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Subprime Auto Loans Reach New Highs

Remember the billions of dollars of poorly-vetted mortgage-backed securities (MBS) that helped destroy Lehman Brothers and numerous banks (not to mention the world economy) in 2008? This time it’s auto loan-backed securities (ABS) that are setting records.  According to Bloomberg Businessweek, $26 billion in subprime ABS bonds were sold in 2016, surpassing the peak reached before the financial crisis.

But don’t panic.  The ABS market (backed by all prime and subprime auto loans) is only about $192 billion, miniscule compared to the $8.9 trillion MBS market as of the end of last year.  So it’s unlikely that the excesses that contributed to the so-called Great Recession (poorly documented loans, unqualified buyers, and even outright fraud) are likely to push our economy over the edge like last time.  What is does mean, however, is that many consumers are loading up on debt that they cannot afford.

The auto industry appears to be highly dependent on finance companies.  As an example Bloomberg cites Banco Santander, a global bank headquartered in Spain, and its relationship with Fiat Chrysler.  Big banks typically provide lines of credit to finance companies that make the subprime loans to support auto sales.  Wells Fargo, JP Morgan, and Citi have been very active in this marketplace.  In Santander’s case the bank directly owns a U.S.-based subprime lending subsidiary that operates under the Chrysler Capital brand name.  In May Santander agreed to pay $26 million to settle allegations brought by Delaware and Massachusetts as part of ongoing investigations into the auto industry’s lending practices.  Some of the questionable activities (which are also being scrutinized by 30 other states) included lax lending standards without income verification and inflating car options values in order to maximize credit.  According to the article, Santander continued to provide loans to dealers with exceptionally high default rates.

What’s the risk for investors?  The banks ultimately buy back the loans, securitize and package them, then sell them.  And just as with MBS in 2007, the quality of the embedded loans is very opaque.  But this time is different.  Many ABS are packaged with more loans than the face value of the security (which is easier to do since the size of the loans is relatively small).  This provides additional protection to investors since the price of such a security can weather a greater number of loan defaults.  Nonetheless investors have been gobbling up these bonds in an apparently desperate search for yield in today’s low-return environment.  Should their risk appetite shift, or should the default rate on the underlying loans increase, current bondholders could be in for an unpleasant surprise.  Even some of the banks floating these securities have been talking about cutting back.

But it’s not investors (or the economy) that are most at risk.  It’s the car buyers. Take Caitlin, a woman in her 20s who couldn’t resist the opportunity to tool around San Jose in a sporty Mustang.  Encouraged by the dealer, she took out a loan to purchase the car for close to 50% of her income.  Yet on her salary Caitlin cannot even afford an apartment in Silicon Valley and is forced to live at home with her mother.  The risk she is facing is that if she should have to sell the car to raise money at some point in the future, she might not be able to collect enough to cover the balance of the loan.  That’s because a car, unlike a house, is a depreciating asset.  Although people had similar problems with housing in 2008, over the long term housing prices do generally appreciate.

My philosophy: if you cannot afford something without incurring debt to purchase it, consider getting a less expensive alternative.  And if you absolutely need it, make sure you have a realistic plan in place to pay back the debt before buying it.  Despite what the banks tell you, debt (especially for depreciating assets) should only be used as a last resort.



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