The Most Dangerous Kind of Lending
According to recent data, there has been a massive increase in subprime auto lending. It is so high that The Washington Post even went so far as to call it a "bubble" that's going to burst.
At first glance, it may seem like subprime auto lending doesn't have the potential to become nearly as big of a problem as the subprime home loans that led to the mortgage crisis. After all, a loan backed by a $400,000 home must be inherently riskier than one backed by a $15,000 used car, right?
Wrong. There is one big difference between the two, and it could lead to a big problem for lenders if things go sour.
It's not the size of the loan
While the size of the loan does somewhat quantify the magnitude of the risk taken, most of the risk comes from the type of asset backing the loan. And, there are two types: appreciating and depreciating.
The most common type of appreciating asset is real estate, and what this means is that the value of a home (in theory) will increase over time. So, lenders are generally more eager to lend for purchases of appreciating assets, because if the borrower defaults, the bank can seize the asset and recover all or most of its money.
A depreciating asset is anything that inherently loses value over time, like the cars backing the subprime auto loans currently being made. While the value will never quite reach zero, cars lose value at a relatively consistent and predictable rate over time. The exact rate of value decay depends on several factors, such as the condition of the car and particular make and model, but the general pattern is the same.
So, if a lender is forced to repossess a car, it becomes a very urgent matter to turn around and sell the car to recoup what they can. If a bank lets a repossessed car sit on its books for even a few months, it could lose a substantial amount of its value.
But can't houses go down in value as well?
Well, sure. Homeowners saw this all too well a few years ago. And if a house declines in value to the point where the mortgage is greater than the market value of the home, a lender would definitely have a tough time recouping its money by selling it.
However, the difference is that over time the house's value has an upward bias. The population is increasing, inflation pushes consumer prices upward, and unlike cars, there is a finite amount of land to build homes on.
Let's say that a lender forecloses on a home with a $250,000 outstanding mortgage, but that the house only has a current market value of $200,000. Well, if the lender hangs on to the house, and maybe even rents it out until the market improves, eventually the lender should be able to get its money back. This is part of the reason why several years after the foreclosure crisis, we're still seeing lots of new foreclosures coming on the market.
On the other hand, after five years a car will lose approximately 50% of its value. Over time, the average car depreciates at about 15% per year, while the average home gains 3%-4% per year, based on historical averages. So, over a five-year period, the value should follow a pattern similar to this one:
Just how big is this bubble?
In 2013, about 27% of all car loans were made to subprime borrowers, or those with FICO scores of 620 or less. And, there are currently over 20 million active subprime car loans.
The average auto loan charge-off is more than $8,500, so even a small rise in the repossession rate could mean big losses for the banks. For example, just 1% of all active subprime car loans represents about $1.7 billion in potential charge-offs.
And, according to myfico.com, 31% of people with FICO scores between 600-649 (the highest of the subprime borrowers) will have a serious credit delinquency over a two-year period. And this percentage shoots up to 70% for the 500-549 range. So, there is a potential for things to get very ugly, especially if the economic recovery runs into trouble.
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