Debris from Subprime Auto Loans to Ricochet across Main Street

Profit on subprime is just too juicy to resist.

We called them “note lots.” People with terrible credit could go buy an old beater there. Ideally, it worked like this: you walked in with $500 cash. The dealer showed you a “cream puff” he’d bought for $500. You didn’t like the car, but you’d been turned down everywhere. The dealer made you a “great deal” for $2,000. He’d already recoup his cost. Everything else was profit. You signed a note for $1,500 with 21% APR and drove off with the car.

Three months later, the brakes shot craps. You had them fixed, thereby using up the money for your monthly payment. Five days after the payment was due, the dealer called and asked for it in cash, to be handed to him. You promised. On day seven, he sent the repo man. He’d sell the same car to the next guy under the same conditions. Even if he couldn’t recover the car, he was still ahead. Because there is one ancient truth in the car business: you can make the most money on people with bad credit.

The opportunity was just too good. Soon, reputable new-car dealers got involved, calling it “special financing” before the word “subprime” was born, and some of them got into trouble over it, but what the heck [for the inside scoop, read my book, TESTOSTERONE PIT, an edgy, raunchy, and funny novel about car salesmen, their customers, managers, and the shenanigans at a large Ford dealership; it’s so cheap it’s almost free].

Over the years, the process moved up-market, became more sophisticated. Now deadbeats can even buy new cars, and the biggest banks are involved, and everyone is happy: manufactures because it moves the iron; dealers because they’re making a ton; and lenders, oh my!

The interest is juicy, if not usurious. They get to package these loans into asset-backed securities and sell them to mutual funds in your portfolio, and everyone is extracting money along the way. Finance companies pop up to focus on auto subprime because banks can be a little squeamish when it comes to the dirty underbelly of the business. However, banks have no problem lending to these finance companies to fund their subprime loans, and the money flows, and it all adds to retail sales, manufacturing, industrial production, a million other closely watched metrics, and GDP. And everyone is happy.

Well, not everyone.

“According to a person familiar with the matter,” at least one unnamed bank regulator is pressing banks for details on their exposure to auto loans, Reuters reported.

Auto loan balances in August soared 10.8% from a year ago to $924.2 billion, an all-time high, with a record of 65 million auto loans outstanding, according to Equifax. Of all the auto loans originated in the first half, 31.2% were to subprime borrowers. But the report pointed out soothingly that “a bubble is not occurring in that space.”

These unnamed bank regulators are fretting that reckless lending is fueling that boom. So they’re asking banks about these auto loans as well as about the loans they extended to auto-loan finance companies. They’re worried that the banks’ complex exposure to auto loans is far greater than meets the eye – reminiscent of their mortgages leading up to the financial crisis. Reuters cites an example:

Wells Fargo & Co, for example, is the largest U.S. auto lender, with $50.8 billion outstanding at the end of 2013. About $15 billion of that was subprime. It is also the largest underwriter of bonds backed by subprime auto loans, having sold $3.3 billion of these securities this year, according to industry publication Asset-Backed Alert.

In addition, since 2011 Wells Fargo has extended more than $1.5 billion of credit lines to some of the largest subprime car lenders through its Des Moines, Iowa-based subsidiary Wells Fargo Preferred Capital Inc….

As in the olden days, the profit is just too juicy. And there’s never any risk – until it all blows up.

But there are differences to the mortgage fiasco that helped take down the banking system. Car loans are much smaller than home mortgages. While their terms are getting longer every year, they’re still far shorter than the typical home mortgage. And cars are easier to repossess than homes; repo man swoops in with his tow truck, and the car is gone.

Cars have other risks. The value of cars sags the second they roll off the dealer’s lot, and it continues to depreciate rapidly. Borrowers buy cars at retail. The amount they were upside-down on their trade-in is added to the loan, along with title, tags, and license fees, extended warranties, credit life insurance, and some fluff and buff. This can bring loan-to-value ratios to 120% or more. When a bank ends up with the car, it has to sell it at wholesale usually at an auction. So even if the bank recovers the car in one piece, the loss is significant. Multiplied by a large number of cars, it adds up.

Delinquencies are already increasing. Loans that are 60 days behind rose 7% year over year, and the repossession rate, though still relatively low, jumped 70%, according to Experian. And there have already been warnings from other corners [read… Subprime Blows up on Retailer, CEO Warns on ALL Subprime, Hits Auto Sales].

But the problem isn’t that an implosion of the auto-loan bubble, or the auto-loan subprime bubble, will take down the big banks. The amounts aren’t big enough. Home-mortgage balances are about ten times larger than auto-loan balances. It would make banks bleed, and their stocks would crash, and Wall Street would shake at its foundation, and it would take down some specialized subprime auto-loan financing companies. But the banking system would survive.

The problem is that when the music stops, when this reckless lending faces reality as losses pile up, when banks have to write off billions in loans extended to finance companies, and billions more in the complex web of the auto loan business, they will curtail their lending and tighten their underwriting standards. Subprime will once again become a sinkhole instead of a profit center.

And suddenly, the over-indebted, underpaid, strung-out American proletariat – the middle class – won’t be able to finance auto purchases, and they’ll have to drive whatever they have. Auto sales has been the one element over the last few years that has consistently boosted retails sales, consumer spending, manufacturing, industrial production, service activity, and finally GDP. Even railroads benefit as they’re hauling the 17 million new vehicles a year from plants, ports, or borders to dealers across the country. Auto sales create a lot of jobs. But when the auto-loan bubble pops, the remaining engine of the economy will slow down with a sharp screech. That’s the risk.

Bitter ironies are piling up – with very crummy consequences. Read…. What the Heck just Happened in Global Stock Markets?

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  11 comments for “Debris from Subprime Auto Loans to Ricochet across Main Street

  1. Vespa P200E says:

    Dejavu 2008. Back then was the subprime mortgage given to anyone with a pulse with no down, negative amortization, exorbitant interest rate or commonly called liar loans. Fannie and Freddie got bailed out not to mention the Fed’s taking over reckless galore basketcase AIG. In any case NOT 1 person got indicted and sent to jail.

    The banksters who got rescued via give away TARP are not at it again – peddling exorbitant interest rate subprime auto loans to essentially rather quickly depreciating asset. Also saw on SF local TV news about the gizmo these banksters put on the cars to prevent it from starting if the poor person is behind the bill (they say safer than repo man trying to take the car away).

    Yep we learn history so as to repeat it.

  2. Petunia says:

    People with bad credit which is most people in Florida don’t even bother with the new car dealers because you get a worse deal from them than the used car dealers. The used car dealers have private financing and are more up front about the fact that the rates are higher and the prices are higher too. Our dealer told us to pay the loan for a year and try to refinance it.

    • Wolf Richter says:

      Petunia, you just confirmed what I was saying in my article: the auto industry – including car dealers – makes more money on people with bad credit than on people with good credit: the rates are higher, the prices are higher, everything is higher – except their cost of the car, which is lower (thus increasing their profit). What surprises me is that you somehow seem to think that this is good for car buyers.

      • Petunia says:

        It is not good for car buyers but for some buyers it is the only option, and not dealing with the bs is refreshing.

        My real point was that the new car dealers get the customers with better credit but don’t give them a better deal. The customer may be getting a better car but being a better credit risk doesn’t help them much financially because the dealers are arbitraging the credit scores. If you have a 720 credit score you still don’t qualify for the advertised lower financing. The rate you get is determined by them according to your score, and its computation is a state secret.

        • Michael Gorback says:

          “the new car dealers get the customers with better credit but don’t give them a better deal.”

          Who told you that? The paragons of virtue who work at the used car lot? If you think there’s no BS at a used car lot it’s because you swallowed it hook, line, and sinker.

  3. LG says:

    Exactly Vespa.
    And its even fancier when the dealer takes a year of payments called “down payment” so he is off the hook if the buyer defaults.

    • Vespa P200E says:

      So much for Repo Man like in classic 1980s flick…

      Why the repo man can remotely shut off your car engine

      Call it the high-tech repo man: The starter interrupt device, a small piece of technology that can disable a car if a borrower is just one day late in making a payment.

      The rise in the devices, as detailed in The New York Times, comes amid a surge in auto loans given to subprime borrowers, or people with credit scores below 640. About one-third of all auto loans are now given to subprime borrowers, up from slightly more than one-quarter in 2010, according to Equifax.

      In an effort to protect their assets and minimize delinquencies, dealers and lenders are increasingly outfitting cars with starter interrupt devices and GPS trackers. Given the euphemistic name of “payment assurance devices,” the technology allows the repo man to shut down a car if a subprime borrower is even one day late in making a payment.

  4. Mark Harry says:

    I sold cars for Downtown Toyota in Spokane for a whole 6 months, that last deal didn’t fund before the end of the pay period, your gone. It was addictive I made $2500.00 in one day, once. My being let go was actually a gift, I’ve never spent so much time around so many people with zero morals.
    I have over 100 books, but Testosterone Pit is my favorite, because it hit home. That led me to buy the Big Like, because your actually an interesting person. By the way, the selling cars thing was over 20 years ago. I’m now self employed and now my boss is an even bigger jerk.

    • Wolf Richter says:

      “… and now my boss is an even bigger jerk.”

      I’ve got the same problem here at my outfit :-)

      Thanks, Mark, for your kind words about both of my books – and for buying them and reading them and commenting on them. Glad you liked them.

  5. Gin says:

    Very interesting article, Wolf.
    I keep my cars a long time and don’t finance them. Most people can’t do that but I learned with my first car that it was good for beyond 18 years, after which a friend clamored to buy it. Go figure…

    • Wolf Richter says:

      Gin, you’re doing it the right way.

      Owning a car for a long time – and taking care of it so that it lasts – is the cheapest way to deal with what is generally the second or for some folks the third most expensive item (after housing and healthcare) in life.

      But back in the day when I was running a big car dealership, we hated people like you. We wanted people to come in every two years and trade cars. That’s how we made money. And leasing, which accomplished that nicely, was one giant gravy train for us (at the customer’s expense).

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