The financial damage in the current cycle has largely already occurred but remains latent. The wave of visible distress is still to come, as it will only surface when borrowers finally exhaust their cash reserves used to subsidize underperforming properties, leading to defaults and forced liquidations.

Years of low interest rates encouraged risk-taking, resulting in a large pool of low-rated loans (B3/B-). Now, sustained higher rates are stressing these weak capital structures, creating a boom in distressed debt opportunities even as the broader economy performs well.

The gridlock in the American housing market is driven significantly by a psychological factor: homeowners' unwillingness to sell at a loss. This 'loss aversion' keeps prices artificially high while causing the volume of sales to plummet to a three-decade low, a trend often overlooked in standard economic analysis.

Tom cites Reuters and Unusual Whales: the $1.7 trillion auto-loan market has one in five Americans behind on at least one loan, the highest since 2010, and the average car is nearly 13 years old. When real wages do not beat inflation, people borrow until the bill comes due.

Rising delinquencies in subprime auto are not a sign of a uniformly weak consumer. The underperformance is largely confined to loans originated from 2022-2024, which were impacted by a unique combination of inflated used car prices and sharply higher interest rates, leading to strategic defaults.

Despite a rise in auto loan delinquencies, default rates have remained low. This is because high used vehicle values ensure that the collateral securing the loan retains significant worth. Lenders face lower potential losses on repossessions, making the asset class attractive despite shakier payment performance.

Investing in non-performing residential loans provides a counter-cyclical opportunity, as the deal flow increases with rising delinquencies. This specialized strategy requires a dedicated operational arm—a special servicer—to restructure mortgages, creating a high barrier to entry and a competitive advantage.

An alternative data point from Equifax reveals significant economic stress. The delinquency rate for subprime auto loans (borrowers with scores below 660) has reached 10%, a level higher than that observed during the 2008-2009 global financial crisis, signaling trouble for lower-income households.

In a highly concerning paradox, delinquency rates for subprime auto loans are now higher than they were during the 2008 financial crisis when unemployment was 10%. This signals extreme stress among lower-income consumers even in a strong labor market.