Subprime Auto Loans

By Todd Zywicki on August 18, 2014

Washington Post article, August 15, 2014, by Todd Zywicki

There has been some interesting commentary in the Washington Post, andill-informed hand-wringing in the New York Times, the past week or so with respect to a purported emerging bubble in subprime auto-financing.

First consider the Washington Post’s take:

It’s a dynamic reminiscent of the subprime mortgage bubble that helped cause the Great Recession ” and, in that sense, precisely what Wall Street and Washington had promised to avoid in the future. But the analogy should not be overstated. The car-loan market is far smaller than the housing market, and the underlying assets ” vehicles ” are by nature more mobile and, hence, more marketable than houses. The risks to individual consumers and investors are significant, but the systemic risks to the U.S. economy from an overheated car-loan market are, accordingly, modest.


So far, it seems that most of the froth in the car-loan market results from legal behavior, which represents the unintended but foreseeable consequence of Federal Reserve policies.

The Post editorial goes on to describe certain cautious steps that the OCC is taking, and some puzzling steps that the DOJ is taking, that might be useful in slowing down what may or may not be a bubble. Indeed, the paper is appropriately cautious on this point too: There’s just one catch, though, and it’s a pretty big one: The car boom might be a bubble. The only real flaw in the editorial, I think is that it couldn’t resist the loaded term seems that most of the froth results from legal behavior, leaving a tinge that while most of the behavior seems legal, the paper implies that it has some reason to believe that there might be illegal behavior somewhere even though it provides no tangible evidence to back that up.

Still, with that one caveat, it is a responsible and newsworthy editorial. First, the Post is careful to point out that we don’t know for sure if there is a bubble, but it bears watching. Second, it points to economically logical sources of the bubble, particularly Federal Reserve monetary policy. Third, and probably most important, the Post makes clear even if there is a bubble in subprime auto lending, it is far different from any bubble in subprime mortgages both in the impact on consumers as well as the non-existent systemic risk effects. While there may be some losers, they are likely to be investors who buy the loans, and their exposure is going to be much smaller than for the housing bubble.

Moreover, although there is some risk that investors might lose money, the risk to consumers from a subprime auto bubble is pretty small. For example, the Post suggests that if there is a bubble, it is because interest rates are so low. But unlike the housing bubble, car loans are short-term loans (five years or so) and interest rates are fixed, not adjustable, so if the Fed eventually raises interest rates, consumers will not be directly affected. They’ll simply be sitting on a car loan with a below-market interest rate. Moreover, there is no reason to believe that there is some speculative motive among consumers in buying cars“unlike the housing prices always increase mania that fueled the housing bubble or the house-flippers in bubble markets who drove the housing bubbles. Consumers know that cars always depreciate in value and they know that if they try to sell their car while it is still being financed they are likely to get less for the car than they owe on their car loan. So while investors may end up losing money (not enough to raise systemic risk issues) the risks to consumers from overly-low interest rates seems pretty remote. Moreover, the Post avoids sweeping suggestions (as they should, given the lack of any evidence) of wrongdoing. Notably, the Post calls for no particular regulatory action or suggestion of criminal activity.

Compare the Post’s measured tone to the almost comically over-the-topNew York Times editorial, When a Car Loan Means Bankruptcy:

The mortgage industry set the stage for the recession by luring people into ruinously priced loans they could never hope to repay, then selling those loans to Wall Street in mortgage-backed securities that went bad. The federal government has since tamed that industry, outlawing most of the risky and deceptive practices that led to that crisis. It must now do the same with the auto lending industry, where the practice of roping people into loans that damage them financially is all too common.

Predatory loans arranged by unscrupulous auto dealers have long been a source of hardship for low-income consumers who can least afford them. But the problem has worsened since major banks entered the picture and began buying up car loans to package them in securities sold to pension funds, insurance companies and others. Banks that are scrambling to buy such loans have sometimes formed alliances with unscrupulous dealers, including one who was indicted on grand larceny charges that he defrauded two dozen buyers.

Dealers who can offload loans to banks before the loans fail take the same rapacious approach that mortgage lenders took in the run-up to the recession. They prey on less sophisticated borrowers, falsifying the borrower’s income information and writing loans with astronomical interest rates and hidden fees that deliver a quick profit to the dealers.

And, of course, the inevitable call for swift and aggressive action:

Federal prosecutors are investigating the subprime auto lending business, focusing on how questionable loans are packaged and sold to investors. One issue here is whether the lenders fully disclosed the creditworthiness of the borrowers whose loans made up the securities.
The government also must require that auto dealers, like mortgage lenders, verify that borrowers have the ability to repay their loans and meet their other expenses. In addition, regulators should bar the dealers from gaining additional profit by manipulating interest rates. Beyond this, banks that buy auto loans should be held strictly accountable for any irregularities.
The main regulators of this industry, the Consumer Financial Protection Bureau and the Federal Trade Commission, need to move swiftly and aggressively on these matters.

And what’s all the hoopla about? According to an accompanying news story in the New York Times with the conclusory title In a Subprime Bubble for Used Cars, Borrowers Pay Sky-High Rates (although the article itself never actually establishes that there is a subprime bubble at all), the size of the subprime market has risen from 20 percent of the auto market at the trough of the recession to 27 percent today“which is still well-below the 36 percent of the market that the Times itself identifies as subprime in 2006.

So what does the Times editorial have here? First, it has some stories of bad practices by car dealers (something called yo-yo financing). Surely such practices exist“used-car dealers wouldn’t have reputation rivaled only by members of Congress if they didn’t have some problems. But are crooked practices more common now than in, say, 2009? I dunno. Nor do they. What’s the basis for concluding that the frequency of unscrupulous practices has increased since banks entered the picture? No idea. To what extent is yo-yo financing and other crooked practices driving a subprime auto bubble? They don’t say. How do even know that there is even evidence that there is a bubble at all? They don’t say. They make no mention of the Fed’s pivotal role in fueling any bubble (if one exists).

The story reports that some borrowers had borrowed more than the car was worth (twice as much!) and that they paid interest rates that sometimes exceeded 23 percent“which I guess sometimes they didn’t exceed 23 percent? Well, the obvious question is how often is sometimes? I dunno.

But consider the additional comment here“the loan amount typically exceeded the value of the car. That’s not atypical, of course, for car loans, although if that is typical, it does seem larger than usual.

But does that make it predatory? Why might a subprime consumer take out a car loan with a fixed interest rate at 23 percent (which is apparently sometimes the high end interest rate) for an amount that exceeds the value of the car? Well, by now, anyone with familiarity with consumer credit markets will readily anticipate what might be going here“the subprime borrower knows exactly what he is doing and for someone whose most likely available alternatives are payday loans and the like, a five-year unsecured loan at 23 percent interest is actually a pretty good deal. Now, do I know for a fact that subprime borrowers know what they are doing and are essentially using the undersecured car loan as a line of credit as an alternative to a payday loan or something? I don’t. Does the Times have any evidence at all as to what subprime borrowers are doing here or whether most of them know what their doing? But aren’t these the basic questions you’d need to ask before you characterize these loans as predatory?

So leaving aside the innuendo, what do we actually know about this market? I don’t have a comprehensive knowledge but looking around a bit after reading these contrasting editorials, here’s what I’ve turned up.

A recent Equifax report concludes (from the press release“I have not purchased the actual report):

  • The industry is at record highs in terms of the number of car loans“and both the prime and subprime markets are booming (in large part because of the interest rate factors the Post identifies)
  • Despite record high balances, serious delinquencies on auto loans remain near all-time lows, representing less than 1% of total outstanding balances for the third consecutive month.

It is true, of course, that just because delinquencies are near record-lows today, that doesn’t mean they might not be record-highs in the future. But it doesn’t necessarily imply the opposite either. In particular, while delinquencies in the future might be higher, is there any reason to assume that the New York Times editorial board has more insight on this than private investors? To be sure, private investors screwed up on the housing bubble“but so did most everyone else. For the record though, someone who read only the Times’s news story would likely be shocked to learn that delinquencies today are near all-time lows, given the focus on supposedly rising bankruptcies caused by these loans. In fact, the only mention of delinquency in the article that I could find suggests the exact opposite (Still, financial firms are beginning to see signs of strain. In the first three months of this year, banks had to write off as entirely uncollectable an average of $8,541 of each delinquent auto loan, up about 15 percent from a year earlier, according to Experian.).

Describing the Equifax report, this story reports that the default rate (as opposed to delinquencies) on car loans was actually at an all-time low. By contrast, default rates on both credit card and home equity loans rose during the same period.

So what do we actually know? Both prime and subprime auto lending is growing. The share of subprime auto loans is lower than it was before the crisis. Some people have complaints that they are getting ripped off, but we have no idea whether that is more or less common than in the past. The severe delinquency rate is near all-time lows and the default rate is at an all-time low, even as credit cards and home equity loan defaults have risen a bit. And many subprime consumers borrow more than the value of the car and sometimes pay interest rates that exceed 23 percent. And no onethinks that if there is actually a bubble here, and the bubble bursts, that it will create any serious degree of systemic risk to the economy or widespread harm to unsophisticated investors or consumers. Nor is there any reason to believe that consumers are speculating on a belief that their cars are a rising asset that they can sell or refinance down the road.

I don’t mean to make light of this, because any bubbles (if we are certain that we have a bubble) will be disruptive in the long-run to economic efficiency. And certainly if consumers are being defrauded, and especially if we believe that fraud is increasing, we want to attack that (although increasing fraud and a price bubble are distinct issues). And the continued role of the Fed in distorting markets and potentially fueling bubbles and speculation, is especially troubling. But let’s not pretend that every market is the pre-crisis housing market or that every bad bet by investors is the next financial crisis.

Kudos to the Washington Post for noticing the differences between these markets and being appropriately balanced and cautious on this and presenting the story in an even-handed way.