Will History Repeat Itself? Talks of Another Subprime Lending Crisis…

There has been a lot of talk out there lately of another subprime lending crisis on the horizon…no, not housing again, but this time autos. I’ve had an automated response in my head for a while now along the lines of “yes, subprime lending exists in the auto industry but nowhere near the level of what caused the housing crisis.” But if we take an in-depth look at the data, is there reason for concern?

In hindsight, the significant increase in mortgage activity leading up to the crisis should have been a red flag, and maybe there is something we can learn from that experience before auto lending gets out of hand.

Source: Federal Reserve Bank of NY

From Q4 2005 to the peak in 2Q 2008, mortgage lending in the U.S. grew by about 13%, whereas in the past few years, auto lending has grown nearly 30%. This in itself warrants attention. Now, compared to 2007, more people have auto loans than they do mortgages — although I’m not sure this would be the case if it weren’t for the various mortgage regulations and tight credit conditions implemented after the crisis, forcing consumers to turn to other big-ticket items on their list. About 42% of the population now has an auto loan, vs 31% with mortgages.

While it is true that auto lending has grown more than mortgages (82% vs 75% since 2003), the total balances are much different. Mortgages still make up more than two-thirds of total outstanding consumer credit, with auto loans comprising less than 10%. In fact, if we really want to focus on concerning credit growth, student loan debt has surged a whopping 458% since 2003. Throughout the recovery, the total number of auto loans has increased by about 50%, compared to over 100% growth for student loans, and a mere 1.6% in total loan growth. (But we’ll leave the student loan story for another time…)

Source: Federal Reserve

Unfortunately, we have seen an increase in auto loan delinquencies. Total delinquencies, in USD amount, have reached the pre-crisis peak, though the delinquency rate is still much lower than it was at its worst point. The share of subprime lending had been on the rise before 2016, but it dropped off a bit recently to about 20% of total loans. Federal Reserve Governor Lael Brainard has warned about subprime auto loans and the increasing potential for default: “Underwriting appears to be quite lax last year in subprime auto lending. Delinquencies rates suggest some borrowers are struggling to keep up with payments.” Borrower fraud is another issue haunting the system as it seriously increases the risk of default if not addressed.

Source: Federal Reserve Bank of NY
Source: Federal Reserve Bank of NY

The good news is that domestic banks have responded accordingly (the opposite of what happened when mortgage lending was booming). Data from Experian shows that the number of subprime auto loans originated in the first quarter of this year dropped to a 10-year low. Domestic banks have been gradually tightening credit standards on auto loans, and auto sales have been declining YoY throughout 2017 and most of 2016. Together, these factors help limit the impact of a major burst in the system.

Source: Federal Reserve

The fact that the majority of auto loans are worth less than mortgages means that we shouldn’t run into the same magnitude of a crisis all over again. However, defaulting on auto loan payments can spur a significant downward spiral — repossessed cars means people have more difficulty getting to their current jobs or finding new opportunities, and when income becomes even tighter, people tend to default on other loans, and on and on and on…

So, a subprime auto loan crisis would not completely derail the economy, but it would put the brakes on the momentum we have been seeing throughout the past year, especially considering that consumer spending accounts for nearly 70% of US GDP growth. For now, it looks like banks are doing enough to prevent another subprime lending crisis, at least one with the same impact as the housing crash, but the situation certainly warrants continued monitoring.