American consumers are borrowing like never before to buy cars. It has been the reason why the US auto industry is intoxicated with its own exuberance. Last year, 16.5 million new vehicles were sold. This year, the industry hopes to breach the sound barrier of 17 million, or even 17.5 million. The industry is already dreaming about new all-time highs.
The growth is funded with borrowed money. Total auto loan balances outstanding grew 9.3% year over year to $975 billion at the end of December, an all-time high, according to Equifax. These balances will likely exceed the $1-trillion mark soon.
Auto lending to subprime customers – people with credit scores below 640 – has been particularly booming. Through October last year, 27.4% of all auto loan balances and 31% of the total number of auto loans were to subprime borrowers. Banks and subprime-focused specialty lenders convert these loans into structures securities, many of which carry triple-A ratings. They’re are selling like hot cakes, as bond fund managers gobble them up to create some yield in a world where central banks have expunged yield.
But bank regulators are warning about the auto lending spree. They’re worried about the ballooning loan-to-value ratios where the loan exceeds the “value” of the car by large amounts. Given that a car loses a lot of value the moment it drives off the dealer lot and continues to lose value, high LTV ratios raise the losses for lenders if the car is repossessed. But high LTV ratios also make the car expensive to finance. To keep payments down, loans are stretched to ludicrously long terms. And bank regulators are worried that these risky loans are made precisely to the riskiest customers.
Just last Wednesday, Darrin Benhart, deputy comptroller for supervision risk at the Office of the Comptroller of the Currency, which supervises all national banks and federal savings associations, warned about these auto loans at a conference of the Global Association of Risk Professionals, according to the American Banker. The OCC was already seeing a deterioration in auto loan portfolios, he said.
Timing was somewhat ironic. Equifax had just gotten through praising these loans and denying that there was a subprime auto-loan bubble. It explained that these portfolios had survived the Financial Crisis in better shape than mortgages, and that they would do well in the next crisis. Now Benhart dashed these hopes, it being “unclear if this paradigm will persist in the future.”
And worse: “So far,” he said, the surging auto loan volume and the relatively low payments achieved with these ludicrously long terms are “masking delinquency and loss rates as a percentage of total volume.” And thus, they understate the risks.
He blamed the Fed-engineered low-interest rate environment that was squeezing the margins of these lenders. To goose their profits, they get into strategies and activities without evaluating or understanding the risks they are incurring. And these risks “could contribute to future vulnerability.”
The OCC has been running itself ragged warning about the risks banks are once again taking on, as if they’d never heard of the Financial Crisis. And these banks are understating these risks, it said. Already last June, it had issued a damning report, singling out, among other risks, the no-holds-barred subprime auto lending with extended terms and astronomical loan-to-value ratios.
Now banks are finally responding.
Wells Fargo, which originated $30 billion in auto loans last year, has for the first time put a cap on subprime auto loans, limiting the dollar volume of subprime loan originations to 10% of its total auto loan originations. The New York Times reported that the bank, “according to people briefed on the matter who were not authorized to speak publicly,” has been “increasingly rejecting loans that dealers expected would be approved.”
And Wells Fargo’s subprime cap of 10% of loan volume is setting the tone for the rest of the industry, where the national average has been 27.4%.
Regulators are not only worried about the banks but also about the structured securities auto lending has spawned.
If subprime auto loans go bad in large numbers, as they’re likely to do, the structured securities based on them will take a hit, and investors will get to lick their wounds once again in their chase for yield. Banks and specialized subprime lenders will take a hit too. Megabanks like Wells Fargo might see their earnings get dented, but the amounts aren’t big enough to topple them. Smaller lenders that have specialized in subprime might not be so lucky. But the auto loan subprime bubble, when it implodes, won’t sink the US financial system as a whole; it’s just not big enough.
Yet if these lenders are cutting back on subprime lending in a drastic manner, all heck will break lose in the auto industry.
How are these financially challenged folks going to finance their new cars? Many won’t be able to. The lucky ones will be switched to used cars, and they’ll have to buy something a lot cheaper. It will hit volume, and it will hit dollar sales even harder.
Subprime lending funded about 8 million new and used vehicle sales in 2014, in a universe of 16.4 million new and 42 million used vehicle sales. It has been a powerful force. It has driven auto sales to levels that have made the industry drool. But when that force buckles, it will impact automakers, their suppliers, dealers, railroads, trucking companies, and other sectors. It will ripple through finance companies and insurers. It will hit employment. And it will show up in retail sales.
Unlike Wall Street, the car business has a huge impact on the main-street economy. But a big part is funded with subprime loans, which are now being curtailed. Fasten your seatbelts.
And these structured securities based on subprime auto loans? Toxic? Hey, they’re triple-A rated by S&P, and they’re hot. Read… Subprime Pump-and-Dump Frenzy Heats Up