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Right now, the auto market’s showing signs of serious stress. After two years -- from 2020 to 2022 -- of short supplies, excess savings, and easy money, the vehicle market boomed. But now, the opposite’s happening. Growth is slowing, savings are near exhausted, banks are tightening credit, and car prices are declining. Many consumers are now falling behind on their auto loans.

A combination of deeper negative equity, anemic real wages, inflation, and higher interest costs are breaking consumers down. Thus the auto loan market is inching ever closer to a tipping point. And like we learned from Ludwig Von Mises, every credit fueled boom will eventually bust. Let me explain.

Auto Loan Defaults are on the Rise – But Especially for Younger and Subprime Borrowers

So, it’s no surprise how we got here. After two years of both Federal Reserve (monetary) and U.S. Treasury (fiscal) stimulus, credit creation exploded. And quite a bit of it flowed into the auto sector. According to the recent New York Fed data, there’s now over $1.55 trillion of U.S. auto loans outstanding as of Q4 2022.

And while it’s true that auto debt’s grown rapidly over the last decade – it’s really accelerated post-COVID-19. For perspective, since Q1 2020, this number has increased over $215 billion as Americans took out significantly more debt to buy vehicles. And most of this aggressive auto borrowing came from the younger generations.

According to the World Economic Forum – between Q2 2020 and Q4 2022 – Gen Z (18-29 years of age) led the pack with a 31% increase in car loans. And the Millennials (30-39) saw a 29% increase. Of course the younger generations are more likely to buy vehicles than the older generations. But these numbers are still very high.

Now the problem is that consumers – especially these younger generations – are falling behind on their auto loans at a very fast rate. The amount of auto loans transitioning into ‘serious delinquency’ (90+ days overdue) over the last year has risen sharply for borrowers under 59 years of age.

But the younger borrowers’ delinquency rates are what’s really troubling, with Gen Z now at 4.3% (back above pre-COVID-19 levels) and Millennials at 2.9% (also back at pre-COVID-19 levels).

Making matters worse, a recent report from Cox Automotive found that roughly 2% of all auto loans in January were ‘severely delinquent’ (at least 60 days behind payment) – the highest level since 2006. That’s a 20.4% increase year-over-year. And most worrisome is that severely delinquent auto loans from those labeled subprime (those with weaker credit histories) were 7.30% – also the highest since 2006.

While Cox Automotive notes that the high level of severe delinquencies hasn’t caused an equivalent growth in auto loan defaults yet – they are rising. Auto loan defaults increased 6.2% month-over-month (December 2022 to January 2023) and were up 33.5% from a year ago.

Thus with a mountain of auto debt and increasingly large auto payments on the back of higher interest rates and costs, consumers are growing increasingly fragile. For instance, roughly 16% of consumers who financed a new car in Q4 2022 have monthly payments reaching $1,000 per month – which is an 11% cost year-over-year.

This is more than double the amount of consumers that were paying this much just two years before (only 6.7% in Q4 2020). To put this into perspective, the median U.S. household income (pre-tax) is roughly $70,000. So a $1,000-a-month car payment is over 17% of household income.

This is a very large amount when looking at the over-burdened U.S. consumer, and it isn’t sustainable. But unfortunately, this trend isn’t going away. . .

Auto Owners are Seeing a Surge in Negative Equity as Debts Overwhelm Car Values

Another ugly trend in the auto market is the build-up of negative equity – a.k.a. being ‘underwater.’ For example, negative equity is when the amount owed on a vehicle exceeds the value of the vehicle. So if a person owes $20,000 on an auto loan but the vehicle is only worth $12,000, then they’re sitting on $8,000 in negative equity.

And, according to Bloomberg, we’ve seen a surge in average negative equity on vehicle trade-ins over the last year - soaring from $4,100 in December 2021 to over $5,500 in December 2022. That’s a 26% increase in negative equity, a startling rise.

See, having negative equity is a fragile position for a borrower. For starters, when the value of the vehicle drops relative to its debt balance, it doesn’t allow individuals to refinance. And it also can lower a consumer’s credit score, making it difficult to access credit altogether (therefore amplifying the problem).

Making matters worse, even though trade-in values for cars have cooled over the last year (pushing negative equity deeper), individuals are still paying very high prices for used vehicles (up over 30% since 2020). Thus many are stuck rolling old auto loans into a new one and even a third, as though they’re playing hot potato with ever higher debt burdens.

Some loans are now stretching 84 months (seven years) to service all this. Historically speaking, this is the biggest issue that plagues a financial system – when asset prices begin falling as debt burdens actually increase (from compounding interest).

Underwater consumers generally lead to deleveraging (selling assets or cutting back consumption to pay their debts). This then may lead to debt-deflation – a vicious amplifying feedback loop between distressed selling to repay debts and further deflation. Thus rippling throughout the entire economic system.

While it’s true that cars are a depreciating asset – hence the term “you lose 10% the moment you drive it off the lot” – deepening negative equity at a time when interest rates are higher is an issue.

Meanwhile, banks have already started tightening credit in the auto loan market, thus making it more difficult for individuals to access favorable loans. And this is especially so for the subprime borrowers.

Banks are Tightening Auto Loan Standards at a Rapid Pace – Cutting Off Credit

A couple of months back, I wrote an article highlighting how U.S. banks were tightening credit standards at dramatic rates. Whether it was credit cards, small-to-large business loans, or auto loans, banks were cutting back credit all over as interest rates rose and economic growth slowed. And things have only gotten tighter since then.

To put this into perspective, the net percentage of domestic banks tightening standards for auto loans in Q1 2023 is 17.3% (up from 2% in Q4 2022). Keep in mind that this was data before Silicon Valley Bank blew up, which most likely led to even further credit tightening by banks.

This essentially means these banks are not going to lend as freely – or that they’ll do so at much higher costs. In fact, some lenders are leaving the auto loan market altogether.

For instance, back in January, U.S. lender Citizens Financial Group (CFG) announced that they had cut back on auto lending over the last few months. They also plan to further reduce their auto loan exposure. Meanwhile, Capital One Financial (COF) also announced plans to curtail their auto loan business.

This is very important. Why? Because the U.S. auto industry is completely dependent on relatively easy credit, thus further tightening and a lack of lenders will only amplify further downside.

In Summary

Consumers are feeling the pressure of declining used vehicle prices, tighter credit (higher borrowing costs), and depleted savings. This trend is leading to a wave of defaults and increased negative equity, creating a feedback loop at the margin.

Subprime auto loans are most at risk as delinquency rates continue upwards, and it doesn’t appear this will reverse anytime soon. Households are paying an excessive amount in auto payments and are stuck rolling over into ever higher new auto loans.

Something has to give. Either car sales (and thus prices) must fall tremendously to alleviate pressure, or easy credit must begin flowing en masse. And I believe it’s the former that will happen as marginal buyers are squeezed and banks tighten credit further.

It’s hard to see any upside from here in the auto loan market. And once defaults begin ramping up (which I expect will happen), things will only amplify from there. Remember, history shows us that when things start their descent into collapse, the subprime market is the first to get hit.

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