans that were worth more than the cars themselves. This, says one of the report authors, poses a significant risk to lenders.

“The combination of plateauing auto sales, growing negative equity from consumers and lenders’ willingness to offer flexible loan terms is a significant credit risk for lenders,” said Jason Grohotolski, a senior credit officer at Moody’s and one of the report’s authors.

Here is what the newswire reports:

Typically, car dealers tack on an amount equal to the negative equity to a loan for the consumers’ next vehicle. To keep the monthly payments stable, the new credit is for a greater length of time.

Over the course of multiple trade-ins, negative equity accumulates. Moody’s calls this the “trade-in treadmill,” the result of which is “increasing lender risk, with larger and larger loss-severity exposure.”

To ease consumers’ monthly payments, auto manufacturers could subsidize lenders or increase incentives to reduce purchase prices, though either action would reduce their profits, the report said.

This is truly terrifying. Indeed, these are symptoms of a much greater problem in the auto loan market. As you can see in the chart below (courtesy of the Mises Institute), despite a brief downward trend, the 90-day delinquency rate for auto loans is going back up again.

When will it be the tipping point? When will auto loans lead to bigger issues on a grander scale? Eventually it will happen, but right now you’re seeing it fall apart at the seams.