Booming Auto Loan Market: Friend or Foe

Whether you consider yourself to be an expert economist or simply an attentive citizen to the state of the U.S. economy, chances are high that you have come across an article or two on the robust auto loan market. An October 2^nd Reuters article reads “U.S. auto sales last month posted their best showing in 4-1/2 years.” The Wall Street Journal recently released an article titled “A Green Light for Car Loans: Banks, Finance Firms Boost Auto Lending; Fed Survey Finds Easier Standards.” All signs seem to be pointing to a light in an otherwise dark economic tunnel. However, is the entire picture visible or is America being blinded by this booming industry?

 On the heels of a great recession, by at large due to the rapid decline of the mortgage market, it is only natural that people are questioning whether the auto loan market is shaping up for a similar disaster. The subprime mortgage crisis, characterized by loose regulation on mortgage lending policies, a 12% increase in outstanding subprime mortgages over a two-year period, and the irresponsible securitization practices employed by banks, left the U.S. in a national economic emergency. The auto loan market is casting a similar shadow to that of the booming years of the mortgage market. U.S. auto sales for September 2012 were nearly 1.2 million, a 13% gain in comparison to that of September 2011. According to the auto loan division of Experian, the value of outstanding auto loans at the end of the second quarter was approximately $725 billion, 5.7% above the previous years value.

 A key driver of sales is the availability of cheap financing. Jesse Tropak, an analyst at TrueCar.com stated, “The money is so cheap now. Higher resale values and cheap money has been enabling automakers to offer some of the most attractive leasing programs we've seen in years." According to Bankrate.com, the September interest rate on a new car loan was 3.19%, down 1.2% from that of September 2011. An increasing number of banks are communicating to the Federal Reserve that they are easing the standards for new auto loans.

General Motors serves as a great example of a beaten down auto giant utilizing subprime loans to boost its revenue. In 2009, GM filed for bankruptcy and was granted a $50 billion loan by the U.S. government to keep the company afloat. In 2010, GM purchased Americredit, a subprime lending specialist, which it renamed GM Financial. GM is now lending to more subprime buyers than ever before. Investors Business Daily states “"From Q4 2010 to Q1 2012, GM Financial loans to customers with the worst FICO scores — below 540 — shot up 79% to more than $2.3 billion." These subprime loans come with a much higher annual percentage rate to compensate for the larger number of defaults inherent in these loans.

The demand for securities backed by car loans is a chief reason that auto lenders have increased their stake in the subprime auto loan market as well. Private equity firms and investors are hastily purchasing bundles of car loans, which they typically view as appealing and safe. Investor demand for auto loan bonds has risen drastically as a result of the low interest rate policy adopted by the Federal Reserve. These auto asset backed securities offer a seemingly sturdy alternative to the historically low yielding Treasury bonds, due to their higher yield and short duration. To date, there have already been more than $14.3 billion in auto ABS issued, $1.6 billion more than were issued in all of 2011.

This flood of investment dollars has added fuel to the subprime auto loan fire, allowing lenders to originate a greater number of loans at extremely attractive rates. Experian recently published that one in four new vehicles purchased during the second quarter of 2012 were by customers in subprime (non-prime, subprime, or deep subprime) risk tiers, an increase of 14% from the second quarter of 2011.  After being burned by the collapse of the mortgage industry, it would seem that these firms and investors would be weary of rushing back into a similar position with a slightly different product. However, analysts believe that there are stark differences between the two markets.

Historically, there are fewer delinquencies on auto loans than on any other major type of loan. Americans seem to be more willing to walk away on a mortgage then default on a car payment. Auto loans performed better than many other areas of the economy even during the deepest stretch of the recession. Lenders also have a great deal of flexibility when it comes to dealing with the delinquency of a car loan payment. The repossession and sale of a car is a much simpler process than that of a home. Another factor is that the auto loan market is not heavily regulated, and the Council for Fair Business Practices (CFBP) has not come forth with any plans to oversee nonbank auto finance lenders. The 2010 Dodd-Frank financial regulation bill explicitly exempts car dealerships from its oversight.

For the time being, it seems that the auto loan market is performing well and spurring growth in an otherwise struggling economy.  The fact that the subprime auto loan market is expanding in number can leave analysts with some concern due to the higher rates being paid by these loan holders. An influx of money into this sector can also cause analysts to be on alert for standards becoming too relaxed and larger losses coming as a result. So is the exponential growth in the auto loan market a good friend of the American economy or an angry foe waiting to rear its ugly head? Only time will tell.