You Can't Drive Your House to Work
A closer look at the business of making car loans indicates that the correlation with mortgage lending may not be as close as many believe.
The world of asset-backed securities is far larger than just mortgages, as similar securities are supported by commercial real estate, credit cards, student loans, and auto loans in addition to just about every other type of receivable. While many of the securities backed by these assets are similar in structure, each industry requires its own analysis in order to identify whether the baby is being thrown out with the proverbial bathwater.
As new data comes out showing additional strains on the American consumer, auto lending has emerged has one of the sectors speculated to be following mortgages into the abyss. While subprime auto lenders like Consumer Portfolio Services (CPSS) and Americredit (ACF) have seen their share prices nearly halved from this summer's highs, a closer look at the fundamentals of the business of making car loans indicates that the correlation with mortgage lending may not be as close as many believe.
Loan losses are measured in two primary ways, frequency and severity. Frequency measures how often losses occur while severity measures how bad each loss is. With subprime mortgages, loss frequency is high due to the poor credit of the borrower, while loss severity has historically been low thanks to rising home prices. Subprime auto loans have a lower loss frequency than their mortgages brethren since car payments are high on the priority list of those in financial trouble because a car represents income in the form of transportation to and from work. Loss severity for auto loans, on the other hand is very high due to the low recovery value through repo sales.
A loan of any kind's value is highly dependent on it's loan-to-value (loan amount divided by underlying asset value), as this ratio represents the equity cushion a lender has in the event of foreclosure or a forced sale. Historically home prices have moved steadily upwards, and the decline in housing prices is wreaking havoc throughout the industry. The subjective nature of determining a home's value combined with the lack of liquidity in the market has made houses, and as a result mortgages, borderline impossible to value.
Automobiles, on the other hand, are depreciating assets. There is no mystery about the value of a car – it goes down with every mile driven. Furthermore, the market for used cars is highly liquid and even though lenders lose money when repossessing a car, its value can be determined quickly and accurately. This liquidity and transparency in asset value strengthens the models used to create securities backed by auto loans.
Asset Backed Securities are created using mathematical models to forecast asset values, delinquencies, and the speed of loan repayments. These models use historical data to predict future events, a dicey endeavor particularly at cusps like we are currently experiencing where markets diverge rapidly from historical norms. As the real estate market has deteriorated nationwide, many of the assumptions on which the models for residential mortgages rely have been proven false.
Since it is widely known that cars depreciate in value and that value does not fluctuate much with market conditions, auto loan securitizations are structured to absorb much larger loss severity. Said another way, investors and lenders know they are going to take a big hit each time they are forced to repossess a car, and securities are structured accordingly.
Mortgage-backed securities have lost immense value because both loss frequency (delinquency rates) and loss severity (declining home values) have risen outside historical averages and broken the underlying models. Although auto loans may experience a similar rise in loss frequency as the American consumer comes under pressure from burdensome debt and rising unemployment, the loss severity is unlikely to increase significantly since car prices are largely insulated from economic downturns. In fact, it is reasonable that used cars may hold their values in hard times as consumers shy away from new cars and look for more affordable transportation options
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