Subprime auto loans could spell trouble for credit markets

The subprime auto-loan market is seeing an increase in troubled borrowings, which could spell wider problems for credit markets and used-car dealers, such as Carvana (NYSE: CVNA) and CarMax (NYSE: KMX).

The overall auto-loan delinquency rate hit 3.9% as of June 30, the highest in 10 years, according to the Federal Reserve. It defines delinquent as at least 30 days overdue.

And for subprime auto loans, the 60-day delinquency rate was 7.4% in October, according to Cox Automotive.

But investors in this risky asset class are apparently unphased. Sales of the worst-rated bonds backed by auto loans totaled almost $40 billion year to date through October, soaring 17% from all of last year, according to JPMorgan Chase, as cited in The Wall Street Journal.

The attraction of low-rated bonds, of course, is their high yield—6% for the lowest investment grade paper as of October, The Journal reported.

However, the strong demand for subprime auto bonds has pushed the yield of the lowest-rated paper to just 3.4 percentage points in October from 5 points in January, according to JPMorgan.

Disconnect: Loan quality vs investor demand

So there’s a growing disconnect between the worsening quality of subprime auto loans and the strong investor desire for them.

This kind of disconnect often arises in times of market bubbles. That’s when investors get so carried away with gains they witness every day in various markets that they treat risky assets as if they were Treasury bonds. This is what happened in 2007 and the preceding years, when investors went nuts over subprime mortgage bonds. That helped precipitate the Great Financial Crisis of 2008.

The auto loan market is much smaller than the mortgage market—$1.5 trillion last year, compared to $20.2 trillion for mortgages. So it’s unlikely that bad subprime auto loans could take down the entire financial system.

Fears of that spiked in 2016, when subprime auto loan delinquencies hit a 20-year high, but credit markets withstood the blow just fine. Still, a surge of auto loan defaults now could well cause serious turmoil in credit markets.

Economy may determine subprime loans’ path

The outlook for subprime auto loans likely rests with the economy. If it’s strong enough to provide adequate wealth for borrowers to repay their loans, there shouldn’t be a major problem.

On the other hand, if the economy slows, there may be trouble. The recent rise in delinquencies has occurred even as the economy has grown buoyantly. Annualized growth totaled 3% in the third quarter. So a weakening economy could really spark trouble.

Rising loan delinquencies obviously are a bad thing for used-car dealers. Carvana, famous for its car tower vending machines, may be among the most vulnerable. It almost went bankrupt in 2022.

But the stock has soared over 3,000% in the last two years amid massive cost-cutting and increased auto sales. In just the past month it gained 27%. Carvana has posted a profit for three straight quarters, and revenue jumped 32% in the third quarter from a year earlier.

However, shares have hit lofty valuations. They trade at 129 times earnings estimates for the next 12 months, way more than the S&P 500’s price-earnings ratio of 22. The price-to-sales ratio totals 3.1, far above the company’s five-year average of 0.28.

Bad news on auto-loan defaults could put a crimp on demand for used car dealers like Carvana and CarMax.