The Subprime Credit Cycle
In an interview last year with ValueWalk, I mentioned a description of the subprime auto credit cycle which I will repeat here. The cycle can be broken down into 4 sequential phases. Because this is a repeating cycle, we can begin at any point on it:
High Profitability: With tight access to capital and few competitors, lenders are able to negotiate favorable terms with borrowers. Return on assets is high, financial leverage is lower, and lenders are able to get high net yields and high profitability.
Expanding leverage: Due to the wonderful reports that are coming out of the lenders in the sector, new entrants begin to enter the market. Capital markets are willing to lend more money at more favorable terms. Increased competition causes ROA to fall as borrowers have more options to choose from. Lenders begin to lever up their capital structure in order to boost ROE.
Low profitability: Intense competition forces lenders into a choice of surrendering market share or decreasing lending standards. Loans are given at lower rates. Leverage is increased even more to maintain ROE. Fraud and mismanagement increase throughout the sector.
Decreasing leverage: Decreased standards from the prior phase will cause defaults to dramatically increase. Loan yields fall below profitable levels. The deteriorating loan performance of the industry causes capital markets to tighten. This deterioration will often happen at the same time as an overall economic recession which causes capital markets to be tight across the economy in general. Lenders are forced to exit the subprime auto market as they find their business unprofitable and/or access to capital markets absent. Some lenders go into bankruptcy. The tightening clears away all lenders with poor underwriting or too much leverage.
