Demand for automobile debt in the U.S. is enabling lenders to make longer loans to people with spotty credit, stoking concern that car shoppers are being lulled into debt loads they won't be able to sustain.
Of the subprime vehicle loans bundled into securities, 73 percent now exceed five years, up from 64 percent during the first three months of 2014, according to data from Citigroup Inc. Loans as long as seven years are increasingly being put into more bonds as auto-finance companies and Wall Street banks sell the securities at the fastest pace since 2007.
The longer loans make it easier for consumers to afford rising new and used car prices by spreading out and lowering payments. While the securities are attracting plenty of buyers with high loss buffers and AAA ratings, some investors are beginning to question the wisdom of lending at terms that have never extended beyond five years.
"Everyone has used the argument that borrowers pay car loans because they have to get to work," said Anup Agarwal, a money manager who oversees $65 billion at Western Asset Management Co. and hasn't bought a subprime auto bond in a year and a half. "But borrowers only pay loans if the car is working. We have not seen this cycle come through yet."
A debt offering recently marketed by American Credit Acceptance LLC demonstrates some of the risks. About one-third of the 14,628 loans in the deal are tied to borrowers with credit ratings under 500 according to the Fair Issac Corp. grading system known as FICO or with no score at all, according to a prospectus obtained by Bloomberg. The company is charging interest rates of between 27 and 28 percent for almost one-third of the borrowers, and more than half of its loans exceed five years.
American Credit Acceptance Chief Financial Officer Tim MacPhail declined to comment.
The shift to longer-term loans makes it easy for borrowers to be duped into focusing on lower monthly payments rather than the costs over the life of the obligation, said Raj Date, former deputy director of the Consumer Financial Protection Bureau who now heads the Washington consulting firm Fenway Summer LLC.
While cars are lasting longer than in the past, regulators are concerned that the value of the vehicles will fall faster than borrowers can pay off the debt.
"Because cars depreciate quickly, a borrower is typically upside down or underwater toward the end of a long loan term," Date said. "If times are tough you might have to sell your car, but you're still going to owe more than you can get through the sale."
The longer terms for auto loans are coming as vehicle demand in the U.S. increases. Auto sales are expected to reach 17 million in 2015, according to the National Automobile Dealers Association, approaching the record of 17.4 million in 2000. Last month, the average price for a new car reached $33,363, up from $32,000 a year earlier, according to figures from Kelley Blue Book. Used car prices hit a record of $16,800 in 2014, according to a report from Edmunds.com.
At the same time, monthly car payments have increased this year for every risk-category of borrower, according to Experian Automotive data released in May.
"My biggest concern is if the consumer is using a longer loan to pay for a car they can't afford," said Melinda Zabritski, a senior director at Experian.
Buyers of top-rated auto securities are being assured they'll be insulated. Auto bonds become safer fairly quickly through a process known as de-levering, where buyers recoup their principal in two-to-three years. So the securities holders get their cash well before the underlying loans are paid off.
The riskiest auto bonds offer compensation of up to four times the coupon of comparably dated Treasuries, Bloomberg data show.
History is also on the side of investors. Since 2004, Standard & Poor's has upgraded 371 classes of subprime auto deals and downgraded none, data from the company show. While delinquencies longer than 60 days have increased, net losses in the debt have dropped from a year ago, S&P said Wednesday in a report.
Even with the built-in protections, some market participants are starting to caution that buyers may be letting down their guard for the sake of higher yields.
Auto securities sold in 2014 have registered the highest loss rate of any period since 2008, according to data from JPMorgan Chase & Co. A total of $68 billion was sold last year, and issuance reached $50 billion through the first five months of 2015.
Loans have been getting longer for prime borrowers as well. The percentage of loans exceeding five years in those securitization pools has grown to 47 percent from 38 percent in 2006, according to Citigroup data.
Some finance companies are avoiding the longest terms. Exeter Finance Corp., a Blackstone Group-backed subprime lending firm based in Irving, Texas, isn't offering them because the risk is too high, said the firm's treasurer, Andrew Kang.
"At this time we have no intention of going longer than 72 months," he said. "The risk is that you extend a loan that a borrower cannot afford over its term schedule. Inching out to 75 and 84 months, I don't think that has been tested yet."