Auto loans to customers with subprime credit ratings are often tempting for creditors because of the associated high interest rates.

The delinquency rate for subprime auto loans has risen to a rate worse than during the financial crisis.

Automakers are grappling with the losses of these customers.

Worst delinquency rates this century.

Auto loans to customers with subprime credit ratings – FICO scores below 620 – are risky affairs. But during good times and endless cheap money, the high interest rates that can be extracted from car buyers who think they have no other options are just too tempting. Now the losses are coming home to roost.

Big banks have become relatively conservative in this category and are sticklers for things like income verification and other details, which has made room for specialty lenders with fewer such compunctions.

There are scores of these smaller specialized subprime auto lenders, some of them backed by private equity firms. And three of them – Summit Financial Corp, Spring Tree Lending, and Pelican Auto Finance – have now collapsed into bankruptcy or were shut down. Allegations of fraud and misrepresentations swirling through the bankruptcy filings.

These lenders generally borrow from big banks to fund auto loans to subprime customers. The difference between the rates big banks charge those lenders and the rates those lenders obtain from their subprime customers (often in the double digits) is their margin.

These specialized lenders can also package their subprime auto loans into structured asset backed securities (ABS), which are then sold in slices to investors. Each slice is rated separately, with the highest rated slice of an issue often carrying an “AA” or even “AAA” rating. Issuers often retain the riskiest slices that take the first loss. That math works well – until it doesn’t.

And it doesn’t when customers, buckling under these double-digit interest rates and too much car, start defaulting in massive numbers. Subprime loans started to be a fiasco that we have been covering at least since February 2016. This has been a slow-motion wreck.

Fitch, which rates these auto-loan ABS, tracks the performance of the underlying subprime auto loans. The index of its 60+ day delinquency rate of subprime auto loans has now risen to 5.8%, up from 5.2% a year ago, and up from 3.8% in February 2014. It’s the highest rate since October 1996, higher even than during the Financial Crisis. Note the strong seasonality:

As bankers say: “Bad deals are made in good times.”

Given the losses in the sector over the past two years, specialized lenders started cutting back. This prevented many subprime customers from buying new vehicles, which was one of the primary reasons why new-vehicle sales in 2017 fell below the total of 2015. This is also why Fitch’s index of subprime auto loan Annualized Net Losses (ANL) peaked in late 2016 and early 2017 and has since backed off just a tad though it remains at financial crisis highs, at 9.8% in February:

And these losses have started to take down the smaller lenders.

Summit Financial Corp, a privately owned company that works with auto dealers in Florida, filed for Chapter 11 bankruptcy on March 23, after it “performed an extensive analysis of alternatives,” its attorney said in a statement. Summit blamed Hurricane Irma.

But Bank of America – which, as Summit’s largest secured creditor, is owed $77 million – alleged in the bankruptcy documents that Summit had repossessed many cars without writing down the bad loans, thus under-reporting the losses. “The move allowed the company to hide operating losses and borrow more money to fund loans, the bank said,” according Bloomberg.

Spring Tree Lending, an Atlanta-based specialized subprime auto lender, is being pushed into bankruptcy by a creditor who filed to force the company into involuntary bankruptcy on March 28. Fraud allegations are swirling.

Pelican Auto Finance, which specialized in “deep subprime” auto loans shut down last month, after private equity firm Flexpoint Ford LLC, decided to cease funding it. “There’s been intense competition. The margins just aren’t there,” Pelican CEO Troy Cavallaro told Bloomberg.

Other PE firms that have together plowed about $3 billion into the subprime auto loan bonanza, based on data cited by Bloomberg, are now licking their wounds, unable to get out. They include:

Perella Weinberg Partners. It acquired Flagship Credit Acceptance in 2010. Flagship then embarked on an aggressive path, and its loan balance surged from $89 million in 2011 to $3 billion in 2017. Then the loans started to curdle. The company is now bleeding. The hopes of an IPO, disclosed in 2015, have fizzled. For now, Perella Weinberg is stuck with a money-losing operation.

Blackstone Group acquired a majority stake in Exeter Finance in 2011, which does business with dealers across the US. Since then, there have been three CEOs. In 2016, the company rebranded itself. Blackstone has put $472 million into it to fund the aggressive expansion. And now the exit doors appear to be closed.

The subprime auto lending business is highly cyclical. For example, according to Bloomberg, citing Moody’s data, 41 subprime lenders filed for bankruptcy during the subprime auto loan bust between 1997 and 1999.

But unlike subprime home mortgages, subprime auto loans won’t take down the financial system. About 25% of the auto loans written are subprime. For new cars, it’s about 20%. Of the $1.11 trillion in total auto loans outstanding at the end of 2017, about $280 billion were subprime – less than a quarter of the $1.3 trillion subprime mortgages before the financial crisis. Even if the total subprime portfolio produced a net loss of 50%, the losses would amount to only about $140 billion.

And there are other differences: Vehicles are quickly repossessed, usually after three months of missed payments. Even in bad times, there is a liquid market for the collateral at auctions around the country, and vehicles can be shipped to auctions with the greatest demand. The results are that lenders don’t end up holding these vehicles and loans on their balance sheet for years, as mortgage lenders did with defaulted home mortgages and homes.

But subprime will take down many more of the specialized lenders. And the survivors will tighten lending standards. This will prevent more car buyers from buying a new vehicles. Many of them will be switched to older used vehicles. Or they hang on to what they have.

So automakers get to grapple with the loss of these customers. When you lose a significant portion of your customers due to credit problems, it hurts. And this is where it adds to “Carmageddon.” Investors and creditors, including PE firms, get to grapple with losses and bankruptcies. But given the limited magnitude of subprime auto loans, and the limited impact on the banks, the Fed will brush it off and continue its monetary tightening, and no one will get bailed out.