Examining Subprime Auto Lending

December 15, 2016
By Daniel Perez


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The housing bubble of the late-2000s and its subsequent burst launched a national dialogue about subprime mortgage loans. Today, the dialogue and concerns about subprime lending is focused on subprime loans for autos. Although some parallels exist between subprime lending for autos and mortgages, there also are significant differences. Before comparing the two directly, several factors need to be considered such as liquidity and market size. Another factor is problems some individual borrowers have understanding and obtaining an auto loan, a problem for which regulators and consumer advocates may be able to provide some relief.

Subprime loans typically are made to consumers with low or nonexistent credit scores (defined for this article as below 620) and come with a price—higher interest rates and fees.1 These loans generally have much higher delinquency rates than near-prime loans made to consumers with credit scores of 620 to 700 and prime loans made to those with credit scores of 700 or higher. Data from the third quarter of 2016 published by the Federal Reserve Bank of New York indicate 3.6 percent of auto loans are delinquent by 90 days or more. However, an increasing amount of these delinquent loans has been made by subprime lenders. Over a four-quarter moving average, 2 percent of new delinquent loans were made by subprime lenders, compared to about 0.7 percent and 0.1 percent for near-prime and prime lenders, respectively.Although these rates are not significantly high, they have been increasing since 2014. An increase in delinquency rates often is associated with higher default rates.

The large number of defaults on subprime mortgages during and following the housing bust generally is considered to be the impetus for the ensuing financial crisis. However, the structure of the auto and housing markets is very different, and a surge in auto delinquencies likely would pose little systemic financial risk.

There are two reasons why structural factors of the auto market suggest low systemic risk. First, autos can be sold or repossessed quickly and repossessions likely are not significant enough to affect market prices. If an economic shock were to occur, the auto market (and by extension the auto loan market) could be expected to quickly correct itself through selloffs. Second, the $1.1 trillion market for auto loans is small compared to the $14.2 trillion mortgage market.3 The effect of a collapse in the auto market would be significant, but nothing like the effect of a collapse in housing. The relatively small auto market share and the ability of the auto market to correct itself indicate low financial systemic risk and a generally stable auto loan market.4

While the overall auto loan market appears stable, individual borrowers face problems with their loans. A New York State Senate report found auto loan credit lenders have used “deceptive and dangerous lending practices” such as “abusively high interest rates, dealership fraud, and GPS tracking devices.”5 The report referred to several cases of consumer abuse and detailed tactics used by dealers: false advertising, bait-and-switch tactics, high fees for inexpensive additions and fraudulent contracts. While not all lenders engage in this behavior, borrowers may not be aware of dealer credibility or these tactics.

Since the financial crisis, consumer advocates and regulators have become more aware of potential problems with subprime loans, and consumer organizations have established an array of tools and information to better educate borrowers about terms and conditions of these loans. Using various resources, borrowers can learn about auto depreciation, accumulated interest and total payments. With these resources, borrowers also can better prepare themselves to negotiate terms when seeking an auto loan. It is hoped that these efforts to inform borrowers and policymakers will prevent a repeat of the subprime housing crisis in the market for subprime auto loans.

 

Endnotes

[1] There is no universal definition of a subprime loan. While the borrower’s credit score is used most commonly, the interest rate charged or the specific lender also can be used to identify a subprime loan. As an example, the subprime threshold for a mortgage is 3 percentage points above a Treasury security of similar maturity. The subprime loans themselves have common characteristics, such as a higher interest rate, that make their terms less favorable to borrowers. There is no universally accepted range for prime either, but 700 or more is the most common. Some industry people consider a credit score above 789 to be “superprime.”

[2] Haughwout, Andrew, et al. 2016. “Just Released: Subprime Auto Debt Grows Despite Rising Delinquencies,” Federal Reserve Bank of New York, Liberty Street Economics blog, November. Available at http://libertystreeteconomics.newyorkfed.org/2016/11/just-released-subprime-auto-debt-grows-despite-rising-delinquencies.html.

[3] See Board of Governors, 2016. “Consumer Credit – G.19,” Federal Reserve, December. Available at https://www.federalreserve.gov/releases/g19/current/. See also Board of Governors, 2016. “Mortgage Debt Outstanding,” Federal Reserve, December. Available at https://www.federalreserve.gov/econresdata/releases/mortoutstand/current.htm.

[4] Although not discussed in this article, banks and other financial institutions have few ties to the auto markets, so a hypothetical collapse in the auto industry largely would be contained. See Scully, Matt. 2016. “Some Hedge Funds Want to Make Subprime Auto Loans Next Big Short,” Bloomberg, February. Available at http://www.bloomberg.com/news/articles/2016-02-11/some-hedge-funds-want-to-make-subprime-auto-loans-next-big-short.

[5] Independent Democratic Conference, 2015. “Road to Credit Danger: Predatory Subprime Auto Lending in New York,” New York Senate, April. Available at https://www.nysenate.gov/sites/default/files/articles/attachments/Subprime%20Auto%20Report.pdf.