The Auto Subprime Bubble is Here

Used car sales have been up since 2008, and the price of used cars has been reasonable. Low-interest rates have made the purchase of used vehicles very affordable and auto loans easy to get. But economic reality has finally caught up with buyers as subprime loan delinquencies are increasing and expected to become worse.

Thanks to the Federal Reserve’s low-interest-rate policy, consumers have had a car-buying spree, with over $1.1 trillion in auto loans outstanding. As interest rates are rising, consumers are finding it more difficult to pay off old loans, while the number of new loans is down significantly.

For anyone paying attention, the subprime auto market is resembling the 2007 subprime mortgage bubble. Used car prices are the lowest since the 2008 market meltdown, although new car prices are up. The automobile industry has reason to be extremely concerned, especially since these defaults are occurring as the economy is supposed to be growing steadily. The question is, if all is well, how can these subprime auto loan delinquencies be near record highs?

Subprime lenders are aware that auto loans to borrowers with a credit score at or below 620 can be risky. They are also easily tempted by the high-interest rates paid by these consumers. These subprime loans are sold to investors, and the lenders make a nice profit. Until the money stops rolling in. With interest rates sharply on the rise, lenders are starting to panic.

This is a repeat of what led to 2008 when years of low-interest rate led skyrocketing mortgage loans. When the Federal Reserve raised its interest rates, chaos soon ensued in the subprime housing market. Will the same happen to the subprime auto loan market as delinquencies keep growing? The value of the used cars continues to depreciate as the subprime market is facing decreasing values as collateral.

Subprime-backed securities are still being bought up, with a $3 billion influx into the market in 2018 alone. This is twice the securities sold during the same period in 2017. In the meantime, the subprime auto market losses are up 8 percent, up from 5 percent in 2013 due to lax standards for auto loans. As the loans become riskier, investors are less likely to continue buying bonds that could face default.

It’s the small subprime lenders that are most at risk. One of them, Summit Financial Corp., filed for bankruptcy during the first quarter of this year after disclosing a $77 million debt to banking giant Bank of America. According to Bank of America, Summit failed to disclose all its defaulted loans and under-reporting losses. This lack of disclosure permitted Summit to borrow even more money for its subprime auto loans. These types of questionable loans were at the heart of the housing bubble. Many other lenders specialize in risky subprime loans. Summit is just one case.

Large banks have been avoiding the subprime lending market. However, they have been providing funds to companies that do lend to subprime borrowers. These loans total $345 billion as of fourth quarter 2017. This is proving to be risky for the large banks involved, especially since they are now worth less than when the loans were issued.

Wells Fargo has an exposure of $81 billion in subprime auto loans, although this isn’t listed on paper. JP Morgan has $28 billion in loans to subprime lenders, while Goldman Sachs has $16 trillion. The concept of large banks lending to a number of smaller subprime lenders was supposed to “spread the risk.” However, with the increasing number of auto loan defaults, the risk is boomeranging back to the major banks.

As the smaller lenders collapse after increasing defaults, larger lenders are likely to follow suit. In addition to Summit, Spring Tree Lending, based in Atlanta, Georgia, has also filed for bankruptcy following accusations of fraud. The demise of subprime lenders is what brought about the housing crisis of 2008. All these companies folded when interest rates increased, and easy credit was curtailed.

The collapse of lenders is affecting the automobile market as a whole. Potential buyers with a low credit rating no longer qualify for a loan, and credit-worthy buyers are hesitant to take out new loans. Automobile sales are at a two-year low after years of booming sales. The cost of a new car is over $31,000, while the average used car price exceeds $19,000. The monthly loan payment for both types of vehicles is around $515 each month.

Americans can no longer afford the price of an automobile. These days, many can’t afford to pay for the vehicles they already own.