The Next Subprime Crisis Has Already Started

January 20th, 2015
in Op Ed

Special Report from Money Morning

by Shah Gilani, Money Morning

Reading about what's going on in the subprime auto lending space is a lot like reading about drive-by shootings.

Unless you're a subprime borrower, or live in a neighborhood where drive-bys are happening, you probably don't know much about either or think they affect you.

Follow up:

But if you listen closely there's muffled financial "gunfire" already in your neighborhood.

And it's much closer to your doorstep than you think.

Here's what you need to know...

Yield Chasers Have Found a New Target

Subprime auto borrowers are getting killed by dealerships, their financing agents, and banks putting them on the financial frontline for default.

Even if not everyone is a subprime auto borrower the trend is rippling out into the U.S. economy.

New and used auto dealerships and their finance arms, manufactured lending partnerships, banks, private equity companies, insurance companies, mutual funds (and the usual cadre of lap-dog lobbyists and paid-for legislators) are doing to subprime auto borrowers what coddled mortgage lenders did to subprime housing borrowers.

They are teeing them up for a long drive down a dead-end road.

The game at both ends and in the middle is just the same. So are a lot of the players.

On the output end are the investors. Fixed income investors from mutual funds and insurance companies to mom and pop investors are once again desperate for yield.

When the Federal Reserve kept interest rates low through the 2000s, fixed income investors reached for yield further and further out on the risk spectrum. On the very end of the yield tree's flimsiest limbs, subprime mortgages and mortgage-backed securities blossomed. And investors picked them off like the low hanging fruit they appeared to be.

We know what happened next.

Ever since 2008's credit crisis and the Great Recession, the Fed's zero interest rate policies made it even harder for savers and bond investors to earn any interest.

So, with the mortgage tree cut down, the usual-suspect financial intermediaries cultivated the next best species of fruit-bearing trees: auto loans.

As financial intermediaries, banks make a lot of auto loans, but not as many as financing arms of auto manufacturers. And because auto loans are so profitable, lending partnerships and private equity companies and other "investors" eagerly provide abundant pools of money to borrowers in need of financing new and used cars

It's really these "intermediaries" that keep the wheels of the auto industry turning.

How fast are those wheels turning? Because of abundant financing and low interest rates, new light-vehicles sales in 2014 totaled over 16.5 million units. That's up 5.6% from 2013 and the highest new vehicle sales level since 2006.

According to, loans to prime borrowers on new vehicles average 2.75% on six-year term loans.

But it's not just auto manufacturers' financing arms and banks providing money to new car purchasers that's making auto sales pop. The same banks and manufacturers' financing units, along with aggressive financing partnerships, are providing huge pools of money to dealers of used cars across the country.

According to the Federal Reserve, outstanding auto loans for new and used cars reached $934 billion at the end of September 2014. That's up from a total of $809 billion outstanding just two years ago. By the end of the first quarter of 2015 the total outstanding volume of auto loans is expected to exceed $1 trillion.

While prime borrowers financing new and used cars aren't worrisome - just as prime mortgage borrowers weren't a problem in the heyday of the housing boom - it's subprime borrowers who are eclipsing prime borrowers in the auto sales arena, just as they did in the late stages of the housing boom, that's becoming a worrisome trend.

And just like in the mortgage-money free-for-all, it's the intermediaries pushing loans on subprime borrowers. They can then charge them exorbitant interest rates. That's what's fueling the rapid increase in subprime auto lending, especially on used cars.

Of course, in the modern era, very few intermediaries keep the loans they make "on their books." Instead, they rely on other banking intermediaries or their own in-house securitization assembly lines to package thousands of auto loans into "asset-backed securities" to sell to eager investors seeking above market interest rate investments.

The difference in the new subprime rip-off game is in the input function of the financing equation.

Used car buyers in the latest push-them, plunder-them, package-their-promises, and sell them to salivating yield-hungry investors are far less credit worthy than the crap-shooting, credit-impaired homebuyers sucked into the mortgage mania game.

Sadly, it's the lowest rung of borrowers, many of them desperate for transportation to look for work, get to work, to take sick family members to and from doctors and hospitals, or to run their small transportation businesses, that get saddled with the worst high interest rate loans.

Of all outstanding auto loans made up to the end of Q3 in 2014, 23% were subprime loans to borrowers with less than a 640 credit score. That's up from 21% in 2009. Still, not as high as the 28% share subprime borrowers accounted for in pre-recession 2007.

Because of the way used car dealers are incentivized to make the biggest loans possible to subprime borrowers, they regularly roll in "extras" to the whole loan they offer unsuspecting or desperate buyers: title, taxes, dealer-prep fees, extended warranties, undercoating and rustproofing charges, sometimes collateral insurance, and the cost of buying out an existing loan on a trade-in.

As a result, on approximately 23% of subprime loans, the outstanding principal owed exceeds the resale value of the purchased vehicle by 200%.

Experian Automobile, a unit of credit rating company Experian, recently reported that as of September 2014 the average loan-to-value on all financed autos was close to 115%.

Of all auto loans made last year, 31% went to subprime purchasers. That's up 17% in two years.

With interest rates often starting at 22% annually, it's not hard to see why delinquencies are on the rise...

Of all auto loans made from January 2014 through November 2014, 2.6% were delinquent by 30 days or more. But, according to Equifax, of all subprime auto loans made in just the first quarter of 2014, by November, 8.4% had missed at least one payment. For comparison purposes, in 2008 the delinquency rate was 9%.

Mark Zandi of Moody's Analytics recently said of subprime auto loans, they're "eroding now, and pretty quickly."

Regulators Have Taken Notice

While the FTC generally oversees auto sales practices and is looking into several dealers and financing operations, the Consumer Financial Protection Bureau (CFPB) has been especially aggressive in attacking dealer "mark-ups" (the profit dealers earn for putting buyers into expensive financing schemes).

Asserting their responsibility to enforce "fair lending" laws the CFPB extracted a $98 million settlement from Ally Financial (formerly General Motors' financing arm) in 2013 for unfair mark-ups. The CFPB has threatened American Honda Finance, Toyota Motor Credit, and others. They are believed to be cooperating with the Bureau's ongoing inquiries.

In addition, the Justice Department has subpoenaed GM Financial, Santander Consumer USA Holdings, and others over their lending practices and dealer mark-ups.

Not to be left out of the action, the Securities and Exchange Commission (SEC) is believed to be investigating Ally Financial and others, and has hinted of possible forthcoming settlements.

The strange thing is not a lot of people are overly worried about excessive subprime auto lending blowing up and undermining markets or the economy.

Institutional investors seem happy with the extra yield they're taking in on the packaged loans they're buying and comfortable believing borrowers will continue to pay up.

Securitizers and raters are confident, for the most part, that auto buyers, many of whom have already declared bankruptcy, aren't able to do so again for another seven years, so they can't easily discharge their new obligations.

And many investors and financiers point to the fact that autos aren't homes. They can be easily repossessed. An increasing number of sold autos are being fitted with automatic cutoff switches that allow dealers to turn off cars remotely if a payment is even a few days late.

All that may be well and good. Still, with the proliferation of subprime auto loans to an increasingly stressed and increasingly delinquent army of struggling borrowers, sooner or later dealers may run out of discredited buyers to sell their repossessed vehicles to.

While I'm not worried about stray bullets in drive-by shootings wreaking havoc in my neighborhood, I am worried that subprime auto drivers might shoot themselves in the foot. That foot's on the accelerator, and the market and the economy are heading into another ditch.

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