by Kyle Scott, PhD
The subprime auto loan market has seen a growing amount of investment from large institutional investors. This infusion of cash has made it easier for car dealers to get loans approved for customers who would otherwise not qualify. The result has been that riskier loans are being put on the books of lenders. While the housing crash was only six years ago it seems like the effects have worn off as this is a similar scenario that preceded the 2008 collapse. Not only are large banks like Wells Fargo and Bank of America entering into the market, but the loans they are funding are being packaged as securities and sold to investors with the blessing of credit rating agencies, the same credit agencies that gave their blessing to the toxic debt sold in the run up to the Great Recession. The scenario would be comical if it wasn’t so frightening.
As recently reported in one of the nation’s largest print media outlets, there has been a 130% growth in subprime auto lending in the past five years, fueled primarily by banks and private equity firms who see the subprime auto loan industry as an untapped revenue stream. The result is that people are getting loans on vehicles they cannot pay for, and the amount owed on the vehicle far exceeds the actual resale value of the vehicle. This puts subprime borrowers, who are usually borrowers with fewer options to begin with, in a situation in which they will almost inevitably default on the loan. 2014 first quarter reports show that banks have written off 15% more auto loans as unrecoverable this year over last, and repossessions this year are up 78% over last year. All this while one of the largest lenders, Wells Fargo, has increased its lending by nearly 9% this year over last. To restate in clear terms: The rate of return is getting worse and the lending is increasing. This is a formula for disaster. But it’s not a disaster that can be avoided by tinkering at the margins. The core of the problem must be attacked.
Selling people a more expensive car than they can afford is indeed a problem. However, the answer is not to infantilize the borrowers or demonize the dealers but to understand the fundamentals. People without much money and even less credit need a vehicle. Car dealers need to sell vehicles. Banks and Wall Street-backed lenders capitalize car dealers who can then supply their product to the consumer. This means, in many instances, the dealer is not the one financing the vehicle but instead acts as a middleman between buyer and lender. So, if the influx of capital from corporate investors was eliminated, and thus forced dealers to “in house finance”, lending would be done more responsibly as dealers have less risk tolerance than a large backer. Banks can take greater risks because they have greater resources and because they know they have the backing of the government if things get too bad; a comfort most other businesses do not enjoy. The dealer would have to make sure the person he is selling the car to has a reasonable chance of paying for the car. Large finance companies understand how to assess balance sheets but in this instance they do not understand the industry behind the numbers. The numbers are mere abstractions, or representations of, a more detailed and nuanced industry. Lending money to people who have almost no chance of paying it back, as is now the case, is a recipe for disaster.
One of the reasons why banks are looking to the subprime market is that it doesn’t make sense to lend to small businesses or low risk borrowers given the rate of return on that investment is quite low. The subprime market allows banks to get a potentially much higher rate of return on their investment. If interest rates were allowed to follow market forces, rather than being artificially set by our central bank, then the incentive to take greater risks would be diminished since safe investments would offer healthy returns.
Car dealers catch a bad rap, and sometimes justifiably so. But in this instance it is the large lenders far away from the daily grind of selling cars who are wreaking havoc in the used car market. This potential spill over of a collapsed used car market into the rest of the economy is something we should all be concerned about.