With the subprime mortgage crisis now more than six years behind us, it seems like the U.S. mortgage industry has learned its lesson. Although lower-credit and low down payment loan options are coming back to some degree, the free-for-all of no money down, low-documentation, and other exotic loan products is a thing of the past.
Yet, there is another aspect of the lending industry that seems to be embracing subprime borrowers -- the auto lending industry. Here's why auto lending can be even more dangerous than mortgage lending to banks, and whether or not we may be heading for another subprime crisis.
Subprime and long-term auto loans are becoming a bigger part of the market
Since the end of the financial crisis, the amount of auto loans made to subprime borrowers (credit scores below 640) has more than doubled. In one recent quarter, lenders originated $20.6 billion in subprime auto loans, which translates to about one quarter of all auto loans.
Additionally, car loans are getting longer and longer. Not too long ago, 48-month and 60-month car loans were the industry standard, but now buyers are choosing longer finance terms to keep their payments lower as auto prices rise.
According to data from Experian, a little more than 40% of new car loans range from 61 months-72 months in length, and another 25.7% have terms between 73 months-84 months. And, 12%-14% of loans now stretch out even longer. In all, nearly 80% of new car loans have terms of 61 months or more, with the overall average new car loan 66 months in length.
The rise in subprime borrowing and increase in long-term car loans has many experts concerned because auto lending can be even more dangerous than mortgage lending when things go wrong.
Why subprime auto lending can be so dangerous
Auto lending can be much riskier than mortgage lending simply because of the nature of the collateral.
A mortgage represents a home, which is (usually) an appreciating asset, or an asset with a value that tends to rise over time. Aside from market fluctuations, a home's value will generally increase over the long run. As you can see from the chart below, the average U.S. home price has even made up most of the ground lost during the crisis.
This is important because if a lender has to foreclose on a home, the home can (in theory) be sold for more than is owed on the mortgage. If home values are down, the bank can hold the home until prices rise and the home can be sold for more money.
While this obviously didn't hold true during the crisis, it will never be the case for auto loans. A car is a depreciating asset, or one that naturally loses its value over time. If a bank loans a customer money to buy a new car and the customer later stops making payments, then the bank is unlikely to be able to sell the car for enough money to recoup its losses.
Banks are especially vulnerable when making the long-dated and low-down-payment loans that have become more and more prevalent. The average car loses between 15%-20% of its value each year, so a $30,000 new car will be worth between $24,000-$25,500 a year later. If the entire purchase price is financed over 84 months at 7% interest, there will still be an outstanding loan balance of more than $26,500 at that time. That's why subprime auto lending leaves banks so vulnerable.
But there is some good news
Despite all of the risks, there are some reasons we shouldn't be too worried just yet. For starters, it seems like the subprime auto lending market is beginning to regulate itself. Just recently, Wells Fargo (NYSE:WFC), which is among the nation's largest auto lenders, announced it would limit the dollar volume of its subprime auto loans to just 10% of its originations.
Although one-in-four loans are made to subprime borrowers with credit scores below 640, only about 10% of loans are made to buyers that are considered "deep subprime." In other words, the majority of subprime car loans are made to borrowers who have somewhat decent credit scores, but can't quite qualify for "prime" financing.
While you may expect the delinquency rate to be rather high among subprime borrowers, it's really not as much of a difference as you may expect. AutoNation recently reported that delinquency rates are approximately 5% on subprime loans, just slightly higher than the overall rate of 3.5%.
Finally, even if things do go south and we see a wave of delinquencies and repossessions, bear in mind that the subprime auto lending market is still small in comparison to the pre-2007 subprime mortgage market. Last year, about $20 billion in investment securities backed by subprime auto loans were sold into the market, while in 2006 alone more than $600 billion in subprime mortgage-backed securities were sold.
So, are we headed for a crisis?
Not yet. As long as lenders continue to keep subprime lending at a small percentage of the total, and the subprime delinquency rate remains relatively low, we shouldn't have too much to worry about.
Subprime lending is a vital part of a healthy market, as long as it's done in moderation and proper practices are followed. So, while the current trend toward subprime auto lending needs to be monitored closely, we aren't in danger of another subprime lending crisis anytime soon.