Even as the Fed Keeps Interest Rates Parked, Many Consumers are Seeing Higher, Not Lower, Auto Loan Rates

The Federal Reserve officially left short-term rate policy unchanged, which was expected. The Fed is determined to leave monetary policy parked in the absence of clear evidence of a material change in the direction of the economy.

Even though their policy statement acknowledged that they have downgraded their view of the pace of consumer spending growth, the Fed’s official statement acknowledged also that economic growth is increasing at a moderate rate with strong labor market conditions. Likewise, they see that their current policy is appropriate to support inflation returning to their symmetric objective. This means they see inflation increasing from the sub-target pace experienced last year, and they are willing to accept a modest overshoot. The rate policy decision was unanimous for the second consecutive time.

If the Fed sticks to rates parked where they are now, their view is out of alignment with expectations in the financial markets, which are pricing in a rate cut by September. The 10-year U.S. Treasury yield has already declined by 30 basis points since the end of 2019. However, much of that January decline has been since concerns about the Wuhan coronavirus started rattling markets.

The Fed’s rate cuts in 2019 did not help all car buyers. Rates actually increased dramatically in 2019 by more than two full percentage points for consumers with subprime credit. Ironically, subprime consumers have seen more rate relief so far this month thanks to the rate declines associated with the Wuhan coronavirus than from the cuts made by the Fed last year. However, those subprime consumers are still seeing rates more than 2 full percentage points higher than last January.

The reason for higher subprime rates is risk. The subprime severe delinquency rate is at record levels right now. Lenders are asking for higher rates to compensate for additional risk.

Record delinquencies makes for strong headlines, but it’s not a reason to question the underlying health of the industry. Here are a few thoughts to consider regarding subprime rates.

So how bad is the subprime market right now in terms of defaults?  
The subprime severe auto loan delinquency rate, based on Equifax data and defining severe as 60 days or more past due, was 5.48% in November, which was then the highest recorded rate in the Equifax data series going back to 2006. During the Great Recession, the subprime severe delinquency rate peaked at 5.37% in January 2009. The rate was 5.52% in December, which is a new record.

Are loan delinquency rates seasonal?
There is a clear seasonal pattern in the data, likely a function of consumer cash flows related to holiday spending and tax refunds. Consumers typically take on more revolving debt during the holiday season. As tax refunds are issued in March and April, consumers pay off debts or reduce balances. As a result, the delinquency rate tends to be lowest each year in April. It then slowly climbs throughout the year and peaks in January or February. Since 2015, the subprime severe delinquency rate has peaked in February.

How high will the delinquency rate go?
Based on how the rate increased and peaked over the last 4 years, the subprime severe delinquency rate could reach 5.78%, an increase of 38 basis points over 2019’s February rate. To put that into perspective, a basis point increase represents almost 1,500 more subprime loans falling into severe delinquency status, given the 14.6 million subprime loans outstanding. Therefore, the new peak this year would mean more than 55,000 additional subprime auto loans would be in severe default status compared to last year. In January 2009, we reached a peak volume of subprime auto loans in severe delinquency status of just shy of 700,000. This February will likely get close to 850,000.

Will lenders stop offering subprime loans and will that hurt auto sales?
We are not seeing lenders substantially curtail subprime auto loan originations. To compensate for higher risk, we are seeing a much higher spread on the rates for auto loans relative to market rates. For example, in December, the average new-vehicle subprime auto loan rate was 18.8%, which was a year-over-year increase of 240 basis points. Relative to the 10-Year U.S. Treasury, the spread for new subprime auto loans has increased by more than 360 basis points.

That rising risk premium is compensating lenders for increased risk. As long as lenders can be compensated for taking on risk, credit will be available, especially in what is otherwise a very low-yield financial market. We are likely to see lenders be more restrictive in some ways, like no longer lengthening terms, but the real challenge is just how high consumers can go with the rates before the payments no longer work.

In an economy with a 3.5% unemployment rate and high consumer confidence, there will be consumers seeking subprime auto loans. There’s also a cap on how high traditional consumer loan rates can get in many states that eventually could curtail subprime lending, as the risk premium theoretically needed may exceed allowed levels. In aggregate, we aren’t there yet.

The key perspective to keep in mind on auto loan rates is that even if Fed-controlled rates remain parked and lower than last year, many consumers are seeing higher, not lower, rates.

The Fed’s decision won’t alter the current trajectory for rates. Their view of the economy is also not likely to alter the market’s perception of risk in subprime. We expect the subprime delinquency rate to register new highs in January and February. As risk remains high, subprime rates will remain higher than they were a year ago.