Is Subprime Auto Loan a Harbinger of a Financial Crisis?

My previous article was on a subprime mortgage. In that article, I very briefly talked about deep subprime loans in the automobile industry and how it could trigger a crisis.

Later, I felt this topic requires an elaborate discussion and decided to churn out a new article focused exclusively on it. So in this article, I am going to discuss how a subprime loan is affecting the auto industry and how the economy at large could be affected by it.

Auto Loan

Who take these loans?

Figuratively speaking, a crisis is like a recipe and the elements that trigger it are the ingredients. In case of subprime lending, imagining it could lead to a medium-scale financial crisis, one of the ingredients is people with poor credit score taking auto loans.

The majority of these people are reckless in nature. They don’t think of the consequences. Not being able to pay off the debt could damage their credit report beyond repair. They don’t consider this as a possibility when they take auto loans.

Increase of delinquency

Data from the Federal Reserve Bank of New York indicate there’s a huge increase in the number of delinquent subprime auto loans. The data also indicate traditional banks have given 4.4% of subprime auto loans, compared to 9.7% loans, approved by equity backed private firms and non-banking lending agencies.

Auto finance companies reported a much higher level of delinquency rate as compared to banks and credit unions. Take a look at the graph below:

Auto finance

The difference is visible in the graph above. The reason behind the difference is underwriting norms. Banks, especially the traditional ones have stringent underwriting policies. Auto finance companies, however, relaxed underwriting guidelines to lure new customers. Their myopic approach to lending is causing the delinquency rate to go higher.

Market share

Auto finance companies hold a whopping 70% share of the market and offer loan to the riskiest of borrowers. The total worth of this market is $200 billion. The more it balloons, the higher becomes the risk of a crisis.

The apparent silver lining

It seems streams of news indicating a surge in subprime auto loan has hit a nerve. Melinda Zabritski, a senior director working in Experian observed: “We started to see delinquencies go up, and lenders really seemed to respond especially in Q1 of this year (2017) by tightening up a little bit.”

Market observers are reporting a pullback from lenders and buyers. A study conducted by Experian in 2017 showed subprime and deep subprime credit ratings are at a 10 year low. In the first quarter of 2017, both categories of lending dropped almost 9%.

This, in my opinion, was seemingly silver lining. I used the word apparent because data received from the fourth quarter of 2017 didn’t look very promising. A number of private-equity firms who earlier gave deep subprime auto loan suddenly discovered how incredibly hard it is to bail out customers.

As subprime auto defaults kept rising, giving equity-based firms a hard time cleaning up the mess, many wondered whether this could lead to a crisis?

Could it?

Luckily, most of the defaulters are people who took the loans way back in 2011 or even before 2011. It means the high rate of defaults might continue only for a short period. The only way we can get an idea of the future is by looking at the present. As the present rules governing subprime auto lending is becoming tighter, we can expect there’ll be no crisis in the future.

Where it all started

Subprime mortgage lending, as opposed to subprime auto loans, has a history that’s more or less known by all of us. The latter has a rather shoddy history. It’s mainly the non-banking agencies responsible for the current-day crisis.

After the 2008 market-crash, the only remaining avenue for profiteers was high-interest auto loans. Billions of dollars were poured into the auto loan industry. By then, the lending guidelines became stricter and the number of people taking auto loan remained far less than that of people who refinanced their homes prior to the 2008 fiasco.

These are the two reasons subprime and deep subprime auto loans never turned into an ugly crisis. However, the financial regulators and authorities could have done more than what they did. They are partly responsible for the high rate of car loan defaults, seen in recent time as they should have taken preventive steps way earlier.

After big banks quit

Analysts agree that delinquency rate being high started getting noticed after big banks quit from the auto lending space. It dried up fresh investment dollars, but in a way, it was a good thing as a full-blown crisis can now be avoided.

Concluding remarks

The century-old adage says “better safe than sorry.” It’s not too late for regulators to introduce new measures to change lax guidelines. It’s good that they started circling the industry. They should continue doing this.

Avery Richardson is a personal finance blogger and writer at moneymanagementiq.com, who loves to write and educate people about money management and frugality.

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