Braking Down Subprime Auto Loan Concerns

Are the seeds for the next financial crisis being planted today? Some believe so based on some recent trends in auto lending. The New York Fed's latest report shows auto loan delinquencies rose in Q4. Subprime auto loans have supposedly mushroomed, driving fears of 2008 redux. However, a quick then-and-now comparison and examination of auto loans shows a subprime auto loans are exceedingly unlikely to trigger a crisis.

The quarterly uptick in auto loan delinquencies isn't wonderful, but it also impacts a very small share of total loans, bank balance sheets and overall output. Yes, both auto loan and student loan delinquencies ticked up-but overall delinquency rates were unchanged, and Q4 borrowing rose $117 billion (1.0%) q/q. Out of $11.83 trillion total debt, auto loans comprise $955 billion or about 8%. Just 3.5% of that $955 billion-$33.4 billion-is delinquent. In our roughly $75 trillion global economy, it would take at least a couple trillion worth of problems to cause a recession and derail the bull market.

So why the 2008 comparison? Some loans in question are subprime auto loans with astronomical, unaffordable interest rates. And these loans have been securitized and snapped up by yield-hungry investors-a contemporary version of 2007 and 2008's supposedly toxic collateralized debt obligations (CDOs), some say. But this, too, falls short. Again, we're talking $33.4 billion, not all of which is subprime. Compare that to the approximate $240 billion^[i] in subprime-related loan losses during the 2008 financial crisis. Plus, those losses alone aren't what caused financial panic. Rather, it was the mark-to-market-accounting rule, which snowballed those $240 billion in actual losses into nearly $2 trillion in unnecessary paper losses, known as "write-downs" in industry lingo, creating the vicious cycle that felled Bear Stearns, Lehman Brothers, Washington Mutual, Fannie Mae, Freddie Mac and AIG-and inspired one of the most haphazard government responses ever. For banks, mark-to-market accounting no longer applies to illiquid, held-to-maturity assets like CDOs or collateralized subprime auto loans. To the extent banks even own any in this post-Volcker-rule America, the bank needn't take a loss as long as it plans to hold the security to maturity.

What about non-bank investors, like yield-hungry hedge funds or your neighbor Jim? It is extremely tough to envision securitized auto loans tanking the way subprime CDOs did in 2008, taking down funds. Consider some key differences between an auto loan and a mortgage. For many folks, a mortgage is a leveraged bet on home prices. The housing bubble imploded partly because people overextended themselves, believing home prices would never stop rising and reward their risky financial decisions-even if they couldn't make their loan payments longer term. Home prices fell instead, and many folks had to pay the piper. The influence of the housing market, and fears (however irrational) about the danger of "under water" mortgages played a big role in CDOs' fall, lending them their "toxic" reputation^[ii].

Auto loans are different. A car, as folks know all too well, is a depreciating asset. An auto loan isn't a leveraged bet on rising car prices-borrowers paying a 23.4% interest rate on their auto loans aren't doing so because they believe they can eventually flip their jalopy for a profit. It's just what they've chosen or been forced by circumstance to do for transportation. Anyone owning an auto loan does so simply to collect the interest and principal repayments. Some borrowers will make payments. Others will default. Banks and investors will take the occasional lump, as they always have.

So how should investors interpret the NY Fed's report? Simply, lending is up, and delinquencies are tame! Credit markets are healthy, and consumers and businesses are accessing ever-more capital to finance whatever needs financing. That's good. As is the fact folks are still on bubble-watch-false fears are bullish.