A surge in lending to would-be car owners with low credit scores has sparked fears of a bubble, but top government economists say there is no reason to panic because subprime loans still comprise a smaller portion of the market than before the financial crisis.
Concerns that auto lenders are placing borrowers into loans they can’t afford has drawn comparisons between the auto sector and the subprime mortgage fiasco and led the Justice Department to launch a series of investigations. At the same time, regulators have warned of a frothy auto subprime market that could result in high rates of defaults to the detriment of bank balance sheets.
Yet in a recent blog post, four economists at the Federal Reserve Bank of New York put the subprime boom in perspective. While loans to borrowers with credit scores below 620 reached $20.6 billion in the second quarter, nearly double 2010 levels, that subprime market is smaller than it was in the years before the financial crisis. And auto loans to all borrowers are up.
“Subprime auto lending is definitely on the rise in absolute terms, although the increase in prime auto lending over the same period makes the relative increase in subprime share less pronounced,” the economists wrote.
The blog was tied to the release of the New York Fed’s quarterly report on household debt and credit, which said banks and other lenders originated $101 billion in new auto loans from April to June, raising the total outstanding auto debt to $905 billion.
Auto loans are the third largest source of consumer debt, behind mortgages and student loans. Mortgage debt dipped in the second quarter to $8.1 trillion, according to the New York Fed, reflecting tepid sales and a continued slow down in homeowners refinancing their loans.
In the face of that dwindling mortgage activity and fierce competition from auto finance firms, banks have extended the length of their loans, a move that lets people buy pricier vehicles. Those larger car loans, coupled with the rise in subprime, raised alarm at the Office of the Comptroller of the Currency this spring, when regulators said “signs of increasing risk are evident.”
Regulators reported that on average lenders were issuing loans for new and used cars that were higher than the value of the cars, what’s known as loan to value. That not only means that car prices are climbing, but also that dealers are tacking on more extended warranties, life insurance policies to pay off the loan if the borrower dies and aftermarket accessories like sound systems into the car financing, according to the OCC. The agency said the high loan to values and longer terms were driving banks to lose money on loans during the past two years.
“These early signs of easing terms and increasing risk are noteworthy, and the OCC will continue to monitor product terms and risk layering practices to ensure that banks manage growth and exposure prudently,” the OCC report said.
Federal prosecutors stepped into the fray a few weeks ago by launching investigations into the subprime underwriting standards at the financing arm of General Motors and the consumer-lending unit of Spanish banking giant Santander, according to securities filings.
Economists at the New York Fed say there is no doubt that the growth in auto loans has been fueled by lending to riskier borrowers, but they are less than 25 percent of all auto loans compared with 30 percent before the financial crisis.
What’s more, the economists pointed out that delinquencies for bank-issued auto loans have hovered around 1 percent for the last few years, while finance companies have reported late payments on about 2.5 percent of loans.
Outright defaults in the subprime auto market did creep up last year, but have retreated in the last six months, suggesting the market may be correcting itself, said Moody’s Analytics senior director Cristian Deritis, in a blog this week.
“The market may have overshot in the opposite direction recently, providing too liberally. But…it is easier to tap the brakes and correct imbalances than to try and move the industry out of a ditch with the parking brake of credit fully engaged,” Deritis wrote.
He cautioned against regulators restricting credit in response to reports of lax underwriting standards, but said “instances of fraud and questionable lending need to be addressed before they become systemic issues.”