Is There a Subprime Car Loan Bubble?

Auto loans are hot. Consumers can’t seem to get enough of them, and the average loan has soared from $14,700 to $17,400 in the past five years, according to TransUnion. Wall Street can’t get enough of them either: Santander Consumer USA just sold off $700 million of its subprime loans to investors within a few hours, even though the average FICO score of the borrower was 552, and 13% had no score, according to Structured Finance News.

But auto loans are also hot for a different reason, and many observers have begun uttering the dreaded “B-word” about the market. “Bubble.”

Meanwhile, state and federal government agencies are lining up to subpoena firms that cater to less-than perfect borrowers who need wheels, known as the subprime auto loan market. Capital One disclosed in a February Securities and Exchange Commission filing that the Department of Justice has issued subpoenas looking for information on its subprime loans. Ally Financial said it has received similar inquiries from the SEC. The Massachusetts attorney general’s office has opened inquiries in a handful of lenders, according to the Boston Globe. New York City’s Department of Consumer Affairs issued subpoenas to Santander in November. And Santander recently settled a lawsuit with the Justice Department alleging it wrongly repossessed more than 1,000 cars with loans being paid by active duty servicemembers. The firm paid $9.35 million but admitted no wrongdoing.

Plenty of observers and government officials are worried that the subprime auto loan market is starting to look and act like the subprime housing market of the last decade.

“Studies show that subprime loans, which have been blamed for the country’s mortgage crisis, are growing at a staggering rate of more than 130 percent since the financial crisis,” said new York’s DCA Commissioner Julie Menin in a statement announcing that office’s probe. “For many families, especially those with low incomes, a car is one of the biggest purchases they make and if they are looking to a subprime loan, it’s because they are already struggling financially.”

Echoes of the Housing Crisis?

The subprime auto loan market might seem like an unlikely place for the next argument over Wall Street financial innovation. After all, what do dealers hawking cars to drivers with poor credit have to do with the mortgage market? A lot, it turns out — the same risk-reward calculation that was wildly profitable for banks and financiers, until the market turned against them.

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    Subprime auto loans carry interest rates that can be double or triple what a buyer with good credit can qualify for — rates for so-called “deep subprime” loans can climb as high as 20%. Even if default rates are high — analysts predicted nearly 25% default rates for the loans Santander sold off earlier this month, according to the New York Times — those high interest rates keep the subprime category profitable.

    Other factors make subprime car loans even more attractive to investors than subprime mortgages. For starters, cars are much easier to repossess than homes are to foreclose. Even technology has made this easier – recently reported on systems that allow lenders to remotely disable cars when borrowers miss payments.

    Repossessed cars have value, too, and can be sold in used car lots, often to other subprime customers in a thriving used car market. Some cars are sold multiple times by the same dealer. And consumers also tend to pay their auto loans more faithfully than their mortgages or credit card debt, even during the Great Recession; many Americans live in places where life without a car is nearly impossible.

    Santander’s $700 million bond offering promised Wall Street investors about 1% returns, according to, which is nearly eight times the return that Treasury bonds are getting. With interest rates for traditional savings instruments so persistently low, Wall Street’s appetite for auto bonds seems voracious. GM Financial issued $1.2 billion in securities backed by about 63,000 car loans last year, which saw $17 billion in subprime bonds floated from January to September, according to Bloomberg.

    That’s the part that has some regulators comparing auto loan market of 2015 to the housing market of 2005. The total amount of outstanding car loans is soaring, and stands at about $950 billion today, a record. Subprime loans are consuming a larger and larger slice of that market — from 20% of originations in 2009 to 27% in 2013, according to the Center for Responsible Lending. And there are other worrisome signs. Some buyers are borrowing for longer and longer terms — 96-month car loans are now being offered. The average subprime auto loan term is 71 months, or about a year longer than a prime loan. And the average monthly payment is $500, about $50 more than prime.

    Some observers and government officials are expressing concern that loan standards are being lowered, or abandoned altogether, in order pump up the volume so loans can be sold off to Wall Street.

    The Future of Subprime Auto Loans

    There are signs of increasing trouble. Auto loan borrowers’ failure rates are rising. According to TransUnion, delinquency levels for subprime borrowers have grown from 4.2% in the third quarter of 2012 to 5.3% in last year’s third quarter. Repossessions are up, too. The repossession rate jumped 70% from the second quarter of 2013 to the second quarter of 2014. It has since dropped, but observers worry the relief is temporary.

    The auto lending market continues to look and act bullish. TransUnion’s annual auto loan forecast calls for the average auto loan to rise to $18,244 at the end of 2015. If the prediction holds true, it would mean 19 consecutive quarters of increases since the beginning of 2011.
    Santander, a Spanish bank, became one of the largest players in the subprime market when it spent $650 million to become the majority shareholder in Texas-based Drive Financial. It renamed the company Santander Consumer USA.
    Laurie Kight, vice president of communications at Santander Consumer, told the New York Times in a statement that the lender has a “rigorous and active dealer control operation, which is part of the company’s overall compliance framework.” She added, “This operation audits, investigates and — if necessary — ceases operations with any dealers who conduct fraudulent or high-risk activities.”

    Santander declined to comment for this story.

    Many lenders and dealers say the booming subprime auto loan market is good for consumers, many whose credit was blemished by the recession and are in need of reliable transportation to stay employed.

    Writing last year for Moody’s, analyst Cristian deRitis acknowledged some problems in the auto lending market, but cautioned against overreacting.

    “Vigilance is needed to protect borrowers, but expanded lending activity with some deterioration in performance may be symptoms of a lending market returning to normal rather than overheating,” he wrote. “Instances of fraud and questionable lending need to be addressed before they become systemic issues. Yet in some respects, auto lending is a victim of its own success.” He also points out that the auto loan market, while significant, is dwarfed by the mortgage market, and a failure in the auto loan market would not have anywhere the impact of the housing meltdown.

    But others worry that if left unchecked, a subprime auto loan bubble will burst with painful consequences.

    “Regulators and law enforcement … should pay more attention to well-known and well-documented abuses in the auto lending market to stop increasing levels of default,” warned the Center for Responsible Lending. “Recent evidence suggests that the problems are already systemic.”

    More on Auto Loans:

    Image: Steve Gorton

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