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Dealer Insights - March-April 2015 - Is a Subprime Auto Loan Bubble Ready to Burst?

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Automobile lending in the U.S. is booming, recently reaching the highest level since well before the Great Recession. According to the Federal Reserve Bank of New York’s August 2014 Household Debt and Credit Report, auto loan originations recently reached the highest level in eight years, while auto loan balances increased for the thirteenth straight quarter.

This is generally good news for dealerships, as more auto loans translates into more automobile sales. But digging deeper into the numbers reveals one potentially disturbing trend: a sharp rise in the number of subprime auto loans being made — especially among auto finance companies.

Subprime borrowers active

About one-quarter of all auto loans are now made to subprime borrowers, which are generally defined as borrowers with credit scores below 620. Since bottoming out in late 2009, auto loan originations and balances have rebounded among all borrowers, but this growth has been most pronounced among borrowers with the lowest credit scores.

For example, the dollar value of auto loans to borrowers with credit scores lower than 620 has nearly doubled since 2010, while the value of auto loans to borrowers with credit scores above 720 has increased by only about one-third. The total volume of subprime auto loans in the U.S. exceeds $145 billion, according to credit rating firm Experian.

Some economists believe that this surge in subprime auto lending is eerily similar to the boom in subprime mortgages that preceded the financial crisis. For one thing, many large banks and private equity firms are investing billions of dollars in subprime auto lenders. Also, like mortgage loans, some subprime auto loans are being bundled together to be packaged as complex securities and sold to investors.

So is the subprime auto loan market a bubble that is ready to burst? The U.S. Justice Department is concerned enough that it launched an investigation into subprime auto lending last August. It’s in the process of investigating the subprime lending practices of General Motors Financial to determine whether any of these practices are unethical or illegal. And some banking analysts and credit rating agencies are warning investors about the potential for severe losses if subprime borrowers fall behind or stop making their loan payments.

For example, a Standard & Poor’s report issued last summer warned investors they should be prepared to withstand “higher losses” on packaged subprime loan securities. And the Office of the Comptroller of the Currency noted in a report issued last June that signs of easing terms and increasing risk in auto loans are “noteworthy.”

Fears may be overblown

However, other economists and experts believe that fears of a bursting subprime auto loan bubble are greatly overblown. They point out that the total subprime auto loan market is a fraction of the size of the total mortgage loan market. So the ripple effects of a burst subprime auto loan bubble (assuming a bubble exists) on the overall economy would be much less significant than those of the burst mortgage loan bubble.

An Equifax report, Not Yesterday’s Subprime Auto Loan, describes the importance of a fair and functioning second-chance market for those with low credit scores who need financing to buy an automobile. Without subprime auto loans, the report states, many people would be unable to obtain a vehicle and, thus, unable to obtain and maintain employment.

The report also notes that, while subprime lending and predatory lending are often closely associated with each other, they aren’t the same thing. Predatory lending encompasses practices designed to take advantage of consumers. These practices are often unethical and even illegal, such as falsifying income and employment information on borrowers’ loan applications.

Conversely, legitimate subprime auto lending provides credit that enables consumers with low credit scores to buy used vehicles. Some lenders point out that, while subprime loans feature higher interest rates, this is necessary to compensate for the increased risk of making the loan.

Loan performance appears adequate

Finally, the Equifax report notes that there’s been no evidence yet suggesting higher delinquency rates or increased charge-offs in the subprime auto loan sector. “The results thus far do not indicate that recently originated subprime auto loans are exhibiting decreased performance,” stated the report.

Only time will tell whether there’s indeed a subprime auto loan bubble. Given the current environment, though, dealerships would be wise to exercise prudence when it comes to financing customers with lower credit scores.

Sidebar:How to avoid subprime lending problems

It’s important to make sure your dealership doesn’t cross over the line that separates legitimate subprime lending from predatory lending practices. Here are a few tips to consider:

  • Verify that all the income and employment information on borrowers’ credit applications is accurate and complete.
  • Be upfront and clear with customers about the loan’s interest rate and any additional fees so they can see the total cost of buying the automobile.
  • Don’t use hardball sales tactics on subprime loan customers when discussing financing, such as unnecessarily making them wait for hours for a financing decision.

Dealer Insights - March/April 2015

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