Why are subprime auto loans still relevant?

What are subprime auto loans?

Subprime auto loans are loans made to consumers who would not qualify for regular auto loans for reasons such as a low credit score or insufficient income. Since these loans are riskier, they tend to come with higher interest rates, higher fees, and longer terms. For example, deep subprime loans for borrowers with a credit score of 300 or less can be accompanied interest rates of up to 20%.

Some lenders then consolidate these subprime loans into asset-backed securities such as bonds and sell them to investors. Investors tend to like these asset-backed securities because as long as borrowers repay their loans, investors and lenders make big profits from the high interest rates attached to them.

So what happens when borrowers can’t make payments?

This is where it gets tricky. Since these are asset-backed securities, the lender first repossesses the asset – the car. So now the borrower doesn’t have a car to get to work and is still stuck repaying the loan.

Because most cars depreciate as soon as they leave the lot, borrowers are often saddled with auto loans that exceed the value of the car. So even after repossessing and selling the car, there is often a balance left on the loan. As a result, some lenders have taken defaulting borrowers to court to sue them for the remainder. When lenders win in court, the borrower’s wages can be garnished until the balance is paid off, which can be devastating for those who live paycheck to paycheck.

To ensure that more borrowers can repay their loans, lenders have also started offering subprime auto loans with longer repayment periods, allowing for lower monthly payments. But it also means that the loan balance earns interest for a longer period. And the longer the loan, the less the car is worth at the end of it. About 12% of those who took out a loan to buy a car ended up with a loan for a longer period than they actually expected to own that car. according to a recent survey.

Subprime auto loans and the problems that come with them also caught the attention of late-night host John Oliver.

“Theoretically, it’s a good thing for car dealerships to lend money to people who can’t get financing elsewhere, but in practice, these dealerships can trick people with few options into paying much more than the value of the car,” Oliver explained last August. year. “That’s just one of the many ways that when you’re poor, everything can be more expensive. The average interest rate on the buy here, pay here lot is 19%, with some paying as high as 29%.

Is Wall Street worried about delinquent loans?

Not really. The whole premise of subprime loans is that they’re riskier than prime loans, so if people default, it’s not really unexpected. It is expected that a certain percentage of the loans will default. But the number of defaults climbing since 2014which is worrying.

According to a recent report by Fitch Ratings, subprime auto loans issued in 2015 are experiencing net losses at a rate that should reach 15%. These losses are even higher than losses on similar bonds from 2007.

Moreover, some banks seemed to have granted loans willy-nilly. Consider this report from Moody’s Investors Services which was released in May. It found that Santander Consumer USA – one of the largest subprime auto lenders in the United States – only verified the income of eight percent of its applicants before granting them a loan.

Will it crash the economy like the subprime mortgage crisis?

Probably not, for several reasons. First, the big banks, which have invested heavily in the subprime mortgage market, are slowly turning away from subprime auto loans. Second, compared to mortgages, auto loans represent a much smaller share of US household debt. And third, while homes with defaulting owners can be difficult for banks to sell to recoup losses, there is still a market for used cars. Yet banks are beginning to turn away from these loans.

If the economy is not going to collapse, why are the banks foregoing these loans?

Because lenders find it difficult to make money from these investments. It may take lawsuits and a lot of borrower hunting to make a profit.

In the first three months of this year, JPMorgan Chase issued just $8 billion in auto loans to its portfolio, down 17% from a year ago. Gordon Smith, head of the retail banking division of the bank issuing these loans, told the Financial Times that subprime loans now represent a considerably smaller share of its auto loan portfolio.

In 2015, Wells Fargo announced that subprime auto loans would only compensate 10% of its new car loanslimiting its exposure to the subprime market.

Last year Jamie Dimon, CEO of JPMorgan Chase, describes the car loan market as “stretched”, adding: “Someone is going to get hurt. … We don’t do much of that.

“There is a problem with auto subprimes, which we see”, Dimon said in april. “But the subprime auto is so small compared to the US debt market that it won’t make a difference to the system.”

Define small.

Auto loans account for about 9% of total US household debt of $12.72 trillion. As of March 31, the distribution of the debt is as follows:

  • Housing: $9.08 trillion
  • Student loans: $1.34 trillion
  • Auto loans: $1.17 trillion
  • Credit card: $0.76 trillion
  • Other: $0.37 trillion

It’s the green ribbon here:

And roughly 3.8% of that $1.17 trillion is seriously overdue — defined as payments three months or more overdue.

In terms of securities like bonds we were talking about earlier, at the end of March only $192.3 billion of them were backed by outstanding subprime and subprime auto loans, according to the Securities Industry and Financial Markets Association.

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