The Next Subprime Crisis Has Already Started

Reading about what's going on in the subprime auto lending space is a lot like reading about drive-by shootings.

Unless you're a subprime borrower, or live in a neighborhood where drive-bys are happening, you probably don't know much about either or think they affect you.

But if you listen closely there's muffled financial "gunfire" already in your neighborhood.

And it's much closer to your doorstep than you think.

Here's what you need to know…

Yield Chasers Have Found a New Target

Subprime auto borrowers are getting killed by dealerships, their financing agents, and banks putting them on the financial frontline for default.

Even if not everyone is a subprime auto borrower the trend is rippling out into the US economy.

New and used auto dealerships and their finance arms, manufactured lending partnerships, banks, private equity companies, insurance companies, mutual funds (and the usual cadre of lap-dog lobbyists and paid-for legislators) are doing to subprime auto borrowers what coddled mortgage lenders did to subprime housing borrowers.

They are teeing them up for a long drive down a dead-end road.

The game at both ends and in the middle is just the same. So are a lot of the players.

On the output end are the investors. Fixed income investors from mutual funds and insurance companies to mom and pop investors are once again desperate for yield.

When the Federal Reserve kept interest rates low through the 2000s, fixed income investors reached for yield further and further out on the risk spectrum. On the very end of the yield tree's flimsiest limbs, subprime mortgages and mortgage-backed securities blossomed. And investors picked them off like the low hanging fruit they appeared to be.

We know what happened next.

Ever since 2008's credit crisis and the Great Recession, the Fed's zero interest rate policies made it even harder for savers and bond investors to earn any interest.

So, with the mortgage tree cut down, the usual-suspect financial intermediaries cultivated the next best species of fruit-bearing trees: auto loans.

As financial intermediaries, banks make a lot of auto loans, but not as many as financing arms of auto manufacturers. And because auto loans are so profitable, lending partnerships and private equity companies and other "investors" eagerly provide abundant pools of money to borrowers in need of financing new and used cars.

It's really these "intermediaries" that keep the wheels of the auto industry turning.

How fast are those wheels turning? Because of abundant financing and low interest rates, new light-vehicles sales in 2014 totaled over 16.5 million units. That's up 5.6% from 2013 and the highest new vehicle sales level since 2006.

According to Bankrate.com, loans to prime borrowers on new vehicles average 2.75% on six-year term loans.

But it's not just auto manufacturers' financing arms and banks providing money to new car purchasers that's making auto sales pop. The same banks and manufacturers' financing units, along with aggressive financing partnerships, are providing huge pools of money to dealers of used cars across the country.

According to the Federal Reserve, outstanding auto loans for new and used cars reached $934 billion at the end of September 2014. That's up from a total of $809 billion outstanding just two years ago. By the end of the first quarter of 2015 the total outstanding volume of auto loans is expected to exceed $1 trillion.

While prime borrowers financing new and used cars aren't worrisome – just as prime mortgage borrowers weren't a problem in the heyday of the housing boom – it's subprime borrowers who are eclipsing prime borrowers in the auto sales arena, just as they did in the late stages of the housing boom, that's becoming a worrisome trend.

And just like in the mortgage-money free-for-all, it's the intermediaries pushing loans on subprime borrowers. They can then charge them exorbitant interest rates. That's what's fueling the rapid increase in subprime auto lending, especially on used cars.

Of course, in the modern era, very few intermediaries keep the loans they make "on their books." Instead, they rely on other banking intermediaries or their own in-house securitization assembly lines to package thousands of auto loans into "asset-backed securities" to sell to eager investors seeking above market interest rate investments.

The difference in the new subprime rip-off game is in the input function of the financing equation.

Used car buyers in the latest push-them, plunder-them, package-their-promises, and sell them to salivating yield-hungry investors are far less credit worthy than the crap-shooting, credit-impaired homebuyers sucked into the mortgage mania game.

Sadly, it's the lowest rung of borrowers, many of them desperate for transportation to look for work, get to work, to take sick family members to and from doctors and hospitals, or to run their small transportation businesses, that get saddled with the worst high interest rate loans.

Of all outstanding auto loans made up to the end of Q3 in 2014, 23% were subprime loans to borrowers with less than a 640 credit score. That's up from 21% in 2009. Still, not as high as the 28% share subprime borrowers accounted for in pre-recession 2007.

Because of the way used car dealers are incentivized to make the biggest loans possible to subprime borrowers, they regularly roll in "extras" to the whole loan they offer unsuspecting or desperate buyers: title, taxes, dealer-prep fees, extended warranties, undercoating and rustproofing charges, sometimes collateral insurance, and the cost of buying out an existing loan on a trade-in.

As a result, on approximately 23% of subprime loans, the outstanding principal owed exceeds the resale value of the purchased vehicle by 200%.

Experian Automobile, a unit of credit rating company Experian, recently reported that as of September 2014 the average loan-to-value on all financed autos was close to 115%.

Of all auto loans made last year, 31% went to subprime purchasers. That's up 17% in two years.

With interest rates often starting at 22% annually, it's not hard to see why delinquencies are on the rise…

Source: Money Morning 16th January 2015

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The Next Subprime Crisis Has Already Started

Yield Chasers Have Found a New Target

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