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This Subprime Bubble Is Getting Ready to Burst

By Amanda Alix - Apr 5, 2013 at 10:05AM

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Subprime auto loans loom large in ABSes being gobbled up by investors.

There's another subprime loan problem brewing, but this time, home mortgages aren't the main ingredient in the securities being created, sliced, rated, and sold to hungry investors.

Subprime auto loans are making a comeback, as are the asset-backed securities that include these and other risky loans. Investors are snapping up these products, and a recent article on the subject strongly suggests that the Federal Reserve is to blame for the whole thing.

This bubble has been expanding at a rapid pace
ABSes have seen a resurgence in popularity over the past year, after falling out of favor shortly after the financial crisis hit. These investment products -- which are made up of debt such as student loans, credit card balances, and auto loans -- have become more attractive as stingy yields have become the norm.

A rejuvenated market for new cars and trucks has revved subprime auto loan production, and Equifax noted in its January report that auto loan balances have risen to a two-year high. By September of 2012, ABSes backed by subprime auto loans totaled more than $14 billion, more than the $12.7 billion issued during the whole of the previous year. For 2013, almost $4 billion has already been sold to yield-starved investors.

Shotguns as downpayments
The Reuters article referenced above is truly spooky, as it tells a tale of one individual with a shaky credit history purchasing a used truck with a shotgun as the primary down payment. One of the most active lenders in this space is Exeter Finance, a subprime lender with big backers such as Goldman Sachs (GS -0.45%), Wells Fargo (WFC -0.79%), Citigroup, and Deutsche Bank.

How is the Fed to blame for this scenario, you ask? According to the author of the Reuters article, Federal Reserve policies designed to jump-start the economy have caused investment yields to plummet, turning everyday investors into ravenous risk-takers willing to go to any lengths to make a buck. While QE3 and other programs have certainly made some investments less attractive, I think it is a great exaggeration to lay the gearing up of risky investment behavior entirely at the Fed's doorstep.

Banks may have helped the subprime auto loan market speed up. Early last year, Bank of America (BAC -1.71%) and Wells Fargo were among the big banks that began loosening credit restrictions for these borrowers, although these two banks primarily financed prime and near-prime auto loans.

A crisis in the making?
The author of the Reuters article notes that a bursting of the subprime auto bubble would not affect the economy in the same way as the mortgage meltdown did, but concerns remain. Even a Goldman Sachs representative expressed worry over this market at the annual American Securitization Forum this past January.

For investors, at least, this type of investment can be dicey. While ABSes backed by prime auto loans have been stable, those containing subprime loans showed annualized losses of 6.72% at the end of 2012.

Even with an industry expectation of a 25% default rate, investments backed by subprime auto loans look to be headed for a crash -- so, investor, beware.

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