The Next Lending Bubble: Subprime Auto Loans
The Next Lending Bubble: Subprime Auto Loans
December 5, 2013
TruthSnap - Remember how awesome the subprime mortgage lending boom was in 2003-2006? A strawberry picker in California who made $15,000 per year was loaned $720,000 for a house. An unemployed 24-year-old bought eight homes. Mansions for everyone! Shockingly, the strawberry picker couldn't afford his mortgage and the unemployed 24-year-old couldn't afford his eight mortgages, and a lot of this ensued:
Well, it appears that Americans have not learned from their extremely
recent and enormous borrowing blunders, because they’re itching to do it
all over again. This time, however, it won’t be houses - it'll be cars (and also maybe houses).
Yes! Shiny new cars. Americans are buying them up like hotcakes; we recently surpassed the previous peak level of car buying that occurred in 2007, before the recession. When times are good, people buy lots of cars. When times are bad, people hang onto their old cars to save money. You would think, since we're in the midst of this current car-buying bender, that is excellent news for the economy. Maybe it is a positive economic indicator and maybe people do have some disposable income to spend; however, there are also new, sneakily scary reasons Americans are gobbling up cars like never before.
From the inception of the automobile until the mid-1950s, if you wanted a car, you had to have the cash to pay for it up front. I know, ridiculous, but that's the way it was. In 1956, Ford Motor Company introduced the "'56 for $56" financing option, in which the buyer put down 20% on a 1956 Ford and paid $56/month for 36 months. The auto industry and consumers have never looked back. Over the next 50+ years, the repayment period on a car loan hovered around three to five years.
Enter the stupidly long-term auto loan.
Consumers are apparently taking out really long auto loans because they want to keep monthly payments down. The longest loans in this crazy new trend stretch payments out for 97 months. That's over eight years. Maybe I'm old fashioned, or just financially conservative, but if you want lower monthly payments on your car loan, maybe you should take out a smaller loan and buy a less expensive car. Taking out a car loan with a ridiculous payback period is absolutely not a responsible way to keep monthly payments down.
Yes! Shiny new cars. Americans are buying them up like hotcakes; we recently surpassed the previous peak level of car buying that occurred in 2007, before the recession. When times are good, people buy lots of cars. When times are bad, people hang onto their old cars to save money. You would think, since we're in the midst of this current car-buying bender, that is excellent news for the economy. Maybe it is a positive economic indicator and maybe people do have some disposable income to spend; however, there are also new, sneakily scary reasons Americans are gobbling up cars like never before.
From the inception of the automobile until the mid-1950s, if you wanted a car, you had to have the cash to pay for it up front. I know, ridiculous, but that's the way it was. In 1956, Ford Motor Company introduced the "'56 for $56" financing option, in which the buyer put down 20% on a 1956 Ford and paid $56/month for 36 months. The auto industry and consumers have never looked back. Over the next 50+ years, the repayment period on a car loan hovered around three to five years.
Enter the stupidly long-term auto loan.
Consumers are apparently taking out really long auto loans because they want to keep monthly payments down. The longest loans in this crazy new trend stretch payments out for 97 months. That's over eight years. Maybe I'm old fashioned, or just financially conservative, but if you want lower monthly payments on your car loan, maybe you should take out a smaller loan and buy a less expensive car. Taking out a car loan with a ridiculous payback period is absolutely not a responsible way to keep monthly payments down.
"I know this 2014 Bentley looks expensive, but I'm only paying $500 a month*, so I can afford it!" - local idiot
* for the next 360 months
If you can't put down a solid chunk of a car's purchase price and
easily pay off the rest in 36-48 months, then you cannot afford that
car. A car is a chunk of metal and plastic that is designed to move
humans about; there are plenty of those that don't cost $31,252, which is the average price of a new car. That is a ridiculous amount of money to spend on being able to move around for a few years.
If you're buying a car and you need to get your payments lower, please do the logical thing and buy a cheaper car. Don't just extend the length of the loan until the payments are small enough, because living at or beyond your financial limits is stupid and reckless. What happens when you lose your job four years down the road, or want to go to grad school, or incur a big expense, and you still have three years of payments left on that Mercedes? Then you're screwed and left with $20,000 of remaining payments on a car worth $13,000. Sounds an awful lot like an underwater mortgage, and it's going to happen more and more with these long auto loans. There are so many better things to spend money on than an expensive car: vacations, investments, savings, fancy dinners, whatever. You know what's cool? A brand new Audi. You know what's cooler? Not being poor and trapped in debt for eight years.
If you're buying a car and you need to get your payments lower, please do the logical thing and buy a cheaper car. Don't just extend the length of the loan until the payments are small enough, because living at or beyond your financial limits is stupid and reckless. What happens when you lose your job four years down the road, or want to go to grad school, or incur a big expense, and you still have three years of payments left on that Mercedes? Then you're screwed and left with $20,000 of remaining payments on a car worth $13,000. Sounds an awful lot like an underwater mortgage, and it's going to happen more and more with these long auto loans. There are so many better things to spend money on than an expensive car: vacations, investments, savings, fancy dinners, whatever. You know what's cool? A brand new Audi. You know what's cooler? Not being poor and trapped in debt for eight years.
So big long car loans are bad. But people - including those who don't
have good credit - need cars to get to their jobs. Enter the subprime
auto loan.
A subprime auto loan is a car loan for buyers with poor credit. These loans typically carry higher interest rates combined with long payoff periods, meaning the borrower is paying a metric shitload of interest over the course of the loan. There are usually financial penalties if the borrower tries to pay the loan off early, ensuring that the buyer pays all that interest in one way or another.
This class of borrower (the subprime borrower) is usually forced to accept auto loan terms that border on predatory in order to get even the cheapest car. That's where BHPH (buy here pay here) auto lots come in and rake poor people over the coals; the borrower usually ends up paying a multiple of the car's actual value over the life of the loan due to the high interest. However, subprime car loans have been around for a long time and three out of four people do end up paying back the whole loan. A 25% default rate is appalling, but these borrowers have no other choice to get a car, so subprime auto loans themselves are a necessary evil.
The lender, which is usually the car dealership selling the car in these cases, is paid a high interest rate in return for accepting the risk of loaning to a person with poor credit. That's how the lending market works. But recently, the lenders have started passing the risk off to a third party while still collecting the huge profits, which average 38% on each car sale, by selling investment securities backed by the subprime loans they originate. Securitization of these high-profit loans will lead to more and more subprime auto lending in the pursuit of larger and larger profits, and the loans will get shittier and shittier, and the bubble will grow and grow until it inevitably pops. We've seen this movie before.
One of the major causes of the 2007 mortgage collapse was the end of the 2-year teaser APR period for many of the loans originated in 2005. So if we learned anything, it's the adjustable rate subprime mortgages are a terrible idea for both the consumer and the end purchaser of any security they back. The person scraping by making loan payments at the lower rate will default on their payments when the teaser APR goes away, and they won't be an isolated case.
In the true spirit of not learning a single goddamn thing from a huge recent blunder, subprime auto loans with adjustable rates are now available. When a ton of subprime auto loans go into default (likely in rapid succession), the security they back becomes almost worthless and the investor gets screwed. So it would seem that subprime auto loan-backed securities are risky and would thus get a poor rating from the ratings agencies, right? Wrong.
A subprime auto loan is a car loan for buyers with poor credit. These loans typically carry higher interest rates combined with long payoff periods, meaning the borrower is paying a metric shitload of interest over the course of the loan. There are usually financial penalties if the borrower tries to pay the loan off early, ensuring that the buyer pays all that interest in one way or another.
This class of borrower (the subprime borrower) is usually forced to accept auto loan terms that border on predatory in order to get even the cheapest car. That's where BHPH (buy here pay here) auto lots come in and rake poor people over the coals; the borrower usually ends up paying a multiple of the car's actual value over the life of the loan due to the high interest. However, subprime car loans have been around for a long time and three out of four people do end up paying back the whole loan. A 25% default rate is appalling, but these borrowers have no other choice to get a car, so subprime auto loans themselves are a necessary evil.
The lender, which is usually the car dealership selling the car in these cases, is paid a high interest rate in return for accepting the risk of loaning to a person with poor credit. That's how the lending market works. But recently, the lenders have started passing the risk off to a third party while still collecting the huge profits, which average 38% on each car sale, by selling investment securities backed by the subprime loans they originate. Securitization of these high-profit loans will lead to more and more subprime auto lending in the pursuit of larger and larger profits, and the loans will get shittier and shittier, and the bubble will grow and grow until it inevitably pops. We've seen this movie before.
One of the major causes of the 2007 mortgage collapse was the end of the 2-year teaser APR period for many of the loans originated in 2005. So if we learned anything, it's the adjustable rate subprime mortgages are a terrible idea for both the consumer and the end purchaser of any security they back. The person scraping by making loan payments at the lower rate will default on their payments when the teaser APR goes away, and they won't be an isolated case.
In the true spirit of not learning a single goddamn thing from a huge recent blunder, subprime auto loans with adjustable rates are now available. When a ton of subprime auto loans go into default (likely in rapid succession), the security they back becomes almost worthless and the investor gets screwed. So it would seem that subprime auto loan-backed securities are risky and would thus get a poor rating from the ratings agencies, right? Wrong.
Although they're backed mainly by installment contracts signed by people who can't even qualify for a credit card, most of these bonds have been rated investment grade. Many have received the highest rating: AAA.
It is sheer lunacy that a pile of subprime loans could be rated AAA
when each loan in the pile is individually shaky. The (flawed)
justification for stamping AAA on these securities is that the thousands
of shitty loans lumped together makes one solid loan. Does that make any sense?
While it is true that the individuals making their loan payments won't
all default at the same exact time, they're all still subject to the
same macroeconomic forces, and it's entirely possible that many of the
loans could go into default in a very short period of time. That is precisely what happened with mortgages in 2007, making subprime mortgage-backed securities essentially worthless. The LA Times notes that most subprime auto loan-backed securities get AAA ratings...
... because rating firms believe that with tens of thousands of loans lumped together, the securities are safe even if some of the loans prove worthless.
I mean, seriously,
that exact sentence could have been written about subprime
mortgage-backed securities in 2005. The ratings agencies were, to put it
mildly, completely wrong about the risk of shitty mortgage-backed
securities. Why are shitty car loan-backed securities any different?
One of the ways buyers of subprime mortgage-backed security buyers got screwed in the late 2000s was by not realizing the weight carried by subprime loans in a security. The buyer might think that subprime loans made up less than 25% of a security, with the remaining 75% made up of prime loans. In reality, the worst securities had over 90% subprime loans in them, so when they crashed, they crashed hard. The same exact thing is happening with subprime auto loan-backed securities, where subprime loans now represent a higher percentage of all-auto-loan securities than ever before.
There is one notable difference between subprime mortgages and subprime auto loans: people who took out subprime mortgages in the mid-2000s believed that their home would continue to appreciate in value (or at least not fall in value). With cars, there is no expectation that the asset will increase in value. Still, one macroeconomic shift, like a jump in unemployment, would cause a wave of defaults across these loans and thus a massive drop in value of the investment instruments backed by the loans.
One of the ways buyers of subprime mortgage-backed security buyers got screwed in the late 2000s was by not realizing the weight carried by subprime loans in a security. The buyer might think that subprime loans made up less than 25% of a security, with the remaining 75% made up of prime loans. In reality, the worst securities had over 90% subprime loans in them, so when they crashed, they crashed hard. The same exact thing is happening with subprime auto loan-backed securities, where subprime loans now represent a higher percentage of all-auto-loan securities than ever before.
There is one notable difference between subprime mortgages and subprime auto loans: people who took out subprime mortgages in the mid-2000s believed that their home would continue to appreciate in value (or at least not fall in value). With cars, there is no expectation that the asset will increase in value. Still, one macroeconomic shift, like a jump in unemployment, would cause a wave of defaults across these loans and thus a massive drop in value of the investment instruments backed by the loans.
In addition to private equity firms such as Altamont, several payday lending chains are moving into Buy Here Pay Here and have acquired dealerships.
Oh, payday lending chains are nice guys. That's great.
The only good news is that the subprime auto loan-backed security market is measured in billions, not trillions like the subprime mortgage market; in the last two years, investors have bought $15 billion in subprime auto loan-backed securities. So if/when those securities explode, it probably won't cause a massive financial meltdown and ensuing recession. The real problem is that the subprime lenders take advantage of our fucked up financial system by gaming the ratings agencies and passing off their risk to gullible investors on the basis that pure crap is an investment grade security. The ratings agencies get paid per security rated, and they get paid by the originator of the security, who basically demands to have the security rated as they see fit. This enormous conflict of interest ensures that ratings agencies are nothing more than puppets of the banks and security originators who keep them profitable. The solution? Implement a small corporate income tax on the financial industry that funds an independent and accurate ratings agency and abolish the current ratings model. Why hasn't this been done?
Nonetheless, It's not like you or I, as independent small-time investors, would or could go out and buy a subprime auto-loan backed security. The investment professional who is aware of and buys these loans is usually acting on the behalf of clients. Read: it's not his/her money invested in these bags of shit. All the investment professional cares about is the high immediate return on the loans so that he/she hits goals and investment return targets, keeps unsuspecting clients temporarily happy, and fattens his/her bank account. The buyers are usually managers of institutional funds, mutual funds, insurance companies, and banks. You may not think you're involved in these crappy investments, but you very well may be, since huge investment companies buy them. Oppenheimer Funds, for example, owns subprime auto-loan backed securities in at least six of its mutual funds.
In summary: A lot of people take out unnecessarily large and long auto loans, thereby committing themselves to years of financial enslavement. But many people with poor credit have to get a car somehow, so they accept subprime, high interest rate auto loans on cheap cars from dealers, who then bundle these shaky high-default-rate loans into investment securities. The puppet ratings agencies slap an AAA rating on these securities because there are many thousands of individual loans backing each security, ignoring the fact that a default on many of these loans would be triggered by the same macroeconomic event, such as a jump in unemployment. To complete the tried and true high-finance cycle of fucking over the consumer, investment professionals buy these "AAA-rated securities with high returns" on behalf of their clients and proudly show off their high rate of return (until the collapse of these loans and securities) to get their bonuses and promotions. Again...
The only good news is that the subprime auto loan-backed security market is measured in billions, not trillions like the subprime mortgage market; in the last two years, investors have bought $15 billion in subprime auto loan-backed securities. So if/when those securities explode, it probably won't cause a massive financial meltdown and ensuing recession. The real problem is that the subprime lenders take advantage of our fucked up financial system by gaming the ratings agencies and passing off their risk to gullible investors on the basis that pure crap is an investment grade security. The ratings agencies get paid per security rated, and they get paid by the originator of the security, who basically demands to have the security rated as they see fit. This enormous conflict of interest ensures that ratings agencies are nothing more than puppets of the banks and security originators who keep them profitable. The solution? Implement a small corporate income tax on the financial industry that funds an independent and accurate ratings agency and abolish the current ratings model. Why hasn't this been done?
Nonetheless, It's not like you or I, as independent small-time investors, would or could go out and buy a subprime auto-loan backed security. The investment professional who is aware of and buys these loans is usually acting on the behalf of clients. Read: it's not his/her money invested in these bags of shit. All the investment professional cares about is the high immediate return on the loans so that he/she hits goals and investment return targets, keeps unsuspecting clients temporarily happy, and fattens his/her bank account. The buyers are usually managers of institutional funds, mutual funds, insurance companies, and banks. You may not think you're involved in these crappy investments, but you very well may be, since huge investment companies buy them. Oppenheimer Funds, for example, owns subprime auto-loan backed securities in at least six of its mutual funds.
In summary: A lot of people take out unnecessarily large and long auto loans, thereby committing themselves to years of financial enslavement. But many people with poor credit have to get a car somehow, so they accept subprime, high interest rate auto loans on cheap cars from dealers, who then bundle these shaky high-default-rate loans into investment securities. The puppet ratings agencies slap an AAA rating on these securities because there are many thousands of individual loans backing each security, ignoring the fact that a default on many of these loans would be triggered by the same macroeconomic event, such as a jump in unemployment. To complete the tried and true high-finance cycle of fucking over the consumer, investment professionals buy these "AAA-rated securities with high returns" on behalf of their clients and proudly show off their high rate of return (until the collapse of these loans and securities) to get their bonuses and promotions. Again...
Morning Scan: Dodd-Frank Turns Four; Subprime Auto Loans Boom
July 21, 2014
Wall Street Journal - New York Attorney General Eric Schneiderman isn't alone in his concerns about Barclays' dark pool activities.
Trading firms including RBC Capital Markets and T. Rowe Price Group
worried in the months before Schneiderman sued Barclays that their
orders were getting subpar treatment on the dark pool because of
high-frequency traders. What's more, "a number of Barclays employees
privately expressed concerns to top stock-trading executives that the
firm was giving high-frequency traders too much access to its dark pool
without fully informing clients," the Journal reports.
The Dodd-Frank Act is four years old today, and House Republicans got it a present: a roughly 100-page report criticizing the law for neglecting to solve too big to fail. A separate article takes a look at Dodd-Frank reforms that have yet to be implemented,
"including standards for the mortgage-securities market and tougher
regulations for credit-rating firms." The Securities and Exchange
Commission is particularly behind on new rules, with only 44% finalized
or close to it.
A new working paper on the effects of the Volcker rule finds that big banks have cut back on proprietary trading but kept up their risk-taking. "Risk at banks is like a balloon," according to "Heard on the Street": "If you squeeze one end, the other bubbles and bulges." Banks have until July 2015 to fully comply with the Volcker rule.
Financial Times
Leaders of the Group of 20 major economies are hitting a stumbling block in their efforts to agree on a solution to too big to fail banks. One big source of dissent is the amount of "bail in" bonds that big banks should be required to issue in order to absorb losses in the event of a crisis. "Japan is one of the countries with problems with the bail-in plans amid concerns that they are not easily compatible with the structure of its banking system," according to the FT. China and France are also holdouts.
Private equity investor Christopher Flowers tells the FT that new regulations are stifling bank profits, which are in turn driving away investors. "Nobody is going to invest in an industry with returns of [5%]," Flowers says.
New York Times
The Times takes an in-depth look at a recent surge in subprime auto lending. "Auto loans to people with tarnished credit have risen more than [130%] in the five years since the immediate aftermath of the financial crisis, with roughly one in four new auto loans last year going to borrowers considered subprime—people with credit scores at or below 640," the Times reports. The boom is being fueled in part by investors eager to take on more risk in exchange for higher returns. In another parallel to the subprime mortgage crisis, auto loan securitizations are also on the rise. The article prompted a huge response from commenters, many of whom criticized both used car dealers and lenders for taking advantage of low-income borrowers for whom vehicles are a necessity. "Traversing long distances to work, doctors' offices and other appointments is a must for most of us," writes one reader. "Car loan gouging practices are another example of how the working poor stay poor."
Dell's decision to start accepting Bitcoin is indicative of the digital currency's growing foothold in major retailers, the Times suggests. "Retailers have very low margins, and online especially, and they're in a constant battle with credit cards and banks to lower those fees," one analyst says. "Now that they see this avenue for fees to go away, that's really their big motivation."
A new working paper on the effects of the Volcker rule finds that big banks have cut back on proprietary trading but kept up their risk-taking. "Risk at banks is like a balloon," according to "Heard on the Street": "If you squeeze one end, the other bubbles and bulges." Banks have until July 2015 to fully comply with the Volcker rule.
Financial Times
Leaders of the Group of 20 major economies are hitting a stumbling block in their efforts to agree on a solution to too big to fail banks. One big source of dissent is the amount of "bail in" bonds that big banks should be required to issue in order to absorb losses in the event of a crisis. "Japan is one of the countries with problems with the bail-in plans amid concerns that they are not easily compatible with the structure of its banking system," according to the FT. China and France are also holdouts.
Private equity investor Christopher Flowers tells the FT that new regulations are stifling bank profits, which are in turn driving away investors. "Nobody is going to invest in an industry with returns of [5%]," Flowers says.
New York Times
The Times takes an in-depth look at a recent surge in subprime auto lending. "Auto loans to people with tarnished credit have risen more than [130%] in the five years since the immediate aftermath of the financial crisis, with roughly one in four new auto loans last year going to borrowers considered subprime—people with credit scores at or below 640," the Times reports. The boom is being fueled in part by investors eager to take on more risk in exchange for higher returns. In another parallel to the subprime mortgage crisis, auto loan securitizations are also on the rise. The article prompted a huge response from commenters, many of whom criticized both used car dealers and lenders for taking advantage of low-income borrowers for whom vehicles are a necessity. "Traversing long distances to work, doctors' offices and other appointments is a must for most of us," writes one reader. "Car loan gouging practices are another example of how the working poor stay poor."
Dell's decision to start accepting Bitcoin is indicative of the digital currency's growing foothold in major retailers, the Times suggests. "Retailers have very low margins, and online especially, and they're in a constant battle with credit cards and banks to lower those fees," one analyst says. "Now that they see this avenue for fees to go away, that's really their big motivation."
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