Subprime Auto Lending: A Case Study in Market Bubbles & Cyclicality

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Right now, the consumer auto loan industry is soaring.  As the bull market continues to charge forward, auto lenders are having a field day helping Americans finance their car payments.  However, amidst the record growth in this one trillion dollar industry, something big is happening: subprime auto loan delinquencies are beginning to escalate.  Sound familiar?  Another bubble is starting to burst.

Subprime Loans: Then and Now

“The increased level of distress associated with subprime loan delinquencies is of significant concern” – The Federal Reserve Bank of New York (November 30, 2016)

If the word “subprime” doesn’t make the hair on the back of your neck stand up, then I would guess that you probably didn’t pay close attention during the Great Recession.  Simply put, subprime lending is the practice of lending money to borrowers with poor credit.  Knowing that many of these individuals will not be able to fully repay their loans, subprime issuers often charge very high interest rates as compensation for taking that risk.

In short, subprime mortgage loans were the underlying cause of the Great Recession.  During the booming economy of the mid-2000’s, mortgage lenders (and especially the big banks) began to issue home loans at a staggering rate.  Because things were going so well, lenders really began pushing the envelope and searched for greater yield by lending to subprime borrowers at higher interest rates.  When these subprime loans began to fail in 2007, everything really started to hit the fan.

Today, the same thing is happening in the auto loan industry (albeit, on a smaller scale).  Since 2014, consumer auto lenders – such as banks like Capital One and consumer finance companies like Credit Acceptance Corporation – have been issuing subprime auto loans at an incredible clip and we are now beginning to see borrowers fail to meet their car payments.

On November 30, 2016, Michael Corkery of The New York Times reported that in the third quarter of 2016, 2.0% of all subprime auto loan balances (or roughly six million individuals) became 90 days delinquent, up from 1.6% in the third quarter of 2014.  To put this in perspective, during the depths of the Great Recession (2Q 2009), that rate peaked at 2.4%.

Market Cyclicality and the Bursting Bubble

“I think it’s essential to remember that just about everything is cyclical.  There’s little I’m certain of, but these things are true: Cycles always prevail eventually.  Nothing goes in one direction forever.  Trees don’t grow to the sky.  Few things go to zero.  And there’s little that’s as dangerous for investor health as insistence on extrapolating today’s events into the future.” – Howard Marks, The Most Important Thing

Right now you might be asking yourself, why are all of these people failing to make their car payments?  Or, why are the banks and consumer finance companies making all of these risky loans – didn’t they learn anything from the mortgage crisis?

The fact that all of this is occurring in a growing economy with low unemployment – during which borrowers would normally be most likely to make their car payments – implies that issuers have (once again) lowered their lending standards.  Operating in an industry that was relatively unaffected by heightened post-recession regulation, subprime auto lenders are also using a lot of the same shady techniques as their foolish mortgage predecessors.  Eerily reminiscent of the final years leading up to the crash, there are numerous reports of alleged predatory lending, “dummy” interest rates, targeting borrowers who have recently declared bankruptcy and even good ‘ole fashioned fraud.

It’s important to realize that this impending downturn in the consumer auto lending sector is a classic case study in market cyclicality.  As Howard Marks notes in his book, The Most Important Thing, there is a natural cycle to everything and people often forget about (or simply ignore) these underlying cycles due to psychological factors.  The movement of the herd can be a very powerful thing.  Mob mentality is basic human nature.  For example, let’s say you were out gambling in Las Vegas and you begin observing a cluster of blackjack tables.  All of a sudden, every single table begins to pay out – the players begin to consistently beat “the house” hand after hand and everyone is getting rich / having the time of their lives.  Initially you might be skeptical, but if we’re being honest, after about 5 minutes of watching this scene you’d ignore the odds and sit down at a table – right?  Put another way, in the midst of a long bull market, most investors are not worried at all about losing money – they are instead too busy worrying about missing out on the opportunity to make money!  They are completely blinded by the greedy herd.

In the same vein, auto finance companies have been so successful in maximizing their profits (i.e. increasing lending volume at higher interest rates) since the Great Recession, that they have tossed prudent credit risk management out the window.  In a few short years they have already forgotten the subprime warnings of the past, as well as the age-old adage that “all good things must come to an end”.

In summary, the consumer auto finance bubble is just beginning to burst.  The cycle will shortly turn from greed to fear and while this won’t be nearly as widespread as the Great Recession, millions of people will have their cars repossessed and their credit scores ruined.  If I were a thoughtful investor looking to maximize my own profits / re-position my portfolio before this major sell-off, I would be investigating – and heavily shorting – the major auto finance companies.

As always, remember the basics:  “Pork bellies… I knew it!”

 


Sources:

Corkery, Michael. “As Auto Lending Rises, So Do Delinquencies.” The New York Times. The New York Times, 30 Nov. 2016. Web. 02 Dec. 2016. <http://www.nytimes.com/2016/11/30/business/dealbook/as-auto-lending-rises-so-do-delinquencies.html?_r=0>.

Haughwout, Andrew, Donghoon Lee, Joelle Scally, and Wilbert van der Klaauw. “Just Released: Subprime Auto Debt Grows Despite Rising Delinquencies.” Liberty Street Economics. Federal Reserve Bank of New York, 30 Nov. 2016. Web. 02 Dec. 2016. <http://libertystreeteconomics.newyorkfed.org/2016/11/just-released-subprime-auto-debt-grows-despite-rising-delinquencies.html>.

Marks, Howard. The Most Important Thing: Uncommon Sense for the Thoughtful Investor. New York: Columbia University Press, 2011. Print.


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