Subprime is a goldmine of profits–until it isn’t.
Written by Wolf Richter of Wolf Street.
Subprime is in trouble again after it managed to come out of the crisis during the free money pandemic when people used some of their arrears to recover their arrears.
In the auto industry, subprime is primarily limited to older, used cars. Less than 5% of his new car sales are financed by loans or leases to subprime-rated customers (more on that later). The sweet spot is vehicles that are 8 to 12 years old, which is only a small part of the used car business. But on the other hand, several subprime-only dealer chains owned by PE firms have already filed for bankruptcy this year, and we’ve highlighted a few of them here. Others are struggling too.
Yesterday, it was the turn of Carmart, an American subprime used car sales chain, to make a confession in its quarterly results. [CRMT] It’s down 21% between yesterday and today. It is down 61% from its free money peak in August 2021. What drove the stock price lower yesterday and today was the revelation of a significant spike in charge-offs and loan losses (graph via) Y chart):
Carmart has 154 stores in small cities throughout the south central United States. It sold more than 15,000 used cars in the quarter, generating $362 million in revenue, including $59 million in interest income from high-interest loans that subprime customers use to finance expensive car purchases.
Subprime is a goldmine of profits–until it isn’t.
Carmart is a good example. But they all work on similar principles. Subprime-rated customers are a source of profit for subprime specialty car dealers. Because these customers have few other options left. They tried other dealers, were turned down because of bad credit, and found one that offered them a loan. No problem after that.
These specialized dealers earn huge profits on each sale in a variety of ways, including:
- Sell vehicles at exorbitant prices and profit margins
- charge dizzying interest rates on loans
- Sales of insurance and warranties. Usually provided by your own affiliate company.
- Billing for late fees
- Repayment after a loan is securitized and sold to investors.
Huge gross profit per unit sold. Car-Mart reported an average gross profit of $6,835 per vehicle sold with an average sales price of $19,035. So the gross margin per unit is about 35%.
Dizzying interest rates. Regarding the auto industry as a whole, Experian’s data shows how high interest rates were on “subprime” auto loans (FICO scores of 501-600) and “deep subprime” loans (300-500). This table compares Q3 2023 and Q3 2022. Notice the rate increase.
| Average Interest Rates by FICO Score per Experian | ||
| Q3 2023 | Q3 2022 | |
| deep subprime | 21.2% | 20.2% |
| subprime | 18.4% | 16.8% |
| close to prime | 13.5% | 11.3% |
| Prime | 9.3% | 7.0% |
| super prime | 7.4% | 5.0% |
Carmart provides these loans through its finance subsidiary, Colonial Auto Finance, and had interest income of $59 million in the quarter, up from $48 million in the year-ago period.
So let’s estimate the average interest rate based on the sparse numbers provided by Carmart. Carmart had $1.1 billion in financial receivables at the end of the quarter. So, very roughly speaking, quarterly interest income of $59 million ($236 million per year) equates to an average annual interest rate of 21%.
Average monthly collections per customer for principal, interest, and late fees increased to $533. In other words, these customers are paying a monthly fee for an older used car.
However, only about 80% of outstanding loans remain “currently”, about the same as a year ago, and 20% are in arrears.
What makes this business even more dangerous is that dealers sell very expensive cars at exorbitant interest rates to people who can’t afford them. It’s like a self-fulfilling prophecy. Because the citizens have a history of defaulting, they pose a big risk to lenders, and many lenders will not lend to them. The lender that actually lends you the loan compensates for the risk by charging extra fees, which inflates your monthly payments and further increases your risk.
In this case, the dealer-financer charges extra for the vehicle and finances it at a very high interest rate, making payments on these older cars very high and increasing the chance of default. And you know what happens.
Risk is back to roost.
Carmart announced a pretax loss of $35.6 million in its quarterly report. For comparison, the company’s pre-tax profit a year ago was $4.1 million.
The reason was a significant increase in the allowance for doubtful accounts. Due to the nature of subprime business, credit losses are always large. And the big benefits discussed above usually more than compensate for them.
However, the allowance for credit losses for the quarter increased 52% year over year to $135 million (versus $89 million in the prior year period).
Net charge-offs rose to 7.2% of average finance receivables in the quarter, up from 5.8% in the year-ago period.
But wait…we’re back to pre-pandemic normal. Net charge-offs of 7.2% were in line with pre-pandemic rates. The company said its pre-pandemic net charge-off rate averaged 7.0% over the five-year period, “indicating a return to pre-pandemic net charge-off rates.”
But wait again.. Not just a return to pre-pandemic normal. The company stated:
“Loss frequency and severity both drove the increase, with approximately two-thirds of the increase primarily due to external circumstances and frequency.
“The severity was driven by longer contract terms and lower recoveries.
“From 2021 to 2022, both frequency and severity increased. [loan] Pool too. ”
A little slow to tighten. Carmart is doing what other companies in the subprime business are doing. In other words, underwriting has been strengthened by increasing down payments (the average down payment in the same quarter was only 4.9%) and shortening the period (the average period was 44.1 months).
Subprime depends on auto loan securitization.
For subprime specialty dealers, it all comes down to whether they can securitize these loans and sell asset-backed securities to investors, avoiding some of the risk. Dealers sell cars, make a lot of money on those sales, and, as Car-Mart showed, offer loans at very high interest rates. They then aggregate those loans into large loan pools, securitize those loan pools once or twice a year, and sell the resulting ABS to investors.
The 60-day delinquency rate for Fitch-rated ABS subprime loans exceeded its pre-pandemic high in August 2019 and rose to a record high of 6.1% in September. In October, it fell to just 6.0%. %. The October dip is seasonal.
However, note that prime rated loans are in pristine condition (green line).
In the era of interest rate restraints, yield-seeking investors preferred ABS backed by subprime auto loans, but that’s no longer the case. And the fabric will start to fray.
A number of ABS deals backed by subprime auto loans have been scrapped in recent days as ABS investors have suffered losses and become cautious, leaving dealers stuck with those loans. Other deals had to be renegotiated before being sold.
If these deals can’t be sold, the dealer could be left with a loan and short on funds. As mentioned earlier, several subprime dealer chains filed for bankruptcy this year.
As a result, credit in the subprime market is tightening. But how big is it?
4.3% of new car sales:According to Experian, 21% of all customers paid with cash in the third quarter. Experian uses credit data collected from lenders and registrations (liens). Of the remaining 79% of customers financed with leases or loans, 5.4% are rated subprime, representing his 4.3% of all new car sales.
7.7% of used car sales. In the third quarter, 63% of customers paid for used cars in cash. Of the remaining 37% of loans made, 20.7% were to customers with subprime credit ratings, which corresponded to his 7.7% of total used car sales.
In other words, subprime is a high-risk, high-profit business on the special fringes of car sales. But companies involved in a small portion of car sales have been hit hard. The risks they took were too great, they became too greedy in the 0% era, and now they are saddled with the consequences of loading up customers with ridiculously expensive cars financed at high interest rates. Risk is back to roost.
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