On the Convergence of Credit Risk in Current Consumer Automobile Loans

Abstract

Risk-based pricing of loans is well-accepted. Left unstudied, however, is the conditional credit risk of a loan that remains current. Using large-sample statistics and asset-level consumer automobile asset-backed security data, we find that default risk conditional on survival converges for borrowers in disparate credit risk bands well before scheduled termination, a phenomenon we call credit risk convergence. We then use actuarial techniques to derive the conditional market-implied credit spread by credit risk band to estimate current deep subprime and subprime borrowers eventually overpay by annual percentage rates of 285-1,391 basis points. Our results are robust to various sensitivity tests.

Keywords: Adjustable premium loans, asset-level disclosures, competing risks, Coronavirus, COVID-19, economic inequality, financial literacy, market inefficiency, Reg AB II

JEL Classification: C58, D11, D12, D18, D53, G14, G32, G53, P46