Subprime Auto Loans: Not Another 2008

Subprime auto loans aren't another crisis waiting to happen.

Photo by fotog/Getty Images.

Subprime. Just uttering the word, for some, evokes memories of the housing bubble and financial crisis. Perhaps that explains why recent media reports of growth in subprime auto loans trigger worries of skyrocketing defaults, a banking crisis and a 2008 economic downturn redux. If that were realistic and likely, it would be scary indeed. But we think once you've had a look at the full evidence and a brief refresher in 2008 history, you'll see subprime auto loans aren't remotely likely to create a banking crisis.

First, a couple points the media gets right: Auto loans are on the rise, as are subprime delinquencies. The Federal Reserve Bank of New York's quarterly report on household debt and credit indicates auto loan balances topped $1 trillion in Q4 2015, above the ~$800 million before 2008's financial crisis. In number, auto loan accounts are also up while the number of mortgages and home equity loans are down slightly. Coinciding with the rise, Fitch Ratings reports US subprime auto loan delinquencies rose to their highest level since 1996 at over 5% in February.

That may seem scary, but some scaling is in order. As of Q4 2015, banks held $12.1 trillion of household credit-auto loans' $1 trillion is about 9% of the total.[i] Roughly one-third of auto loans went to borrowers with credit scores below 660, one common definition of subprime .[ii] Hence, subprime auto loans account for roughly 3% of outstanding bank loans. Of these, only about $20 billion are securitized, so the originating bank overwhelmingly owns the loans. This is dwarfed by the roughly $2.8 trillion in outstanding securitized mortgages as of Q4 2015. While media coverage of subprime auto lending is surging, it isn't taking up a materially larger share of lending. (Exhibits 1 and 2)

Exhibit 1: Auto Loan Originations by Credit Score

Source: Federal Reserve Bank of New York Consumer Credit Panel/Equifax. Auto Loan Originations by Credit Score, Q1 2004 - Q4 2015. * Credit Score is Equifax Riskscore 3.0.

Exhibit 2: Subprime Share of Auto Loan Origination

Source: Federal Reserve Bank of New York Consumer Credit Panel/Equifax. Subprime auto loans as a percentage of all auto loan originations, Q1 2004 - Q4 2015. Auto Loan Originations by Credit Score, Q1 2004 - Q4 2015. *Credit Score is Equifax Riskscore 3.0.

While some folks are falling behind in loan payments, most aren't. Just 3.4% of subprime auto loans are currently 90+ days delinquent.[iii] Not all of these will end up defaulting-some will catch up on past-due payments. That said, even if every borrower currently behind eventually receives a visit from the repo man, this segment of the credit market is way too small to cause a systemic banking crisis.

Now, in our view, it is overly simplified to argue the housing bubble caused the 2008 financial crisis (as we'll explain shortly). But even if you go with that assumption, consider: The housing market became inflated in the mid-2000s partly because people thought home values would keep rising. A mortgage that was a stretch for them to afford wouldn't matter much if they could sell their house for a profit. But no one thinks car values are going to soar ever higher-it's pretty darn well known cars depreciate the moment they are driven off the lot. The likelihood a banker extends credit on super-loose terms to risky borrowers when the collateral is a depreciating asset is low.

What's more, when folks default on an auto loan, the resolution process is much less onerous and time consuming than for foreclosures. Depending on the state, it can take anywhere from a few months to a few years for a bank to foreclose on a house. Foreclosure rules mean it takes a long time to clear the uncertainty of defaulted home loans. They linger on bank balance sheets as non-performing loans for quite a while. Auto loans, as detailed here, are very different. When someone defaults on their car payment, their car is repossessed within days or even hours, eliminating uncertainty in one fell swoop.

Overall, though, the worries seem mostly tied to misunderstandings about what caused 2008's crisis. Because part of 2008's backdrop was an overheated housing market, and subprime lending was a big story at the time, many presume this was its proximate cause. But that's inaccurate.

2008 didn't happen because of actual loan losses. It resulted from banks' forced writedowns on securitized home loans, combined with the Fed and US Treasury's panicked response. FAS 157-the mark-to-market accounting rule implemented in October 2007-forced banks to value illiquid assets as if they had to be sold immediately. The illiquidity often meant no market price was readily available. Hence, each bank wrote down assets based on what others just did, creating a system-wide event. In so doing, this rule turned what seemed like a manageable amount of loan losses into a massive crisis by overstating loan losses from a few hundred billion incurred over several years to a few trillion dollars of capital needlessly wiped off bank balance sheets in a hurry, stoking the panic, bringing down major firms and crushing the survivors' ability to lend. As part of Congressional testimony on FAS 157, former FDIC chairman William Isaac demonstrated the rule's caustic effects on bank balance sheets. He showed one $3.65 billion tranche of non-subprime mortgage-backed securities, held by Wells Fargo, that had incurred $1.8 million in actual losses. The bank expected the underlying mortgages' maximum loan losses to possibly hit $100 million. But FAS 157 required Wells to write down the value by an astounding $913 million. (Exhibit 3)

Exhibit 3: FAS 157 Greatly Magnified Actual Loan Losses

Source: Senseless Panic and William Isaac's Testimony to Congress dated 3/12/2009. This is an example Isaac used of an actual tranche of $3.65 billion of MBS owned by Wells Fargo as of 12/31/2008.

Moreover, this effect was not limited to prime loans. As part of JP Morgan Chase's brokered purchase of Bear Stearns in March 2008, the Federal Reserve created a fund called Maiden Lane to buy Bear's so-called "toxic" assets: securitized subprime mortgages. In so doing, the Fed removed them from a mark-to-market accounting environment and ended up reaping a profit on them. Similarly, the British government recently sold off its portfolio of Northern Rock's "bad loans"-which fell roughly -90% in 2008-at nearly the full face value, a startling tale illustrating the vortex's transatlantic reach.

Without FAS 157, subprime mortgages were too small a portion of bank balance sheets to cause a crisis, and subprime auto loans are an even smaller portion now. Besides, banks no longer have to mark held-to-maturity assets to market, so even a subprime mortgage boom similar to what occurred in the mid-2000s likely wouldn't cause a crisis either.

When push comes to shove, there is little-to-no sign US consumers are stressed or stretched presently. Consumers' balance sheets are largely fine. As Exhibits 4 and 5 show, the consumer debt-service ratio-a comparison of debt-service payments to disposable income-is low. Ditto for the broader financial obligations ratio, which includes leases and rent. Consumers are simply not overextended. Finally, a wave of spiking defaults are usually the result of economic downturns, not the cause of them.

Exhibit 4: Consumer Debt-Service Payments to Disposable Income

Source: Federal Reserve Bank of Saint Louis, as of 3/21/2016. Consumer debt-service payments as a percentage of disposable income, Q1 1980 - Q4 2015.

Exhibit 5: Financial Obligations to Disposable Income

Source: Federal Reserve Bank of Saint Louis, as of 3/21/2016. Consumer financial obligations as a percentage of disposable income, Q1 1980 - Q4 2015.

Subprime auto loans, as we've detailed, are very unlikely to cause a crisis. In our view, the fact folks still see 2008 ghosts around every corner is a clear sign sentiment isn't stretched, which suggests the bull market likely has further to run.

[i] Source: Federal Reserve Bank of New York, Quarterly Report on Household Debt and Credit, February 2016

[ii] Ibid.

[iii] Ibid.

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*The content contained in this article represents only the opinions and viewpoints of the Fisher Investments editorial staff.