Are subprime auto loans the cause of the next financial crisis?

One commentator argues that the lack of regulation of subprime lending could lead to massive defaults.

For most Americans, owning a car is a necessity. People rely on cars to get to work, take their kids to school, and participate in their communities. Historically, cars represented economic success, but without prompt action, cars – and the loans consumers take out to buy them – could trigger a major crisis for the US economy.

This is the argument that Andrew Schmidt, a law student at the University of California at Berkeley Law School, makes in a recent article. He urges state officials, lawmakers and regulators to intervene in the auto credit market to limit the ability of lenders to issue subprime loans.

Since the Great Recession, the number of car loans made in the United States has reached an all-time high. Along with the increase in consumer demand, the rate of lending to people with low credit scores and high default risks has also risen sharply. Often, lenders charge cars up to twice the Kelley Blue Book value, a practice that allows them to “just profit from the down payment and assembly fees”. The subprime loans they issue also carry exorbitant interest rates, sometimes exceeding 30%.

Consumers are already in dire financial straits when they take out a subprime loan – they cannot qualify for a conventional car loan. Without bargaining power and in dire need of a car, they have little choice but to accept the lender’s terms.

In addition to staggered loan terms, lenders also frequently turn to deceptive remedies for repossession, including luring borrowers to dealerships on the promise to renegotiate or install remote-controlled devices that prevent the engine from car to restart. By engaging in “self-help” repossession, lenders avoid hiring “repo men” to track down and recover cars, further protecting their profits. Since many borrowers default within a year, the cars secured on the loans hardly depreciate, allowing lenders to resell them on similar terms.

Although lenders profit from defaults, some borrowers spend decades paying off a car they’ve only driven for a few months. To recover loan balances, lenders engage in aggressive collection tactics such as lawsuits and wage garnishments. Some subprime lenders have attorneys on staff to deal with rapid default rates.

Schmidt fears a massive series of auto loan defaults could have “disastrous consequences” for the economy. Risky loans create high demand for used cars, causing price inflation. Since lenders profit even when borrowers default, they have an incentive to offer default-prone loans. As with the housing crisis of 2008, a systemic scenario of massive default would lead to a higher supply of repossessed cars. Used car prices would fall, followed by new car prices. As loan-to-value ratios rose, borrowers close to default would not be able to refinance, leading to another wave of foreclosures and price cuts. Schmidt notes that an auto crash would hit poorer households the hardest. For low-income Americans, repossessing a car could mean the loss of gainful employment, the accumulation of crippling debt and even the loss of eligibility for public benefits.

Subprime auto loans are not exempt from oversight by state and federal regulators, including members of the Consumer Finance Protection Bureau (CFPB) and the Federal Trade Commission. These agencies investigate and prosecute lenders for unfair, deceptive, and abusive tactics. Schmidt suggests their efforts are failing, however, because the agencies’ actions only target unfair financing, debt collection and repossession practices, rather than lenders’ disregard for borrowers’ ability to repay loans.

The CFPB seems reluctant to tackle subprime auto lenders. Of 135 actions the board took, only 13 involved subprime auto lenders.

Citing the Dodd-Frank Wall Street Reform and Consumer Protection Act (Dodd-Frank), the CFPB determined that a payday lender’s disregard for repayment capacity was abusive under the law, but the agency has not yet imposed this standard on auto lenders. Building on the precedent applied to payday lenders, Schmidt explores the feasibility of issuing a “repayment capacity rule” modeled on that which applies to mortgages. The rule would require lenders to screen borrowers using verifiable information such as pay stubs and tax records. Loans issued under the rule would carry a rebuttable presumption of validity. Under this regime, private market participants would have the right to sue lenders and pursue civil remedies such as termination and restitution of contracts.

Schmidt warns that the flip side of restricting lending is to withhold credit from consumers who rely on cars to participate in the economy. Specifically, economists who have studied the impact of the mortgage repayment capacity rule argue that the stricter underwriting standards have a disproportionate impact on African-American and Latino borrowers, as well as borrowers living in low-income communities. Virtually all borrowers with FICO scores below 660 are shut out of the mortgage market. The credit scores of subprime auto loan borrowers are often lower than this by 100 points or more.

Introducing a repayment capacity rule could also prevent entire communities from buying cars on credit. The consequences are particularly stark in the auto industry, which does not offer cheaper alternatives like rental housing. Schmidt acknowledges that “limiting subprime borrowing in the housing market can prevent individuals and families from creating intergenerational wealth through homeownership.” But he observes that “the impact of limiting car credit could be more immediate and devastating for many low-income people.”

To avoid banning entire communities from car ownership, Schmidt advocates an aggressive enforcement approach that would stem the tide of subprime lending without cutting off access to credit. Unlike a new rule, which could take a year or more to implement, agencies could immediately bolster enforcement of existing laws like Dodd-Frank. The application is also discretionary and flexible, allowing regulators to tailor their response to a specific case. Regulators would have to apply the rules uniformly, which would prohibit them from adjusting their response if necessary. Furthermore, Schmidt touts the absence of a private right of action as an advantage for enforcement. He argues that limiting lenders’ liability will encourage them to continue extending credit, even under increased government scrutiny.

Without meaningful intervention, the subprime auto loan bubble is poised to burst, warns Schmidt. Regulators can glean valuable insights from the 2008 housing crisis, but since most car owners require credit extension, solutions such as the repayment capacity rule cannot be easily implemented. Instead, Schmidt calls on agencies to step up enforcement efforts against the most abusive lenders without cutting off millions of consumers from private transportation.