Higher interest rates expected to hit US auto sub-prime sector says Fitch

Fitch Ratings notes that rising interest rates could put pressure on US auto asset-backed securities (ABS) transactions, particularly subprime deals. The Federal Reserve's plan to raise rates gradually over four years could increase the monthly debt burden on auto loan borrowers, with the subprime borrowers facing the greater financial burden as they are more exposed to stagnant wage growth and have a weaker history of financial stability. Fitch states that finance companies may be "forced to increase extended-term lending or incentive spending to keep monthly payments at affordable levels for US consumers". The ratings agency also warned that vehicle values will be pressured due to increased supply over the next few years, which will contribute to lower recovery rates; in this environment, coupled with higher interest rates, it predicts "both the prime and subprime annualised net loss indices to climb higher".

NEW YORK -

Fitch Ratings isn’t necessarily sounding alarms over what the Federal Reserve did with interest rates before the holidays arrived. It’s how the Fed might adjust rates during the next four years that is sparking analysts’ interests.

Fitch acknowledged on Monday that rising interest rates could pressure U.S. auto ABS transactions, especially first on subprime deals.

“While last month's initial rate increase is expected to only have a marginal near-term impact on borrowers, the Federal Reserve plan to raise rates gradually over four years could increase the monthly debt burden on auto loan borrowers,” analysts said.

“Although the rate increases are expected to affect the entire market, Fitch believes subprime borrowers may face a greater financial burden within this environment as they are more exposed to stagnant wage growth and have a weaker history of financial stability,” they continued.

Fitch emphasized that any economic setback would touch subprime borrowers first even though the U.S. employment rate has sunk to 2007 levels. Despite slight upturns in 2015, analysts pointed out that wage growth has largely been stagnant over the past five years and hasn't matched inflation or housing prices.

“Should this trend continue, wage growth for certain consumers may not match the Federal Reserve's planned increases,” analysts said.

“Over the past five years, consumers have taken advantage of low rates to prepay loan balances,” they continued. “With higher interest rates, greater higher prepayment rates become less feasible and may prolong loan terms. The household debt-to-income ratio could also increase, creating less discretionary cash available to pay down auto loan balances.”

Fitch then discussed how finance companies might respond in order to keep their origination volumes at projected levels.

“In this environment, auto loan originators could be forced to increase extended-term lending or incentive spending to keep monthly payments at affordable levels for U.S. consumers,” Fitch said.

“Extended-term contracts are already a raising concentration in ABS pools that hinder asset performance over time and typically perform weaker than standard-term 60-month or less auto loans,” the firm continued. “Loss severity on extended-term contracts is high since defaults typically occur earlier in the life of a loan when the borrower has little to no equity in the vehicle.”

During the past five years, Fitch noted the auto ABS market has largely been buoyed by a robust used vehicle market that will remain healthy in early 2016.

However, Fitch expects vehicle values to be pressured due to increased supply over the next few years, contributing to lower recovery rates.

In December, Fitch's auto ABS annualized net loss indices reached 0.60 percent and 9.20 percent for prime and subprime, respectively.

If defaults increase due to higher interest rates in a weaker wholesale market, Fitch expects both the prime and subprime annualized net loss indices to climb higher,” analysts said.