Friday, January 22, 2016

Subprime auto lending: the revenge of auto-dependence

In the past year, several commentators  (and the US government's Consumer Financial Protection Bureau) have pointed to a worrisome rise in subprime auto loans, doled out to individuals with low credit scores and offering increasingly lengthy periods of repayment.

By spreading out interest payment over a longer amount of time, such loans provide an illusively small monthly payment to insolvent individuals, that obscures the high cumulative interest such individuals end up paying.

Of course, this hasn't stopped Wall Street from bundling these loans into securities. Nor has it prevented profit-hungry investors from snatching these securities up, as this Bloomberg News article from last June points out:

Of the subprime vehicle loans bundled into securities, 73 percent now exceed five years, up from 64 percent during the first three months of 2014, according to data from Citigroup Inc. Loans as long as seven years are increasingly being put into more bonds as auto-finance companies and Wall Street banks sell the securities at the fastest pace since 2007.The longer loans make it easier for consumers to afford rising new and used car prices by spreading out and lowering payments. While the securities are attracting plenty of buyers with high loss buffers and AAA ratings, some investors are beginning to question the wisdom of lending at terms that have never extended beyond five years.“Everyone has used the argument that borrowers pay car loans because they have to get to work,” said Anup Agarwal, a money manager who oversees $65 billion at Western Asset Management Co. and hasn’t bought a subprime auto bond in a year and a half. “But borrowers only pay loans if the car is working. We have not seen this cycle come through yet.

If Agarwal hints at a potential for implosion, Raj Date, the former head of the Consumer Financial Protection Bureau, points to factors that make such a scenario likely:

The shift to longer-term loans makes it easy for borrowers to be duped into focusing on lower monthly payments rather than the costs over the life of the obligation, said Raj Date, former deputy director of the Consumer Financial Protection Bureau who now heads the Washington consulting firm Fenway Summer LLC.
While cars are lasting longer than in the past, regulators are concerned that the value of the vehicles will fall faster than borrowers can pay off the debt.
Because cars depreciate quickly, a borrower is typically upside down or underwater toward the end of a long loan term,” Date said. “If times are tough you might have to sell your car, but you’re still going to owe more than you can get through the sale.”
"Never worry", say investors. The ratings agencies back us up.

History is also on the side of investors. Since 2004, Standard & Poor’s has upgraded 371 classes of subprime auto deals and downgraded none, data from the company show. While delinquencies longer than 60 days have increased, net losses in the debt have dropped from a year ago, S&P said Wednesday in a report.
Even with the built-in protections, some market participants are starting to caution that buyers may be letting down their guard for the sake of higher yields.
If any of this sounds familiar, its because this is exactly the type of risk-taking (in houainf investment) that precipitated the 2008 recession.

This is not to state that auto loans represent the number one threat to the US economy. The economic slowdown in China will likely infect market performance in the near future regardless of the state of auto loan securities.

And yet, if the balloon in auto loans threatens financial stability, it does so because Americans continue to rely on the automobile even as car ownership becomes less economically sustainable for most.

Although the American job market has (by this point in time) rebounded from the last recession, wages have remained stagnant. For instance, jobs added to the economy in the first half of 2014 offered wages that were, on average, 23 percent lower than the jobs lost in 2008 and 2009.

At the same time, auto sales reached an all-time high in 2015, with more than 17.4 million vehicles sold.

The latter piece of news  may come across as a surprise to many readers (particularly those who are avid urbanists). After all, haven't per capita Vehicle Miles Traveled been on the decline since 20051? Aren't millenials, especially, driving at a later age and less frequently than previous generations?

For one thing, the past decade's decline in vehicle miles by no means implies that people are giving up driving altogether. Weary of incessant freeway gridlock (resulting from the broach of peak road capacity), people may simply be driving more locally2. Indeed, in Los Angeles, where per capita Vehicle miles have declined by nearly nine percent from 2002, more than 50 percent of personal trips currently have a range of three miles or less and 80 percent of these trips  are made by car.

As for the much-touted decline in youth driving over the past decade-and-a-half, research  from UCLA's Kelcie Ralph and the University of North Carolina's Noreen McDonald  indicates that more of the decline has stemmed from an increase in "carless" (in the phrasing of Ralph) individuals, whose lack of access to an automobile (often for economic reasons) constrains daily mobility, rather than in "multimodal" individuals, who purposefully substitute access to a car (by choice) with alternative modes such as walking and public transit. According to Ralph's study, the percentage of "drivers" among youth remained high at 79 percent.

Other data shows in the state of California alone (which is far from being a national leader in motorization), the single-occupancy automobile was the commute mode of choice for about 73 percent of the general population and 59 percent of the population under 20 (with an additional 18 percent of the under-20 population carpooling) in 20123, figures that changed little from 2007. Only slight fluctuations in the vehicle commute mode percentage occurred between these years).

Even though Americans now drive less frequently, they do not (yet) seem ready to give up driving for other modes of transportation.

Thus, Americans continue to buy cars although they can no longer afford them.

This paradox fuels risky lending practices. It also bodes ill for the environment

1. page 10.
2. As hinted in pages 12-13.
3. "Factors influencing Vehicle Miles Traveled in California: Measurement and Analysis." Pps. 25-26.

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