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A warning this week from Fitch Ratings on a rise in delinquency rates on US subprime car loans has focused attention on a key area of finance that caters to people with low credit scores.

What is the subprime auto asset-backed securities (ABS) market?

Asset-backed securities are bond-like instruments backed by loans for homes, cars and credit cards. They help provide auto companies, banks and others with a means of funding their lending. That plays a crucial role in facilitating sales of new cars, bolstering broad economic activity.

The subprime auto ABS market grew to its largest ever size  last year. There was $27bn in new subprime issuance, compared with under $9bn in 2010 as US car sales boomed. It is catching up with prime auto ABS, which issued $42bn last year. So far in 2016 there has been $5.7bn in subprime auto ABS issued, up 13 per cent compared with the same period last year, according to Barclays.

Why has ABS issuance boomed?

More lending has come from independent, non-bank companies that are willing to extend credit to riskier borrowers. There is growing competition from more traditional lenders moving down the “credit spectrum”, putting further pressure on lending standards, according to rating agencies.

Some of the independent issuers are backed by private equity firms and rely heavily on securitisation, causing concern that their access to markets will decline as borrowing costs increase.

“The overall universe of subprime autos is deteriorating in terms of collateral performance,” says Brian Ford, an analyst at Barclays. “Anything with the name subprime in it kind of gives portfolio managers pause.”

How serious are the signs of stress within the sector?

The difference between a highly rated, prime issuer and subprime debt was 84 basis points in August 2014, according to research from Credit Suisse. That has now more than doubled to 182 basis points.

This reflects more underlying loans souring. In 2011, only 12 per cent of securitised loans went to high risk borrowers with FICO scores of 550 or lower, according to Barclays data. By 2015, that proportion had risen to 30 per cent.

Banks are also blaming stricter capital rules  that penalise them holding risky bonds on their balance sheet, pushing investors to demand higher yields as a “liquidity premium”.

“It is a big problem right now,” Thomas Pai, a director at Credit Suisse, told an ABS conference in Las Vegas earlier this month. “That will continue. It is a function of liquidity and the capital rules that were implemented.”

Could subprime woes trigger broader credit turmoil?

Regulatory scrutiny has also been building for months. In October, Thomas Curry, comptroller of the currency, a US regulatory body, warned of risks surrounding auto lending.

However, investors are stressing the importance of assessing each individual deal, and remain calm.

“While there has been a pick-up in delinquencies, in subprime it is not to the point where we are alarmed,” says Rick Figuly, a portfolio manager at JPMorgan Asset Management who invests in both prime and subprime auto ABS.

A number of more recent deals have seen increased “credit enhancement” offered to investors. This means that investors are more heavily protected from losses, counteracting risks from the declining quality of underlying collateral but reducing the already narrow margins earned by issuers.

S&P also points out that it currently has no subprime deals on watch to be downgraded. 

“It’d be very hard to imagine a scenario in which senior bondholders have any risk of loss,” says Mr Ford. “You can make an argument for some of the very junior pieces that there is a chance of loss, but investors knew that going in. Although delinquencies are going up, there is a higher level of credit protection.”

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