These are the good times, but why are subprime credit cards, auto loans, and short-term installment loans blowing out?
This is the transcript from my podcast last Sunday, THE WOLF STREET REPORT:
OK, we’ve got a situation in subprime consumer loans. The delinquency rate on credit-card loan balances at the nearly 5,000 smaller commercial banks in the United States – this means all banks except the largest 100 – is blowing out, according to Federal Reserve data. In the third quarter, the delinquency rate at these banks rose to 6.25%. That’s higher even than during the peak of the Financial Crisis.
Back in 2016, the credit-card delinquency rate at these banks was in the 3% range. It has more than doubled in two years.
Credit card balances are considered delinquent when they’re 30 days or more past due. This delinquency rate means that out of the banks total credit card balances, 6.25% are 30 days or more past due. This is a disturbingly large rate.
But delinquencies are a flow. Balances are removed from the delinquency basket either when the customer cures the delinquency, such as catching up with past-due payments, or when the bank “charges off” the delinquent balance against its loan loss reserves. But as these delinquent balances were taken out of the delinquency basket, even more new delinquencies fell into the basket, and the delinquency rate rose.
Subprime auto loans have also been blowing out. In the third quarter, the serious delinquency rate of the $1.3 trillion in auto loans has risen to 4.71%, the highest since the worst months of the Financial Crisis, when the auto industry collapsed, and when the US was facing the worst unemployment crisis since the Great Depression. In the third quarter, about 21% of all subprime auto loans were seriously delinquent – meaning 90 days past due.
Then we got another glimpse of this upheaval in subprime with some of the specialized lenders that cater to them.
For example, World Acceptance Corp., which does small short-term consumer installment loans, and some larger medium-term loans to people who need money desperately and have subprime credit ratings. Like most specialized subprime lenders, World Acceptance charges blistering interest rates, but then it also has large default rates.
It reported disappointing results now two quarters in a row, and its shares have plunged 45% over the past four months. So what’s going on here?
Back in 2009, people were defaulting on their auto loans and credit cards and their installment loans because over 10 million people had lost their jobs. This is not the case today. Back then, new unemployment claims – a sign of layoffs – spiked to astronomical levels. These days, they’ve been hovering near historic lows. So today, these people are working, and they’re falling behind on their debt service.
Subprime doesn’t mean poor or uneducated. Subprime means having a credit score below 620.
For example, a family of two working adults and two kids: The household income is $200,000. They bought a house and stretch to make the mortgage payments. They bought nice cars and have to make payments. Their kids cost all kinds of money, and it adds up, and they’re spending every dime they make. Then one of the earners gets seriously sick and can’t work for a few months, and the deductible on their health insurance is $4,500, and soon their six credit cards are maxed out.
So they go through daily triage about what to pay: mortgage payments, auto loan payments, minimum payments on their maxed out credit cards, groceries, clothes for the kids, bills, gas, and so on. And they fall behind, and late fees are racking up, and their credit score drops below 620, and they’re subprime.
They can still borrow, and they can still get more credit cards, but now under the terms of being subprime.
So banks take risks on credit cards because credit cards are immensely profitable. Until they’re not. Credit cards – unlike auto loans or mortgages – are unsecured loans. And recovery when the loan goes sour is small. The bank may sell the delinquent credit-card account to a debt collector for cents on the dollar and that’s all it may get.
The hope is that income from interest and fees from other subprime credit cards that are still current are making up for the credit losses. The whole thing is structured that way.
So the banks take big credit-card risks for big profits. And when the losses pile up, at least at first, they’re just part of the cost of doing business. The calculus works out in good times, and snaps back in bad times.
We can use the nearly 5,000 smaller banks with their credit-card delinquency rate of 6.25% as a stand-in measure for subprime. Here is why:
The largest 100 banks have a delinquency rate of just 2.56%, which remains low by historical standards, and is just a small fraction of the peak delinquency rate during the Financial Crisis. They can offer the most sophisticated incentives and marketing to attract the prime-rated customers. Overall, they have most of the customers and most of the credit card balances. And they get the lion’s share of prime customers. They also go after subprime. But since they have the lion’s share of prime customers, the portion of subprime customers don’t weigh heavily in the mix.
But smaller banks can’t offer the same kinds of incentives and marketing and often miss out on prime customers. So proportionately, they end up taking more subprime customers, including those that were turned down by the largest banks. And in this way, they become a measure of subprime credit card delinquencies.
But why are credit card loans and auto loans and other risky consumer loans now running into this kind of turmoil, when they hadn’t in 2016? There is no employment crisis. We haven’t seen millions of people getting laid off. But there is something else going on here.
I can see two factors.
One factor in the subprime turmoil is greed. People with a subprime credit score know their credit score. They know they’re having trouble borrowing. They’ve been turned down. They can’t buy a car and finance it at the ultralow interest rates they see in ads because they don’t qualify. Same with credit cards. They tried to get the 2% cash-back credit card with no annual fees and 7.9% APR and got turned down. They’re now conditioned to take whatever they can get.
In other words, for the industry, they’ve become sitting ducks. Lenders offer them credit cards with the highest interest rates and the biggest fees. Auto dealers make big-fat profits off these folks. And specialized subprime lenders charge them dizzying interest rates to finance these cars.
That’s all they can get. No one forces these people to take those loans and credit cards, but they’re trying to maintain their lifestyle, however basic it may already be, and they’re trying to feed their kids and drive them to school, and so they borrow at these high rates to make ends meet.
But the high interest rates increase the probability of default because these people who are already strung out will have even greater trouble making the payments. That part is driven by the industry’s greed. Aggressive subprime lending went into overdrive starting in 2014, and private equity firms piled into it, and smaller banks went after it, and it’s now coming home to roost.
The other factor in the subprime turmoil may well be something else, something that would impact people the most who are already strung out, people who have jobs but they’re living from paycheck to paycheck, and not necessarily because they’re splurging, but because, at their level of the economy, prices of goods and services they need have risen sharply and outpaced their incomes. And this can happen overnight.
This includes healthcare costs, and it includes food costs, and apartment rentals, and cars have gotten a lot more expensive, and the like. But cars and apartments and cellphones have gotten a lot better too, and these quality improvements are added to the price. Think of the move over the years from a four-speed automatic transmission to an eight-speed automatic, or from two airbags to 10 airbags, or from a basic cellphone to a smartphone.
But for figuring the inflation measure of the Consumer Price Index, the costs of these quality improvements are removed from the index. This is the principle of hedonic quality adjustments.
Inflation measures the loss of purchasing power of the dollar: what the same thing costs over time. But when quality improves, such as in a car, it’s no longer the same thing, and the costs of those quality improvements are removed from the inflation index.
So the CPI for new cars has been essentially flat since 1995, meaning no inflation for 20+ years, when in reality, the actual prices have jumped. For example, the price of a new Toyota Camry jumped by 25% between 1995 and 2019.
With used cars, it’s even worse. The CPI for used cars has declined by 11% since 1995. But actual used car prices have soared since then.
This goes for many other products and services across the spectrum. And then consumers, even when their income rises faster than inflation as measured by CPI, run into this problem where their income no longer suffices to buy these goods and services, including used cars and health care or housing, because actual prices of these goods and services have far outpaced both inflation as measured by CPI and wage increases.
This goes increment by increment. What might have worked last year, suddenly doesn’t work anymore this year. These consumers with jobs, that have been living from paycheck to paycheck, suddenly find themselves confronted with a 20% increase in health insurance premium or a 10% increase in rent, or both.
And suddenly, their whole fragile equation doesn’t compute anymore, from one day to the next. And they fall behind. As more consumers are getting caught up in it, subprime starts to blow out, even in what are considered the good times because actual prices have outrun these people’s incomes, and they’re confronted with it, such as with rent or healthcare, from one day to the next.
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