Is Another Financial Crisis Coming Down the Road?

A wave of subprime lending is making its way across the automotive industry, and could cause serious problems if it continues

Jul 27, 2014 at 1:00PM

Recent data indicates more subprime borrowers than ever are applying for and receiving loans to buy cars. In fact, about a quarter of all car loans made in the U.S. in 2013 went to borrowers with subprime credit scores.



While subprime lending itself is not inherently bad, it's the manner in which it's being done that is the most disturbing thing. Many of the current lending practices in the automotive industry are the same things that caused the mortgage crash and resulting foreclosure epidemic a few years ago. Here's what is going on, and what could happen if things don't change quickly.

Who is borrowing?
About one in every four car buyers has a FICO credit score of 640 or under, which is considered "subprime". These borrowers are considered more likely to default than average buyers, due to having shaky credit histories.

In fact,, the website where you can check your score, publishes default rates for each range of credit scores. That is, it approximates the likelihood of someone in that range falling 90 days or more behind on an obligation like a credit card, mortgage, or other loan in a two-year period.

For example, those consumers with FICO scores in the top tier (800-850) have less than a 1% default rate. These rates increase dramatically for consumers with lower scores. For example, 27% of those with scores between 600 and 649 default within two years. For the lower score ranges like 500-599, the rate jumps to 45%, or nearly half. So, why are the banks and dealerships lending to this group of consumers?

Dangerous lending practices
Basically, the banks and dealerships are lending to subprime borrowers because they can get away with a lot more. Borrowers with excellent credit scores can get a loan virtually anywhere, and therefore won't accept high fees or outrageous interest rates.

However, it seems like a lot of subprime borrowers are being set up to fail.

The New York Times recently reported the case of an unemployed man who obtained a $15,197 car loan, even with a bankruptcy in his credit history, after the dealership listed his income as $35,000 on the application after he told the dealer he hadn't worked in years.

And this wasn't from some mom-and-pops auto lender. The loan was approved by Wells Fargo, which recently became the largest auto lender in the U.S.

Naturally, after several months of non-payment, the car was repossessed. There are other reports of customers obtaining loans they can't afford, leading to reposessions and even bankruptcies in some cases. So, why are dealerships helping customers get loans that obviously can't afford to pay? And why are the banks approving them?

Who's making money?
Dealerships make their money by charging more than the car is actually "worth".

In fact, the loans can be as much as twice the car's value.

For example, say a dealer pays $6,000 for a 2007 Honda Civic LX Sedan, which is the current wholesale value in "good" condition, according to Kelley Blue Book. The retail value is about $7,600, but if a subprime customer doesn't have any other options, all of a sudden the price jumps to $10,000 or more. So, the dealer has a huge incentive to obtain a loan for the buyer. They really don't care if the loan ever gets paid.

Lenders also have a good incentive to make the loans, as they can charge extremely high interest rates -- as high as 23% -- to subprime borrowers. A $15,000 car loan at 20% for 60 months comes with a $397 monthly payment. Over the course of the loan, the buyer will end up paying $23,820, or 59% more than the car cost.

So, it's easy to see why a bank might be tempted with a profit like that.

We need to tighten up, and fast
Even scarier is what the lenders are doing with these loans. Just like in the years leading up to the mortgage crisis, these loans are being packaged and sold by banks to insurance companies and mutual funds.

There is a right and a wrong way to lend money to subprime borrowers and this is the wrong way. In housing, subprime borrowers are a big part of a healthy housing market, but banks are making sure they verify a solid employment history, as well as get a large down payment which encourages buyers not to buy more than they can afford.

The wave of subprime auto lending is very real and very alarming, and could lead a massive wave of car repossessions and even bankruptcies over the next few years if things don't change.

What car company has Warren Buffett scared? (Hint: It's not Tesla)
A major technological shift is happening in the automotive industry. Most people are skeptical about its impact. Warren Buffett isn't one of them. He recently called it a "real threat" to one of his favorite businesses. An executive at Ford called the technology "fantastic." The beauty for investors is that there is an easy way to ride this megatrend. Click here to access our exclusive report on this stock.

Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.

4 in 5 Americans Are Ignoring Buffett's Warning

Don't be one of them.

Jun 12, 2015 at 5:01PM

Admitting fear is difficult.

So you can imagine how shocked I was to find out Warren Buffett recently told a select number of investors about the cutting-edge technology that's keeping him awake at night.

This past May, The Motley Fool sent 8 of its best stock analysts to Omaha, Nebraska to attend the Berkshire Hathaway annual shareholder meeting. CEO Warren Buffett and Vice Chairman Charlie Munger fielded questions for nearly 6 hours.
The catch was: Attendees weren't allowed to record any of it. No audio. No video. 

Our team of analysts wrote down every single word Buffett and Munger uttered. Over 16,000 words. But only two words stood out to me as I read the detailed transcript of the event: "Real threat."

That's how Buffett responded when asked about this emerging market that is already expected to be worth more than $2 trillion in the U.S. alone. Google has already put some of its best engineers behind the technology powering this trend. 

The amazing thing is, while Buffett may be nervous, the rest of us can invest in this new industry BEFORE the old money realizes what hit them.

KPMG advises we're "on the cusp of revolutionary change" coming much "sooner than you think."

Even one legendary MIT professor had to recant his position that the technology was "beyond the capability of computer science." (He recently confessed to The Wall Street Journal that he's now a believer and amazed "how quickly this technology caught on.")

Yet according to one J.D. Power and Associates survey, only 1 in 5 Americans are even interested in this technology, much less ready to invest in it. Needless to say, you haven't missed your window of opportunity. 

Think about how many amazing technologies you've watched soar to new heights while you kick yourself thinking, "I knew about that technology before everyone was talking about it, but I just sat on my hands." 

Don't let that happen again. This time, it should be your family telling you, "I can't believe you knew about and invested in that technology so early on."

That's why I hope you take just a few minutes to access the exclusive research our team of analysts has put together on this industry and the one stock positioned to capitalize on this major shift.

Click here to learn about this incredible technology before Buffett stops being scared and starts buying!

David Hanson owns shares of Berkshire Hathaway and American Express. The Motley Fool recommends and owns shares of Berkshire Hathaway, Google, and Coca-Cola.We Fools don't all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.

©1995-2014 The Motley Fool. All rights reserved. | Privacy/Legal Information