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This is the next subprime fear worrying investors

While the global economy may still be dealing with the after-effects of the financial crisis of 2008, the latest subprime fear in the auto industry has already started to worry investors.

In a note last week, UBS analysts Matthew Mish and Stephen Caprio said the latest subprime auto default data has been more than raising eyebrows in financial circles and the wider economy. While many analysts have been trying to explain subprime default rates for recent vintages that have reached levels just prior to the financial crisis of 2008, a number of U.S. banks have predicted consumers and auto delinquencies to rise further in 2017.

Another report from Morgan Stanley recently described a third of the risky loans bundled into bonds as "deep subprime". The report said that this level has spiked since 2010 and is now slowly translating to higher delinquencies on loans. And the securitization market has become more heavily weighted towards issuers that would consider deep subprime.

"The percentage of subprime auto-loan securitizations considered deep subprime has risen to 32.5 percent from 5.1 percent since 2010," Morgan Stanley said. "Auto loan fundamental performance, especially within ABS pools, continues to deteriorate."

Robotic arms work on the bodyshells of Mini cars as they pass along a section of automated production line at the BMW Mini car production plant in Oxford, west of London.
Geoff Caddick | AFP | Getty Images
Robotic arms work on the bodyshells of Mini cars as they pass along a section of automated production line at the BMW Mini car production plant in Oxford, west of London.

Why are these auto subprime defaults happening?

UBS explains that the root causes of the rise in delinquency rates can be traced back to rising U.S. consumer income inequality and aggressive easing in lending conditions, primarily from non-bank lenders. "Central bank reflation efforts have been more successful at fuelling wealth creation for a subset of the consumer and less effective in stimulating broader income growth," according to UBS.WHowever, the global automotive wing of London-based Evercore ISI research thinks the auto lending is not the next subprime bubble.

"Third parties have flagged that auto delinquencies are at or close to record levels," Evercore ISI's George Galliers, Arndt Ellinghorst and Chris McNally wrote in a research paper. "Similarly, outsiders have noted an uptick in credit losses. However, it needs to be recognized that delinquencies are high in absolute terms because lending is at an elevated level. Delinquency rates do not look concerning and, in fact, remain at very low levels."

But data from TransUnion points out that subprime auto lending balances total $179 billion, which is 16 percent of all auto loans outstanding. UBS estimates subprime consumer debt outstanding is $1.25 trillion – comprised primarily of mortgage, student and auto loans. This is down from 2009 peak levels of $1.9 trillion.

Are autos a robust asset class?

"We continue to believe that auto as an asset class is extremely robust. Not only are contracts underwritten in the knowledge that the asset's value will depreciate but also vehicles are easy to repossess and have an intrinsic tangible value," according to the Evercore ISI research. The note further explains that consumers tend to keep up payments and in the event that they do not, recovery can be made.

Cars for sale at a motor dealer in Bristol in the U.K.
Matt Cardy | Stringer | Getty Images
Cars for sale at a motor dealer in Bristol in the U.K.

"Even in the depths of the financial crisis in extremely stressed end markets such as Spain, auto collateral held up well and losses were contained."

But a number of analysts and reports from various banks and research firms have pointed to the overall credit quality of borrowers not keeping pace with the improvement in the economy. UBS carried out research that found 38 percent of U.S. consumers do not generate positive cash flow and 25 percent-30 percent of U.S. consumers have not seen improving consumer finances.

"As of Q4'16, 18 percent of US consumers indicated they were likely to default on one loan payment over the next 12 months vs. 13 percent in Q3'16. This cohort of at-risk consumers reported being about 4x as likely to embark on a major durable goods purchase (e.g. house, car) in the next year."

While the growing number of defaults poses a risk to the overall economy, analysts still do not believe it implies a pending economic downturn. However, it is a data-point that investors should not overlook.

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