Big thanks to our partners in AMDS, especially Tanay Trivedi, who helped in putting this study together.

With unemployment at record lows and US consumer balance sheets strong, recent under-performance of some non-prime ABS deals has surprised market participants. Indeed, recent sell-side research reports note the conundrum of high delinquencies and defaults despite strong consumer fundamentals. Collaborating with our data science colleagues, we sought to analyze these trends and to identify future risks as well as investment opportunities. In conclusion, performance of 2022 vintage ABS deals should not have been surprising and stems from factors affecting credit scores in the pandemic, not simply the expected normalization of credit trends and inflation effects.

Looking specifically at non-prime auto loan asset-backed securities, delinquency and default rates for 2022 vintage deals are markedly worse than prior vintages. In an environment of low unemployment and one where lenders have reaffirmed that they have not been loosening underwriting standards, this has caught most by surprise.

Source: Intex. Aggregate auto loan ABS data as of 12/2022

We believe the deterioration in ABS payment trends is driven by a confluence of factors stemming from responses to the pandemic. First, an economy in lockdown meant fewer opportunities for consumers to spend, which translated into increased household savings. Second, transfer payments and tax credits from the US government approached $20,000 for a family of four with household earnings less than $75,000, which is consistent with a typical non-prime borrower. These factors, along with broad payment moratorium programs, drove sharp decreases in household debt levels and enhanced their ability to service existing debt.

Quantifying the impact of these positive factors on credit scores reveals that credit scores for the lowest cohorts – by income and credit score - increased disproportionately. This finding aligns with the fact that fiscal stimulus was targeted toward that cohort. The magnitude of the positive impact to lower credit score consumers’ credit scores was striking. In fact, the bulk of the overall increase in the national population’s credit scores occurred in this segment while the credit scores for the highest cohort of borrowers remained unchanged.

Source: Experian Ascend Data Services. VantageScore changes tracked over 10/2019-12/2022 period for fixed customer population

Credit scores are a valuable input to the underwriting decision-making process for most lenders. Increases in score are a positive indicator of creditworthiness. However, we believed that as the temporary factors – transfer payments, curtailed spending, and debt moratoriums - which led to these large score increases expired or abated, the credit improvement would fade as well. Recent Chase data also indicates that credit utilization is increasing rapidly as excess savings by lower-income households are depleted amid elevated inflation. These real-time trends indicate that the positive impacts are dissipating and pressures are mounting.

Source: Internal Chase customer data as of 12/2022.

Taken together, these dynamics help explain recent negative trends in 2022 ABS performance. Deals originated in 2022 represent loans originated when credit scores reached peak levels. As a result, the performance has been weaker than prior vintages, with the deterioration largest in cohorts of lower-income/credit scores, where the temporary positive impact was also largest. The outsized impact from the temporary pandemic factors lead to material improvements in consumer’s credit profiles. As a result, there was an underappreciation of risk in recent consumer loan originations, as temporary positive factors improved borrower’s profiles just as inflation and a reopening economy served to place unprecedented pressure on those same borrowers.

Source: Experian Ascend Data Services. As of 12/2022. VantageScore at time of origination used.

What has followed is credit performance deteriorating at a more rapid pace than market expectations, which has been difficult to explain in an environment where unemployment remains at record lows. Our findings suggest that some of the unprecedented dynamics from the last three years led to meaningful but temporary improvements in borrower’s credit profiles, which lead to unnoticed credit expansion just as macro pressures on lower-income consumers continued to mount. This resulted in 2022 vintage performance deteriorating more rapidly than market expectations. For existing ABS bonds, this means increased potential for negative ratings migration and spread widening as market awareness around this this dynamic increases. However, for new originations, this could represent a tailwind as originators tighten their underwriting and credit scores normalize while rating agencies demand increased credit enhancement, looking at 2022 performance in the rearview mirror.

09yc232102181248