Auto loans and leases have generally performed well since the global financial crisis, supported by low unemployment, healthy consumer balance sheets, and previously rising car prices. However, loan delinquencies and losses are rising, and S&P Global Ratings thinks a variety of factors--such as high interest rates, high loan balances, falling used car prices, consumers' declining savings rates, and a likely economic slowdown--will result in further deterioration in auto loan and lease performance.

We expect that the entities that will be affected the most are the banks that are most active in auto lending, captive auto finance companies, and nonbank subprime auto lenders. We also think elevated funding costs and tighter funding conditions will eat into profitability and likely limit lenders' appetites for new originations. At the same time, we believe these pressures will generally be manageable for most rated institutions, and we don't expect negative rating actions to be widespread.

The recent rise in auto loan delinquencies and losses--even amid relatively low unemployment--has been in part due to weakening borrower performance, higher interest rates, and declining recovery rates. Auto loan delinquency rates (30 days to 89 days past due) fell during the pandemic, likely helped by government stimulus to households, but they have trended gradually higher over the past two years and are now comparable with pre-pandemic levels (see chart 1).

Recent years have also seen average loan amounts and monthly payments rise significantly on high car prices. We think a likely slowing of the economy, a weakening of consumers' finances, and high interest rates will make it more likely that more borrowers will fall delinquent or default on those loans. In second-quarter 2023, several banks, including Ally Financial Inc., reported much higher delinquency rates, loan loss provisions, and net charge-offs than they did in the same period last year, and all of those metrics reached levels that exceeded pre-pandemic levels. Early third-quarter results indicated similar trends.

Positively, in their base case, S&P Global Ratings economists don't expect a recession; they only expect an economic slowdown, without a sharp rise in unemployment. Interest rates stabilizing could also limit the rate of deterioration on auto loans. That said, we expect banks' provisions for loan losses and net charge-offs to rise on auto loans, particularly for lenders with a high proportion of nonprime and near-prime borrowers. If the economy performs worse than we expect or if there's an especially sharp decline in used car prices, the deterioration of auto loan and lease portfolios would likely accelerate.

Chart 1

If Used Car Prices Decline Further, It Would Fuel Loan Losses And Depreciation On Leases

According to the Manheim Used Vehicle Value Index, following a 70% spike from 2019 to 2021, used car prices fell more than 11% from their peak (see chart 2). The monthly Consumer Price Index shows a similar trend for used cars and trucks. Still, prices are well above pre-pandemic levels, partly because of pandemic work stoppages and previous supply constraints, particularly for semiconductors, and we think lingering supply bottlenecks and autoworkers' strikes may limit further price declines in the near term. At the same time, we think high loan payments and loan levels in excess of values could result in rising defaults.

Loans made in recent quarters while car prices were elevated and interest rates were rising--particularly those to less creditworthy borrowers--are probably most at risk. We think challenges in repossessing cars could also hurt recovery rates on defaulted auto loans, potentially boosting loan losses.

We don't think lessors face a material risk of significant losses related to depreciation on auto leases. However, at a minimum, their lease income will fall if used car prices continue to decline. Banks have limited exposure to leases; captive finance companies bear most of that risk.

Chart 2

While auto originations remain above where they were before the pandemic, they have fallen over the last year (see chart 2). We believe banks and credit unions have tightened standards and have been impacted by rising funding costs. According to the Federal Reserve's July 2023 survey of loan officers at U.S. banks, standards for auto loans have tightened, consistent with the tightening in credit card and other consumer loans, while demand for auto loans has weakened. In particular, a significant net share of banks reported wider interest rate spreads on auto loans, while moderate net shares of banks reported raising minimum repayments and credit scores and decreasing maximum maturities and loan amounts granted to some customers that don't meet credit score thresholds.

Banks' Auto Loan Performance Hinges On The Quality Of Underwriting And Exposure To Less-Creditworthy Customers

We rate nine banks whose auto loans made up at least 10% of their total loans on June 30, 2023 (see table 1). We view these banks as being the most at risk to a deterioration in auto loan quality. That said, the portfolios of these companies vary considerably. For instance, lenders like Huntington Bancshares Inc. and Fifth Third Bancorp focus almost entirely on prime lending. Ally Financial, Santander Holdings U.S.A Inc., and Capital One Financial Corp.--three of the country's largest auto lenders--had a mix of prime, near-prime, and subprime loans.

Chart 3

Table 1

Captive Finance Companies Wrestle With Rising Rates And Risk On Leases

This year, rising interest rates, falling used car prices, and normalizing credit performance have been weighing on the previously strong operating performance of captive finance companies. Additionally, the ongoing United Auto Workers (UAW) strike has created uncertainties around original equipment manufacturer (OEM) production volumes, which could affect captives' originations in the near term because of lower inventory levels.

General Motors Financial Co. Inc. (GMF; BBB/Stable/--) and Ford Motor Credit Co. LLC (FMCC; BB+/Positive/B)--the captives we focus on here--reported declines of 36% and 64%, respectively, in their net income in the first half of this year from strong levels a year earlier. Both companies expect earnings to be down significantly for the full year. Despite that, GMF and FMCC still have relatively healthy profitability as measured by return on equity and other metrics.

Higher rates have significantly affected both GMF's and FMCC's net interest income. Captive finance companies typically fund their fixed-rate retail installment loans, operating lease contracts, and floating-rate commercial finance receivables through a combination of unsecured debt and securitization debt. Because of their liability-sensitive balance sheets, they reported declines in their net interest margins on higher rates, which drove their earnings lower in recent quarters.

For example, in the first half of 2023, FMCC's total financing revenue rose 14% year over year while interest expense increased 130%, leading to a 31% decline in net interest income that accounted for almost half of the EBT decline in that same period. We expect FMCC's net interest margin to stabilize over the next several quarters, assuming that its funding costs don't rise much further and that recently originated loans (which have had relatively higher rates) account for a greater portion of the lending portfolio.

Falling used car values are also affecting GMF's and FMCC's leasing businesses. We believe both companies this year have seen greater depreciation on the vehicles they lease, as well as lower gains at lease termination; high used car prices in recent years had led to substantial gains in prior periods.

Among the auto lenders we rate, we believe the captive auto finance companies have the greatest exposure to leasing, which is subject to residual risk arising from declines in used car prices. That said, leasing as a proportion of rated captives' total financing portfolios (loans plus leasing) has declined since the pandemic, and we view the risks related to leasing as being manageable overall. According to Experian Automotive, leasing accounted for about 20% of new-car transactions in 2022 and the first half of 2023, compared with 28% in 2021.

GMF's lease receivables decreased to 29% of total gross receivables in second-quarter 2023 from 44% in 2019 as more consumers chose to buy their cars at the end of their lease terms and as GMF received less lease subvention from its parent, GM (see chart 4). Under the subvention programs, GM makes cash payments to GMF for offering incentivized rates and structures on its finance products. FMCC's lease portfolio was 20% of its gross receivables as of second-quarter 2023, a figure that has been relatively stable in recent years and is below what we see at most peers (anywhere from roughly 20% to nearly 60%).

Chart 4

While declining leasing penetration and return rates have lowered captive lenders' exposure to residual risk, a continued decline in used car prices in 2024 could lead to larger-than-expected depreciation on leased automobiles and larger-than-expected impairment charges, which would weigh on profitability.

At year-end 2022, GMF reported that the estimated residual value of its leased vehicles was $24.7 billion and that a 1% decline in that value would cause a $181 million increase in depreciation in 2023. FMCC seems to be less sensitive to residual value, and it expects that a 1% decline in future auction values will lead to a $10 million increase in accumulated supplemental depreciation for its U.S. Ford and Lincoln brand operating lease portfolio.

Chart 5

In addition, we expect further deterioration in captives' asset quality. GMF bears greater asset quality risk than FMCC: It has more exposure to less-creditworthy borrowers while FMCC focuses almost exclusively on prime customers. GMF reported that, as of June 30, 2023, 74% of its retail loan borrowers had FICO scores of 680 or greater while 13% had scores below 620. The average FICO score for FMCC's U.S. retail financing and operating lease placement was 757 for second-quarter 2023, with what it called its higher-risk portfolio mix at only 4% of originations. As of June 30, 2023, GMF's annualized retail net charge-off rate was 0.8%, and FMCC's loss-to-receivable (LTR) ratio was 0.15%; both figures were still below their pre-pandemic levels.

Because of the UAW strike, there are uncertainties around auto production volume and concerns about potential supply chain disruptions (see our Sept. 15, 2023, publication "Credit FAQ: How Will The United Auto Workers Strike Impact Ratings In The U.S. Auto Sector?"). Production stoppages by OEMs and reduced inventory levels likely will hurt captives' origination volume, though they would be partly offset by pricing tailwinds due to lower supply.

Our ratings on the captive finance companies are the same as the ratings on their auto manufacturing parents; that follows from our view that the parents would provide support, if needed. Therefore, some weakening of the captives' creditworthiness wouldn't necessarily cause us to lower the ratings on both the captives and their parents. Still, weakened creditworthiness at a captive would certainly be a negative rating factor for its parent, and it could contribute to lower ratings on both the captive and parent if the weakness was significant enough.

Nonbank Lenders Face Funding Strains And Asset Quality Risk On Subprime Loans

The inherent volatility, credit risk, and funding risk in subprime auto lending limit our ratings on the subprime auto lenders we rate: Cobra Equity Holdco LLC (B-/Stable/--) and Credit Acceptance Corp. (BB/Stable/--). We expect the current macroeconomic headwinds to strain the asset quality of those lenders. Delinquencies already normalized to pre-pandemic levels in 2022, and we expect net charge-offs, which have remained low, to follow.

Cobra has significant portfolio credit risk due to its nonprime borrowing base, and we expect the slowing economy, potentially rising unemployment, high interest rates, and the decline in used car prices to affect its asset quality and profitability. In second-quarter 2023, the company's owned basis net charge-off ratio was 7.7%, slightly lower than the historical levels of 8%-10%. The company's 2022 vintages performed worse than expected because of higher inflation and the end of government stimulus. The 2022 vintages were originated when used car prices were at their peak, which will result in lower recovery rates as used car prices have started to taper off.

Credit Acceptance will also likely see some pressures, though its unique business model and robust profitability offer protections. It indirectly lends to high-risk borrowers who often default on their loans: For the six months ended June 30, 2023, about 83% of total unit volume was to customers with either FICO scores below 650 or no scores at all. But the company compensates for this risk by requiring the dealers it works with to bear a portion of the credit risk.

On average, there's a 1% variance between Credit Acceptance's current cash collection rate and initial expectations, a sign of management's ability to track predicted expected cash flows from the loan. However, because of a more competitive environment and elevated inflation, vintages like its 2022 assigned loans led Credit Acceptance to recognize a higher provision for credit losses on forecast changes in the first six months of 2023 compared with the same period last year, reducing earnings. The variance on those loans was negative 3.2%, reflecting their underperformance relative to loans with similar characteristics. Credit Acceptance estimates that a 1% decline in the forecast net cash flows on loans as of Dec. 31, 2022, would reduce net income by around $45.9 million (or roughly 9% of earnings).

While the subprime lenders have no operating lease exposure, they aren't immune to the expected decline in used car prices since they're dependent on recoveries through auction sales on repossessed vehicles. Credit Acceptance has market risks from its exposure to used car pricing because the company repossesses and sells roughly one-third of the vehicles it finances; as a result, the prices that it auctions the repossessed vehicles off at affect the company's net losses.

Additionally, some industry participants believe that falling used car prices can lead to higher defaults (not just lower recoveries). Increased depreciation will put more of the company's customers further underwater on their loans than they would otherwise be, in our view.

On top of asset quality deterioration, subprime lenders continue to come up against regulatory headwinds; Credit Acceptance, in particular, currently faces potential legal pressures. In January 2023, the U.S. Consumer Financial Protection Bureau and the New York attorney general filed a lawsuit against Credit Acceptance alleging that the company violated federal consumer protection laws. The lawsuit seeks to force Credit Acceptance to stop certain alleged practices and pay penalties, among other things. The lawsuit adds meaningfully to the legal and regulatory risks that we already factored into our rating on Credit Acceptance, and we're not sure how and when it will be resolved, or whether other states will follow with similar suits.

Tougher financing conditions could also weigh on subprime lenders' origination volume and profitability. Access to funding to support new originations is crucial to auto finance company operations, and funding can be more difficult to access during periods of economic uncertainty or recession. The unfavorable debt market conditions we see now, coupled with macroeconomic headwinds, have worsened financing conditions for speculative-grade companies looking to refinance or issue debt. As a result, we expect that these lenders will rely on secured markets to both fund their portfolio growth and address upcoming corporate debt maturities.

Furthermore, by increasingly relying on secured debt, companies are encumbering their balance sheets. In our view, this reduces the companies' financial flexibility and incrementally weakens the position of unsecured creditors. We consider balance sheet encumbrance in our ratings on unsecured debt. The movement to secured debt is more meaningful for Credit Acceptance than Cobra since the latter already has relied overwhelmingly on securitization funding.

Competitive Conditions And Diversification Will Also Factor Into Auto Lenders' Performance

In 2022, credit unions, which had considerable amounts of cash to deploy, grew their market share significantly in auto lending. That increased competition for loans, and banks and captive lenders saw their market shares in originations shrink. Data from Experian shows that credit unions' share fell somewhat in the first half of 2023, although they had the top share in used-car loan originations. (Finance companies also grew their share of used car lending in 2022, perhaps as banks slowed their growth, and they continued to take share in the first half of 2023.)

If credit unions exercise more caution in lending, it will ease competition and perhaps reduce the credit risk on future originations. We would expect some of the same funding pressures that banks and nonbanks are experiencing to potentially slow auto loan growth this year at credit unions, as well.

Diversification, not only in different products but also within the auto lending segment itself, will likely be another determinant of performance for banks and nonbanks. We see the lack of dependence on a single car manufacturer or a single dealer, vintage diversification, and a higher level of used cars (versus new cars) in the financed portfolio as supportive factors through the cycle.

Related Research

• U.S. Auto Loan ABS Tracker: August 2023 Performance, Oct. 12, 2023
• U.S. Auto Sector Ratings Could Remain Resilient Despite Slowing Macro Conditions And Rising Pricing Pressure, Oct. 11, 2023
• Comparative Statistics: U.S. Banks, Oct. 11, 2023
• Rating Component Scores For U.S., Canadian, and Bermudian Banks, Sept. 29, 2023