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Smoke on Cars

A dubious doomsday scenario: Subprime autos won’t trigger crisis


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This article was originally published in The Hill on July 20, 2018:

A persistent automotive doomsday thesis that continues to have favor with some in the media and on Wall Street is that subprime auto loans are booming and creating the next great financial crisis. Don’t believe it. As an economist who covered housing during the mother of all bubbles and subsequent financial crisis, I can confidently assert that what is happening today is not setting the stage for 2008 all over again.

It is true that record volumes of auto loans have supported strong growth in new vehicle sales in recent years. According to Equifax, a record 29 million auto loans and leases were originated in 2016, helping the industry achieve record levels of new-and-used cars sales.

Subprime auto lending also grew during this period, but 2016 actually saw a 3 percent decline in the number of subprime auto loans and leases. Indeed, the share of subprime auto loans and leases peaked in 2015 and has been declining.

As the subprime share increased, the default rate on auto loans increased. This, of course, was expected, but the default rate peaked at 1.08 percent in October 2016 according to S&P/Experian and is far from a crisis by historical standards. In February 2009, during the Great Recession, auto loan defaults rates reached 2.75 percent.

Lenders responded to the deterioration in loan performance by tightening standards. According to Federal Reserve Senior Loan Officer survey data, credit tightening for auto loans began in earnest in 2016. Since then, we’ve seen:

  • four straight quarters of lenders reporting tighter loan standards
  • five quarters of increasing spreads on loan rates
  • four of five quarters with increases in minimum required down payments
  • five quarters of higher minimum required FICO scores
  • six quarters of tightening policies on customers who do not meet credit score thresholds

Defaults have been declining as a result. In fact, S&P/Experian reported that the auto loan default rate fell to 0.82 percent in June 2017, the lowest level in the data series, which dates back to 2004.

The time to write about possible problems in auto loan defaults was a year ago, and even then the volume of defaults was not near crisis levels. Instead, it led to appropriate tightening and now a healthy and normal distribution of auto loans.

Furthermore, broader economic and credit data suggest the average consumer is in good financial shape. Defaults on all types of loans are down and trending lower. Total financial obligations are lower, debt service ratios are lower, personal incomes are up and wages are again growing faster than inflation thanks to low unemployment.

Assuming current lending standards and trends hold, automotive credit should remain accessible, and any contained losses in subprime are not likely to cause pain for the economy more broadly. The insinuation that a bubble in subprime auto lending could take down the economy like the mortgage market did is comical.

The real mortgage credit bubble was fueled by rapid growth in securitization that dwarfed automotive lending at its peak by comparison. The current $1.1 trillion level of auto loans outstanding is 9 percent of total household loans. At the time of the financial crisis in Q3 2008, mortgages were worth almost $11 trillion and represented 76 percent of household loans.

Furthermore, the very nature of a real estate loan is very different from an auto loan. Real estate is an investment that typically appreciates over time. During the bubble years, consumers and lenders falsely believed appreciation would bail them out from poor judgment.

Vehicles, on the other hand, depreciate. There is no false hope of higher values in the future to bail out a borrower or a lender. It is also far easier and less expensive to repossess a car compared to foreclosing on a home. Furthermore, as default metrics from the financial crisis show, a consumer is more likely to pay their car loan ahead of other debts.

That’s a key reason why the market normally sees at least 20 percent of auto loans as subprime. The lender receives a higher rate to compensate for the higher risk, but the risk is low enough to make the loan work for the subprime borrower. The same is not true of housing — subprime mortgage lending has almost disappeared as a result of the experiences of the financial crisis.

Subprime lending plays an important and natural role in the automotive market. While the subprime share did grow and cause a higher rate of default, subsequent tightening of standards have returned the market to a more normal level of subprime lending.

Bottom line: There is no crisis.

Jonathan Smoke is chief economist for Cox Automotive. The Cox Automotive family of brands includes Autotrader®, Dealer.com®, Dealertrack®, Kelley Blue Book®, Manheim®, NextGear Capital®, vAuto®, Xtime® and a host of others. Cox Automotive is a subsidiary of Cox Enterprises Inc., an Atlanta-based company with revenues exceeding $20 billion and approximately 60,000 employees. For more information about Cox Automotive, visit www.coxautoinc.com.

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