Subprime lending is facing a worrisome rise in mortgage and auto loan delinquency rates.  Consumer behavior, economic conditions, and policy decisions each play a role in the overall state of the subprime asset class.  The question now is whether the recent rise in delinquency rates is a harbinger of an economic shift echoing past downturns.

Mortgage Trends in Focus

The core concern arises from the fact that the subprime mortgage sector has long stood as a bellwether for the broader economy, and the recent rise in delinquency rates signals growing distress among borrowers that have recently been stable.

Early indicators suggest a marked increase in delinquencies vs. 2019 or 2020. According to TransUnion forecasts, the 60-day-plus delinquency rate is expected to rise to 1.4% by the end of 2023. The delinquency rate for mortgage loans on one-to-four-unit residential properties increased to a seasonally adjusted rate of 3.62% at the end of Q3 2023. This rise in delinquencies is notable in that current delinquency rates are similar to those observed in 2008, just before they shot up in 2009 at the peak of the crisis.

The resulting strain is evident in the shifting composition of mortgage originations, where subprime borrowers now find themselves increasingly marginalized.

 Rising Rates, Shifting Market

The increase in interest rates, while curtailing inflationary pressures, has intensified the challenges for subprime borrowers, pushing them further to the periphery of the housing market.

Particularly concerning is that even a modest rate hike can tilt the scales, and the impact on those subprime borrowers is disproportionately severe. The consequence is a shift in the borrower profile, with lower subprime borrower participation, as economic pressures intensify on this important segment of potential homeowners.

In contrast to past economic conditions, it is evident that the current scenario is unlike previous periods of economic instability, where interest rate fluctuations were often a reaction to diverse economic factors.  The current rise is predominantly a response to inflationary pressures coupled with a post-pandemic economic and housing supply and demand recalibration. The result is a housing market grappling with limited supply and higher interest rates, both of which resonate deeply through the fabric of the subprime mortgage sector.

 Delinquencies: A Closer Look

The Mortgage Bankers Association (MBA) reports a Q3 delinquency rate of 3.62% for mortgage loans on one-to-four-unit residential properties. This is up both from the previous quarter and the same period in 2022.

Recent signs of weakness in the labor market, with the increase in the October unemployment rate to 3.9% (the highest since January 2022), is expected to exacerbate mortgage delinquencies, particularly among Federal Housing Administration borrowers. The FHA delinquency rate has risen 55 basis points to 9.50%, while the VA delinquency rate increased to 3.76.

In contrast, the seriously delinquent rate, which includes loans 90 days or more past due or in foreclosure, was at 1.52%, the lowest since 1984. This decrease across conventional, FHA, and VA loans suggests a complex market condition where early-stage delinquencies are increasing while long-term distress shows signs of easing.

The rise in early-stage delinquencies and the decline in serious delinquencies, combined with the broader economic conditions and labor market changes, outline a multifaceted scenario in the subprime mortgage market.

Auto Loans Under Scrutiny

In 2023, the subprime auto loan market has also been significantly impacted by the Federal Reserve’s interest rate hikes. Cox Automotive reported, jointly with Moody’s Analytics, that auto loan rates surged to 10.5% for new vehicles in September.

This increase has particularly affected the subprime and deep subprime segments, traditionally avenues for vehicle ownership for those with lower credit scores.  According to Cox Automotive, in 2018, subprime buyers made up more than 14% of new vehicle sales, and deep subprime buyers were close to 10% of the market. However, as of May 2023, with rising rates, subprime buyers accounted for roughly 6% of new vehicle sales, while deep subprime buyers constituted less than 2%. This trend suggests a growing exclusion of this segment of buyers from the market, as higher rates and stricter lending criteria create new barriers.

The delinquency rates for subprime auto loans underscore the growing stress in the sector. S&P Global Ratings notes that in April 2023, the 60-plus-day delinquency rate for subprime auto loans reached 4.84%, an increase vs the 4.63% in the prior month and significantly higher than the pre-pandemic level of 4.33% in April 2019. Fitch Ratings reported that the percentage of subprime auto borrowers at least 60 days past due on their loans reached 6.11% in September 2023, the highest level since 1994.

Changing Policies, Market Reactions

The subprime lending sphere is significantly influenced by economic policies, particularly the Federal Reserve’s rate hikes in response to inflation. These measures have constricted credit availability, impacting subprime borrowers in the mortgage and auto loan markets.

This period contrasts with the more accommodative monetary stance during 2019 and 2020. At the time, lower interest rates facilitated easier access to credit, including for subprime markets.

The Federal Reserve’s recent tightening cycle, which increased the federal funds rate by 5.25 percentage points from March 2022 to July 2023, led to a substantial increase in the two-year Treasury yield and tighter financial conditions. This tightening cycle is essential in understanding the impact on credit availability and the consequent rise in delinquency rates.

In response, institutional investors are similarly adjusting their risk tolerance and investment parameters in subprime loans. The recent increase in delinquency rates is causing concern about the sector’s financial stability.   Some investors are seeking higher yields to offset these perceived risks, while others are sharply reducing their overall exposure.

Subprime Markets: Future Path

The road ahead is fraught with uncertainties in an environment marked by stringent credit conditions, especially for subprime borrowers. Looking forward, the resilience and adaptability of the subprime lending markets, coupled with the strategic actions of stakeholders, will chart the course for these sectors.

Will innovative lending practices emerge to offer relief to subprime borrowers? Can policy adjustments unlock new opportunities? Or will ongoing economic challenges continue to cast long shadows?  These questions loom large, underscoring the subprime lending markets’ role as a critical barometer for both the broader economy and the longstanding debate regarding financial inclusion vs exclusion.