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The auto debt bubble threatens stock market again

Image: Flickr/Lars Plougmann​

Screaming car ads have caught my eye lately, in the Metros and the Suns at Tim Horton's and the auto body repair shop. One banner offered a 2015 Prius for less than $20,000. While that's still a lot of money,  it's about half the regular retail price for a brand new Prius -- a heckuva lot of depreciation in two years.   

At the same time, I've noticed articles about a coming tsunami of late-model cars "coming off lease," as in this Reuters story: "By the end of 2019, an estimated 12 million low-mileage vehicles are coming off leases inked during a 2014-2016 spurt in new auto sales, according to estimates by Atlanta-based auto auction firm Manheim and Reuters."

This glut occurs just as, the story says, "Demand for new vehicles is slowing after seven consecutive years of rising sales. Meanwhile, carmakers' discounts on new vehicles have surpassed record levels set during the Great Recession."

I was curious. Why the big surge, and big drop-off? While Americans love their cars, and most literally can't get through their day without one, that's not enough to spur them all to go buy new cars in the same year, is it? So I dug a bit and found the answer: apparently cheap credit.

First of all, lenders are extending the duration of loans, up to 72 and 83 months, allowing them to upsell the customer to a more expensive car. Many car buyers approach the purchase with a monthly figure in their minds -- say, $350 a month for the car --  without thinking  long term. A borrower who keeps the car for six years and pays out the contract at a reasonable rate of interest, say six percent, will have paid a total of twice the agreed price for the vehicle. Meanwhile, depreciation will have whittled the vehicle's value to a fraction of its retail price. Most borrowers want to trade in their car after five years, though, so they add the new loan to what's left of the old loan and carry on.

Canada's Financial Consumer Agency spoke out against extended loans in March 2016. "Recent trends in extended-term car loans have raised several concerns," said Lucie Tedesco, commissioner of the FCAC. "Consumers must carefully examine their needs and their financial situation to ensure they can repay their car loans without undue strain, and with a full appreciation of the total interest charges and value of the car throughout the loan period."  That is, people are buying cars they can't afford, and paying too much for them. 

Also, some people are taking out loans to buy vehicles even though they have credit scores below 620, or no credit scores at all. Those car lots that advertise, "No Credit? No Problem!" steer customers right to subprime auto loan providers. As with subprime mortgages, subprime auto loans offer financing to people with low credit scores, in exchange for high (25 per cent) interest rates.

In Canada, a May 2017 Canadian Business article asked, "When will Canada's subprime car loan bubble burst?" and continued "A report by the Moody's debt rating agency last year noted that some car buyers even wind up borrowing 135 [per cent] of the value of the vehicle. That's a sign of desperation. So too is the fact that one-quarter of all auto loans are to people with lousy credit. That's what they call subprime lending, folks." 

In the U.S., Forbes reported in July that, "As car sales are plunging, the number of risky car loans is rising...and so are incidents of credit fraud. In a UBS survey, one in five borrowers admitted that their applications contained inaccuracies."

The "Auto Loans: A Wolf in Sheep's Clothing" article continued: "However, lenders are actively participating in building this particular Potemkin village. The biggest auto loan provider, Santander, is under investigation in at least 30 states for fraudulent lending practices and recently settled a lawsuit for $25 million."

Santander's practices harmed both low-income borrowers (who borrowed more than they could afford) and high-income investors who bought Santander's bonds based on bundled high-risk loans, said Forbes. "Rating service Moody's reported that Santander verified the incomes of just 8 [per cent] of borrowers whose loans it recently packaged into a $1 billion bond issue. Furthermore, on top of unverified income, 9 [per cent] of those borrowers had low or no credit scores and no co-signer."

Some of us recall that the same sort of bundling unpayable debts into junk bonds created the 2008 subprime mortgage meltdown. "Auto loans are a reminder of the housing crisis," warned Business Insider in April. "Auto Loan Fraud Soars in Parallel to the Housing Bubble," was Bloomsberg's comparison in May.

And yet, and yet -- for many workers (especially in the U.S.), a car is essential in order to get to their jobs. During the 2008 market crash, people who were defaulting on their mortgages, still made their car payments because they absolutely had to have their cars to get to their jobs.  

So low-income or self-employed people tend to feel gratitude, not wariness, when a kind car salesperson bends the financing system rules in order to making owning a car possible. One woman signed a contract after the dealership said it would hire her part-time, and counted her supposed future salary towards her eligibility for a loan. Of course, the job never happened, and she couldn't carry the loan without it.

"As car buying skyrocketed after the recession to record heights, more Americans with bad credit started obtaining auto loans -- oftentimes with interest rates as high as 29 [per cent]" writes jalopnik.com "Between 2009 and 2016, loans issued to people with bad credit jumped from $52.6 billion to $119 billion, an increase of more than 126 [per cent]."

"Those who default on a car loan can fall into a nasty, cyclical trap: their credit gets shot, they lose their vehicle, they struggle to make arrangements to gather money to get their car back, fall behind on their bills, lose their car again. Rinse and repeat."

Conversely, Santander's and other subprime lenders also threaten the entire economy in the same way subprime mortgages did. They bundle a "billion dollars" worth of these dubious loans, and sell junk bonds to investors -- high risk, high yield bets that B grade borrowers will pay back their loans over six years, 25 per cent interest and all. Problem is, the rate of defaults is rising. That's a big part of why so many cars are "coming off lease."

Still, "Subprime auto loans may be suffering from higher delinquencies," Bloomsberg reported in early August, "but investors are still clamoring for bonds backed by the debt, according to Wells Fargo analysts."

"An $800 million subprime auto bond sale from Westlake Financial Services Inc. last week was priced at some of the highest valuations...since 2014, the analysts wrote in a note Monday. The portion of the security rated BB, or two steps below investment grade, offered the least additional yield for a deal of its size and rating on record. Demand for the offering was strong enough to increase its size from a planned $700 million."

Although the idea that financing drives auto sales may seem perverse, that's actually an industry truism. As Forbes reported in 2012, "Financial results for the six publicly traded, new-car dealer groups in the United States show that to a great extent, dealerships are in the business of selling new and used cars so they can service them and finance them."

"Dealerships also make a profit on loans and leases negotiated at the dealership. In effect, the dealer gets a cut of the interest rate profit made by the lender...between the dealer markup on loans and leases, plus the sale of F&I  [Finance & Insurance] products, the six publicly traded dealer groups averaged about $1,100 per vehicle in F&I revenue."

Altogether, U.S. wheeling and dealing in new and used cars usually generates about $1 trillion in F&I, compared to the U.S. mortgage market of about $8 trillion. But then, subprime mortgages were a small part of the mortgage market, and their failure damaged everyone. 

"About a third of the risky car loans that are bundled into bonds are considered 'deep subprime,' a level that has surged since 2010 and is translating to higher delinquencies on the loans, according to Morgan Stanley..." a sevenfold increase in seven years.

Business magazines have been warning since spring that the subprime auto loan market is hanging over a precipice. The stock market has been sharply down for months. Now autumn is here, and the subprime bonds still haven't defaulted -- yet. Unfortunately, if auto debt drives down the market, even people who never owned cars in their lives will be affected.

Image: Flickr/Lars Plougmann​

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