Auto loans have long been what we in the industry call “a shit show.” Long terms, high payments and predatory lending tactics have dominated the industry for years. well, one shocking study by Consumer Reports shows things are worse than anyone thought – and with increased investment in auto loan-backed securities, another financial crisis could be brewing. Double, double, hardship and trouble.
Before you embark on some big shortLet’s start with the Consumer Reports study. After reviewing data from auto loans issued in 2018 and 2019, the organization found that the auto loan market is a true Wild West — an ill-regulated wasteland where each participant is on their own.
Consumer Reports analyzed over 850,000 auto loans from 17 different lenders for a year. The data showed an average monthly payment of almost $600 for new cars — a 25% increase over the past decade. Disturbingly, that’s not the worst part:
The investigation revealed:
- A credit rating does not necessarily dictate the terms of the loan being offered. Borrowers in every credit rating category — from super-prime with scores of 720 and above to deep subprime with scores below 580 — received loans with APRs ranging from 0 percent to more than 25 percent.
- Some high-credit scorers receive high-priced credit. While low-credit borrowers are, on average, offered the worst terms, about 21,000 prime and super-primary borrowers, about 3 percent of all borrowers in this group, received loans with APRs of 10 percent or more — more than double the average rate for high scorers in our data.
- Many borrowers receive loans that they may not be able to afford. Experts say consumers shouldn’t spend more than 10 percent of their income on a car loan. But almost 25 percent of the loans in the reviewed data CR exceeded this threshold. For subprime borrowers, that figure is nearly 50 percent, about 2.5 times higher than for prime and superprime borrowers.
- Underwriting standards are often lax. Lenders rarely checked borrowers’ income and employment to confirm that they had sufficient income to pay off their loan. Of the loans CR examined, these reviews took place in only 4 percent of the cases.
- Late payment is common. More than 5 percent of the credits in the data — 1 in 20 or about 43,000 in total — were reported in default of payment. While arrears have been falling over the past year and a half, likely thanks to pandemic-related deferral programs, industry bodies and regulators are bracing for a potentially sharp spike in the coming months.
Scary enough for you? Regardless of their creditworthiness, car buyers face high rates; either to enrich the financial institution underwriting the loan, or to Earn the dealer a few extra dollars in kickbacks. Oftentimes, underwriters don’t even perform basic due diligence to verify that the borrower can afford the loan – just raise the interest until the buyer says “uncle”.
Five percent of auto loans in the US are in arrears, and almost half are under water. With both New and used cars skyrocketing costs and Credit deferral programs due to Covid comes to a halt, this pattern is unlikely to change any time soon. At least it doesn’t change for them better.
Much like late-stage trick-or-treating, when the houses run out of candy, it only gets worse from here. You may recall a niche little historical event called “the 2008 financial crisis.” If not, please don’t comment and make me feel old, but here’s the basic story:
Investors invest huge sums of money securities backed by residential mortgages. Essentially, investors lent their money to banks to fund mortgage loans with the expectation that those mortgages would be paid off and investors would reap the interest as a reward. But these mortgages were fundamentally unsound and never paid back—billions of dollars disappeared from the financial system, banks closed, and so on The world still hasn’t recovered.
Now the same is happening with car loans. Securities backed by car loans are all the rage, and investors are pumping money into an already crowded market. Although car loans are becoming increasingly precarious, bond prices based on them continue to rise. Out of market observation:
New subprime auto bonds rated “junk” BB were sold at yields of just 3.5% this month, down from as high as 9% four years ago, according to bond tracking Platform Finsight.
Demand for low-rated subprime auto bonds has been so strong that some investors are now feeling left out.
“More auto ABS have been chasing cash this year,” said Toby Giordano, a portfolio manager at Braddock Financial in Denver, Colo., a buyer of BB-rated subprime auto bonds or asset-backed securities in recent years.
Falling yield on a bond where returns are stable means rising prices – prices investors are willing to pay to enter this house of cards market.
The incredible lack of due diligence given to auto lending is already frightening, but the amount of investment flowing into auto loan-backed securities is downright terrifying. Rising defaults and defaults mean investors are looking at their ‘stable’ Asset backed returns. It doesn’t take a crystal ball to see where things are going from here — just a glimpse of what happened a decade ago.