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The subprime auto lending market has experienced dramatic growth over the last few years. In a low interest rate environment, investors have been looking for yield, and subprime auto loans have become a preferred vehicle. However, as the New York Times reported, Wells Fargo has put a cap on the amount of subprime auto loans that they are willing to originate. They have capped subprime at no more than 10% of their total originations, which was $29.9 billion last year. Wells Fargo made itself famous during the subprime mortgage crisis, because it managed to largely escape unharmed. They are famous for avoiding the “growth-at-all-cost” strategy that brought down much of the financial world. So, when they start capping certain loan types, we should all pay attention.
The subprime auto lending market has been demonstrating signs of excess for quite a while. Auto dealers sit at the center of this market, and they control access to the customer. Their lending desks (the place where you sit, after you selected your car, and try to get financing) want to deal with lenders who approve the biggest loans, with the highest dealer discount (commission paid to the dealership) and the fewest requirements. The auto dealerships make most of their money from the commission paid by the lenders, and so they are intensely focused on maximizing that fee.
As you can see from this arrangement, there is a huge conflict of interest in this setup. The auto dealer is not looking for the best deal for the consumer.
And, as yield hungry investors and lenders look for more business, they have to compete to win the dealer’s business, not the borrower. So, competition does not drive prices down. Rather, it drives up the commission paid to the dealer. It also removes, to a bare minimum, the compliance and control checks placed upon the dealer. If you owned an auto dealership, would you want to give your business to a lender that is constantly auditing your work, or would you rather deal with a lender that gives you complete control?
Inevitably, lower controls and higher commissions leads to the increased risk of falsification of income information. In addition, lenders will start approving unprofitable business, because that “marginal tranche” of business gives them access to the whole dealership business flow. This helps the auto dealer get more loans approved, but it also results in an increasing number of people signing up for loans they can not afford to repay. And that is why we are seeing delinquencies increase.
Even worse, we see the same misalignment of risk from the mortgage crisis. For most of the major subprime auto lenders, they do not retain the risk on their balance sheet. Rather, they slice and dice the business and sell it to investors. And the sale does not happen before credit rating agencies give the paper AAA ratings. How can subprime (below 640) customers end up with AAA or AA ratings? Well, the same rating agencies are using the same logic from the mortgage crisis. An individual with a 640 score is high risk. But, a portfolio of loan is low risk because of diversification.
There is also a belief that these loans are secured, and that people will pay their auto before their house. However, people are using data from 2008, which shows underwater homeowners prioritizing their car over their home. These days are over. Not to mention that dealers have an incentive to inflate the value of the used cars, making the level of security questionable.
We all know that automobiles are depreciating assets. In that, everyone agrees. So, it ultimately comes down to making sure people can pay back their loans. The increasing delinquency, and the worries of Wells Fargo, says that for many people, they can not afford the loans. We fear this problem will only get worse before it gets better.