In April of 2018, some investors awoke to an unpleasant reality and risk to the financial market’s stability – then apparently quickly forgot about it. Three specialized subprime auto lenders filed for bankruptcy or were shut down, and the allegations of fraud were enough to comfort people that it was an isolated issue, and not a systemic problem.
But, here’s the thing: subprime loans have such high-interest rates that they just too tempting for certain lenders. Banks steer clear of them, not wanting to get burned by another round of subprime problems, and are adamant about income verification for potential vehicle buyers. Specialist lenders are not so picky.
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They also finance used cars. In fact, that’s their bread and butter; and a business model based on the trustworthiness of used car salesmen is… well, skating on thin ice, to say the least.
The broader market
Now, if a shaky business goes bankrupt, no biggie, right? Well, these specialist lenders borrow money from banks to finance their lending – often lending it out at double-digit interest rates, and pocketing the difference. Not a bad profit margin, assuming everyone pays – but if they don’t, and the specialist broker goes bankrupt, who’s going to pay the loan back to the bank?
But, wait, there’s more! The specialists will also package their subprime loans into structured asset-backed securities (ABS) and sell to third-party investors. These then get rated as … oh, you already guessed at AAA+. Yep.
OK, before you get too overwhelmed with deja vu, let’s look at a relative positive side. Auto loans in the US account for $1.22T in debt, which is a lot; but not on the same level as mortgage debt which is just under $10T, or about the level it was at the start of the subprime crisis. So, it’s not such a large scale. On the other hand, it’s not as transparent or regulated. And while houses largely keep their value over time, cars depreciate with use. Should a borrower fail to pay, the house can’t drive away.
Delinquencies
Another factor that brought this issue to the attention of the press in April and was subsequently forgotten is that at the time, the delinquency rate for subprime-auto loans peaked above where it was during the financial crisis – and then dropped back swiftly in the next couple of months. Whew, not a problem.
Except subprime auto delinquencies are seasonal; bottoming out in May and peaking in February or March. Since 2013 each peak has been higher than the year before. And the delinquency rate has been creeping up again ever since May. The last peak was at 5.74% and then bottomed out at 4.08%, with the latest figure from October back up to 5.47%. So, don’t be surprised in April of 2019 when the press gets into panic mode over auto loans, again.
The trends
Along with the creeping delinquency rates, there is also the continual increase not only the total amount of debt, but the number of loans issued. At the end of 2017, there were 109M loans, a 25% increase over 2010.
While mainstream analysts focus on new car loans, because that information is easier to track and is more relevant to auto-makers, from a financial risk aspect, the loans on used cars are more dangerous to the market. And it’s frustratingly hard to get reliable information on how much exposure there is.
Furthermore, as the Fed increases interest rates, it makes the cost of capital necessary to finance risky loans more expensive, pushing up rates for subprime borrowers as well.
The underlying concern is that as wages grow, and unemployment drops, borrowers should be moving out of subprime status and delinquency rates should be going down. But they are not; they are going up.
This incongruence is a matter of concern. The absence of a specific crisis to explain why people are progressively less and less able to pay back their loans is indicative of an underlying issue that isn’t properly understood; for example, that lenders are expanding their potential customer base to people who are less able to borrow in order to chase high-interest rates.
Now throw that into the mix of concerns in the auto market that already includes the impact of the trade war, rising costs from emissions standards, and a drop in consumer demand.
