What about Subprime Auto Loans?

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One thing that never changes in this world, is the ability to minimize the perception of major risks until a catastrophe strikes. The 2008 Financial Crisis is a recent example of how ignoring risks led to the collapse of the financial system. We might think that we have learned from past mistakes, but to believe in that notion will be misleading yourself. While we have managed to create better underwriting standards in the mortgage industry, there are other parts of the economy that is still left almost unregulated, such as the Auto Loan industry. The auto loan industry makes up about nine percent of the overall US household debt, and more than 65% of buyers finance their vehicle purchases with the help of an auto loan. The situation is similar in Canada as well, where auto loans share similar characteristics in size, popularity, and quality.

Before I dig deeper into the auto loan industry, I would first give a brief overview of the automotive industry. The auto industry, especially in North America, is a stagnant industry where revenue growth does not exceed GDP growth. The auto industry has low revenue growth, and low-profit margins, but high reinvestment requirements. The number of automakers has declined from more than 2000 companies in the early 20th century, to approximately less than 20 companies today. Despite the consolidation, margins have not improved at all because the competition is aggressively competing against each other for the same market size. Moreover, competition has been increasing in the technology provided in automobiles, and this comes at a cost of higher R&D. Most of the major automobile companies sell their cars through a dealership network, and these dealerships are usually independently run. Many automobile manufacturers realized the stable stream of income that lending money to car buyers can generate and have decided to establish a financing division. For example, half of Ford Motor’s profits come from its financing division. Usually, automobile manufacturers offering in-house financing will only offer to lend to borrowers with good credit scores, but recently Ford has decided to lower its underwriting standards for financing the new Ford Maverick model. Besides the manufacturer’s in-house financing, dealerships will offer financing from other lenders as well, including subprime lenders.

Another major segment is the used-car industry. Americans bought almost 40 million used cars in 2019, which is more than twice the number of new cars bought (17 million). During the chip shortage, manufacturers have been unable to meet the demand for new cars, so new car buyers have resorted to buying used cars. Since the supply of used cars does not change, it led to an increase in the prices of used cars. The demand for used cars is less volatile as compared to the demand for new cars because, in times of an economic contraction, customers prefer to buy a used car which is typically cheaper than a new car. Used-car dealerships also have relationships with lenders to provide financing to their customers.

Non-bank lenders provide financing to a wide range of credit scores, including subprime borrowers. Subprime borrowers typically have a credit score below 620 and are considered riskier. Subprime borrowers tend to have a higher default rate compared to prime borrowers, so they are charged higher interest rates by lenders to compensate for the additional risk. Some of the popular US subprime lenders are Santander USA, Credit Acceptance, and Capital One. Subprime lending comprises approximately 25% of the loans issued in the auto loan industry. It’s a simple business model filled with hidden fees and deceptive business practices.

My interest in the subprime auto loan industry started around 2017 when I noticed that auto dealers would let a buyer finance a car without focussing on the ability of the borrower to repay that amount. Intrigued by hearing about the extremely loose underwriting standards, I decided to do the research myself. I went around a couple of local used-car dealerships, posing as a freshman college student, working casually part-time and without any co-signer available. I realized that dealers wouldn’t even care about doing credit or income verification for loans up to the amount of $40,000. The response was more like figure out the car you want, we will get the financing figured out. The finance team responsible for underwriting the loans could be replaced by chimpanzees, and I believe you wouldn’t notice any difference in the number of loans originating from the dealership. When I asked my economics professor regarding the quality of the loans issued, the response I got was that even if the quality of loans is bad, the risk of a collapse in the industry is less likely to happen because lenders can repossess the car and sell it, which allows them to get some of the money back. He reasoned that the cycle is likely to continue because people need cars. I, however, completely disagree with this reasoning. Yes, people need cars, but excess in anything is bad, if there are more cars on the market than needed, then it can cause serious problems in the industry in the future.

The dealership’s incentive is to sell and finance cars without any regard for the buyer’s ability to repay. There also have been reports that dealerships make higher commission by issuing subprime loans to their buyers. Auto loans, similar to mortgages, usually do not remain on the dealership’s books, instead, they are usually originated or later bought out by bigger financial institutions. Securitization of auto loans has also increased over the last 10 years. While securitization increases investors’ access to financial products, it also decreases the responsibility of lenders, as risk is shifted to investors. The incentive for lenders is to originate as many subprime auto loans as they can and then securitize the loans to collect the fees associated with the securitization. After the 2008 crisis, securitization of any asset was carefully scrutinized, and auto lenders would sometimes guarantee to buy back the securities or establish a reserve fund if default rates were higher than expected. But in recent years, investors have grown to be less cautious, and lenders no longer need to assure investors of protection against excessive default rates.

Bank of Montreal (BMO) vs Basant Motors Ltd. is an interesting case that I accidentally ended up reading. In this case, BMO alleges that Basant Motors sold them auto loans that were so bad that the default rates were higher than expected and that some of the loans did not have any income verification at all. BMO purchased car loans from Basant, totaling about $1.8 million. $370,000 worth of loans were found to have inaccurate employment information, and eventually become delinquent. The case was interesting because a bank is no stranger to the possibility of higher default rates in auto loans, and if a major bank decided to sue a dealership for loans with higher default rates, it gives the perception that the default rates were extremely high from just 1 dealership. While this case is based in Canada, it does show the quality of loans that are being issued by dealerships.

The interest rates on these subprime loans can range from 9% to 25%. If one would include fees, and other costs, sometimes the APR could exceed 50%. The high-interest rate leads to the total interest amount exceeding the value of the car. People who buy cars with subprime loans are most likely to fall in the lower-income bracket and are also likely to be leveraged in other high-interest products, such as credit cards. In times of high unemployment, if a borrower loses their job or faces income reduction, their ability to keep up with the payments diminishes. Some states have passed laws that limit the interest lenders can charge on loans, but lenders have managed to go around these laws by charging additional ‘fees’ instead of increasing the interest percentage. There have also been cases where consumers were charged a higher APR due to low credit scores, but the dealers assured them that they have the option to refinance and get a lower APR after a year, only to be turned down by the lender when the time came. Therefore, the borrowers end up being stuck with a payment that they don’t want anymore.

The nature of auto loans has changed dramatically after the 2008 recession. Before, the maximum term for a car loan would not be more than 5 years, and nowadays I have witnessed car loans that are 7–8 years long. Longer terms help in lowering the size of the payments that borrowers must make, but it comes at a cost of higher interest paid over the longer duration of the loan. Longer terms do provide the ability for a borrower to purchase a more expensive vehicle that they could have otherwise afforded. This leads to borrowers being stretched too far and being stuck with a loan for a car for a very long time. For newer vehicles, a 7-year loan might make sense, as the vehicle is likely to last for 7 years. However, the lifespan of a used car can be lower, and a 7-year loan might exceed the lifespan of the vehicle bought. Even if a vehicle ceases to operate due to mechanical issues, the borrower is still on the hook for the payments. If the borrower wants to purchase a different vehicle, they will first need to pay off the remaining balance of their loan, and subprime borrowers are least likely to afford to pay off the entire loan balance. Borrowers can decide to roll over the old loan to a newer loan for a different car, but the payments will likely be higher than the previous payment, which is unaffordable for the borrower. Thus, they get stuck with a car that doesn’t function, and a car payment that might last for several years.

While lenders charge higher interest rates and justify these rates with the higher default rates that subprime loans incur, their downside risk is usually limited. Lenders will rarely ever lose the entire loan amount without recouping any of the losses. When a borrower misses their payment, the lender will repossess the car, and then sell it at an auction. Automobiles typically depreciate at a faster rate than the borrower can pay off a portion of the loan with the payments, leading to borrowers still owing the remaining amount to the lender. There have been complaints where lenders would force the borrower to pay the remaining balance, usually by getting a legal judgment, such as wage garnishment, that leaves the borrower on the hook even after they lose their car. In fact, subprime lenders have been accused by state attorneys of using deceptive practices to underwrite loans that are known to fail. Looking at the behavior of the auto lenders closely, it seems that higher default rates are essential to their business model, as lenders can profit from repossession and other legal remedies. I understand that lenders originate loans to make money, but if the lending practices are designed to keep a higher target default rate in mind as part of the profit strategy, then it is likely to be completely against the interest of the borrower. Default rates for subprime auto loans are higher for non-bank lenders compared to banks, which might indicate a lower quality in the loans issued by non-bank lenders.

Bankruptcy is a legal proceeding designed for the borrower to declare their inability to pay off their debt. In the US, there are different bankruptcy chapters designed to accommodate different situations between lenders and borrowers. After an individual is discharged from bankruptcy, there is a time period where they are not allowed to refile for bankruptcy, usually between 6–10 years, and the bankruptcy remains on the credit file during that period. It is hard for borrowers to get a loan right after a bankruptcy discharge, as it puts a drag on the credit scores, and also lenders consider newly discharged borrowers as riskier compared to the normal pool of borrowers. Even if a consumer decided to buy a car after filing for bankruptcy, the only option left is to obtain a loan from a subprime lender. You might think that subprime lenders might be cautious in giving these loans, but the lenders take advantage of the fact that the borrower cannot file for bankruptcy again for a long time. During that time, the borrower is on the hook, and the lenders can have every legal remedy to pursue the borrower in case of missed payments.

In 2020, when the pandemic led to a slowdown in economic activity, the US and Canadian governments provided fiscal stimulus to the economy. The US government announced three rounds of stimulus checks and offered enhanced unemployment insurance. The Canadian government offered approximately $2000 per month as a relief to people whose jobs have been disrupted. Both countries also announced several measures to provide financial assistance to businesses and provide protection to individual borrowers as well. Due to economic activity slowing down, many restrictions were put in place regarding traveling and social distancing. The Central Banks also lowered interest rates and announced the expansion of its Quantitative Easing (QE) program. This led to an unprecedented boom in certain areas, such as the housing and auto industry. The auto industry saw demand stabilizing quickly, but the supply side faced additional problems. Due to the chip shortage, and supply-chain crisis, the automobile manufacturers had a hard time getting cars on time to sell in dealerships. Since the supply of new cars did not keep up with demand, the demand for used cars went up, and so did prices in double digits, especially in 2021.

Subprime lenders did not shy away from originating loans at a time when car prices were temporarily inflated due to external factors. The higher car prices led to loan amounts reaching record highs. In the US, the average monthly auto loan payment for new and used cars is $650 and $503, respectively. The average loan amount for new and used cars is $39,540 and $27,945, respectively. Auto loan origination has doubled since 2011, which is led by an increase in both, loan volume and loan value. While this trend has favored the auto manufacturers and auto loan lenders after the 2008 crisis, it has left the industry exposed to vulnerabilities.

As mentioned earlier, vehicle prices have increased in double-digits during the imbalance between supply and demand during the pandemic. The auto loans issued during this time, based on the inflated value of the vehicles, add additional risk to the industry. When vehicle prices revert, the borrower might see their vehicle values drop significantly more than the average depreciation faced during normal times. Also, people have managed to trim down their household debt, such as credit cards during the pandemic, with the help of the fiscal stimulus provided. Although the credit score is calculated based on the history of the person’s relationship with credit, if people have managed to reduce their outstanding credit, it might’ve provided a temporary boost to their credit score. The auto loans originated during this period might not have a reliable dataset regarding the credit score of the borrower, which poses an additional risk. If the unemployment rate increases, then borrowers might not be able to afford the loan payments and might be forced to sell their vehicle or give it up for repossession. I have mentioned before that some subprime lenders rely on repossessions to earn money on their lending operations. However, if vehicle prices decline rapidly, and are below historical norms, then even lenders might end up losing a significant amount of money during repossession. If an extraordinary number of borrowers give up their vehicles, there is likely to be a flood of used vehicles on the market, which will depress prices further, leading to more losses. Since some automobile manufacturers operate an in-house finance division, it would hurt them more during an economic slowdown, because the profit from their lending activity will decline, and sales from newer automobiles will likely decline as well. The auto loan industry is vulnerable to economic shocks that might impact other types of consumer credit as well. The chain of events that led to the boom in the auto loan industry, can quickly reverse itself and be the reason for its downfall.

While approximately $1.5 trillion of auto loan debt represents only 9% of the overall household debt, it is the 3rd largest type of debt held by households, only behind mortgages and student loans. Before the pandemic, the subprime auto loans were experiencing higher delinquencies, as 7 million Americans were behind their loan payment by 3 months or more. I have also mentioned that the securitization of auto loans has led to a reduction in the quality of loans issued recently. However, even if the auto-loan-backed securities witness a higher default rate, I assume the losses to investors would not replicate the losses seen in the collapse of the subprime mortgages in 2008, because the auto-loan industry is a much smaller part of the markets compared to mortgages. But, if defaults and losses become extraordinarily higher, there is still a possibility of the losses spreading to other industries.

American household debt has steadily increased by 45% since 2013, and while debt is fueling economic growth, in not-so-ideal times, it can also fuel an economic contraction. The subprime auto loan is just a part of the problem. 35% of Americans have subprime credit, and subprime borrowers are more vulnerable to economic shocks. If borrowers begin missing their auto loan payments, then it is likely they will not be able to keep up with other payments. Then a small slowdown in the auto loan industry might indicate a bigger trend in overall household debt. The high inflationary environment, coupled with the high-interest rate might put a strain on the borrower’s ability to repay their loans. The current inflationary environment is less likely to continue forever, but if it continues for a long time, it will not help the borrowers who will face lower purchasing power.

In Canada, household debt has been increasing at an alarming rate as well. On average, $1.83 of consumer debt is owed for every $1 earned by Canadians. Since 2009, the growth of non-mortgage debt has been slower than the growth of mortgage debt. One of the reasons for the growth in mortgage debt can be attributed to the increase in house prices after 2010. Borrowers have higher mortgage amounts to assist them in purchasing more expensive homes. Recently, home prices in popular cities have gone beyond $1 million, leading to higher mortgage amounts. This makes the borrower more exposed to interest rate changes, and even a 1% change in interest rates can constitute a difference of several hundred dollars in their monthly mortgage payment. The reason I bring mortgages in my article about car loans is that if Canadians are unable to afford their mortgage payments, then there is a high chance that the auto loan payment will be missed as well. Higher living costs coupled with high debt payments and low wage growth can create a situation where people will have a hard time paying off their debts. This phenomenon can lead to a bigger impact on the economy as borrowers face the burden of higher borrowing costs.

While I have mentioned earlier that the losses in the auto-related industry are less likely to repeat the losses experienced to the economy in 2008, it is important to note that the possibility of it happening is still greater than 0. Borrowers in the US and Canada might not be able to make their payments on time, and this can lead to a ripple effect on other parts of the economy. I am not trying to say that this will cause a recession, but it is still not worth it to dismiss these risks completely. I understand that subprime lenders do play an important role because, without them, many people with bad credit scores would have not been able to afford a vehicle. Having access to a vehicle is important for people in many aspects of their daily life. But lenders should take a borrower’s ability to pay back the loan into consideration. Borrowers should also bear the responsibility of trying to minimize the size of their loan if it comes with higher interest rates and risk of non-payment, as it will likely cause more financial problems in the future.