As car sales soften and values on failed car loans fall, the possibility of a blowup in subprime auto loans looms

It’s starting to look like déjà vu all over again—except this time it isn’t cratering mortgage securities, but rather faulty car loans that are in the spotlight.

Moody’s Investors Service recently found Santander Consumer USA Holdings, one of the biggest subprime auto lenders, verified income on just 8% of loans that it bundled into a $1 billion securitization. Earlier this year, Santander settled a joint investigation by two U.S. states over allegations it made loans to borrowers it knew couldn’t afford them. Santander didn’t return calls for comment.

The securitized auto-loan market, at $1.1 trillion, is a fraction of the size of the mortgage market, and subprime auto lending is 16% of the overall auto-loan market. Recently, there have been disturbing auto-industry trends, including declines in April year-over-year sales of 3.7% in the U.S., 6.8% in Europe, and 1.8% in China, according to Michael Belkin, publisher of the Belkin Report, an asset-allocation newsletter. That has occurred while inventory and production remain high. As a result of softening sales, shares of United States Steel, a key supplier to the auto industry, are down more than 50% from their recent peak in February, he notes.

“Car values on loans that fail are coming in way below what [finance companies] thought they used to be,” says Belkin. He cites an inventory glut and a rise in cars coming off leases. Santander itself has fallen 24% from its peak in February, to a recent $11.40. “Subprime [auto loans] will blow up,” he says, and it will be “bad for the junk-bond market and for financials.”