Why the U.S. subprime auto market is geared for failure

Since 2008 when the world was faced with the Global Financial Crisis, reform was implemented and banks became regulated by the government to avoid, or at the very least off-set, such an economic downturn in the future. However the international scale of the Crisis, with Wall Street being the epicentre, meant that not everyone was restricted to new rules.

The U.S. overtime recovered from the GFC, however the housing bubble was one thing and it also seems to have slowly resurrected in the form of the subprime auto market. Subprime borrowers (people who have a greater chance of defaulting) after buying a new vehicle in the U.S. are paying astronomical figures to get wheels on the road as there is no degree of separation between the car yard and financiers, but the loan agreements are untenable. The vicious cycle of loan repayments and repossession is once again facing the U.S., but the question is; how do we avoid another GFC as a result of inflated vehicle loans?

The answer, unsurprisingly, is complex with numerous variables. The concern is the lack of regulations that American lenders face – it is a distinct possibility that the bubble may burst once again as it appears geared for failure. However, the biggest problem we face here in Australia is that the crisis may affect the market and be brought over to our shores.

According to the S&P Global Market Intelligence, looser credit standards after several years of low losses (i.e. 2010-2013), in addition to heightened competition, and lower recovery rates on defaulted loans may contribute to higher losses.

However, some lenders are countering these effects by reducing origination volume and moving up the credit spectrum. But, the net loss rate seems to be mimicking the 8.63% (2008) and 9.39% (2009) figures at the height of the GFC and has now spiked at 7.28% in 2016 after a period of much lower records.

Not only have large mainstream subprime lenders increased their maximum loan term to 75 months, but others have extended their loan term to 72 months from 60 months. This ultimately means a lower repayment schedule for borrowers, but a higher interest paid by the close of the loan. Is this really attainable for lenders and borrowers alike, especially when financing an older vehicle to begin with? Generally, the optimal loan term is between 24 and 48 months, however, longer loan terms can mean increased delinquencies at the backend of loan contracts.

Losses are partly to blame because lenders in the U.S. are repossessing more often from defaulted borrowers, selling them and recycling the asset back into their own auto yards, which in turn means that less money is being returned on the securitised loan.

As the creditworthiness of borrower’s declines, we can see a spike in defaults and unfortunately, unstable lending business practices in the U.S. market. Banks seem to be pulling back, and taking their place are the new players with looser lending standards who notoriously approve almost anyone who applies.

The Federal Reserve Bank of New York noted in November 2016 that delinquency rates of auto loans were increasing. A Liberty Street Economics report analysed that data, which revealed some advanced deterioration in the performance of subprime auto loans.

“This translates into a large number of households, with roughly six million individuals at least ninety days late on their auto loan payments,” the report said.

Time and time again, we hear of horror stories in the U.S. of fraudulent loan applications that are lodged in a desperate bid for a vehicle and only 6 months down the track are untenable for the borrower to continue to repay. Lenders then repossess, and the borrower is back to square one as the cycle continues.

The Massachusetts Attorney General Maura Healey launched an investigation into the unfair securitisation practices in the subprime auto loan market, which was settled for US$22 million in March this year in an attempt to combat “fraud dealers” who plague the auto industry in the U.S. This matched with a borrower’s change in attitude on defaulting leading to the death of good credit, the U.S. auto loans market looks to repeat the mistakes of the past for lenders who engage in these duteous practices.

We are fortunate in Australia to have strict guidelines imposed on lenders with a responsible lending protocol in place. Finance One, the wholly owned subsidiary of Investors Central, is a secured vehicle loan company which takes into heavy consideration an applicant’s capacity to repay at the time of the application through to the end of the loan term. The average loan term is just 41 months, and all clients pay principal and interest from day one.

By following the responsible lending obligations as set out in the National Consumer Credit Protection Act 2009, Australian lenders are able to avoid irresponsible approvals that have seen the U.S. subprime auto market decline.

A responsible lender must make reasonable inquiries about a consumer’s financial situation, and their requirements and objectives; take reasonable steps to verify the consumer’s financial situation; and make a final assessment about whether a credit contract is ‘not unsuitable’ for the consumer. Historically through the application of these practices, Finance One averages 1 in 5 loan settlements. Therefore 4 out of 5 applicants don’t make it through.

The lack of proactive legislation in the U.S. following the GFC could be to the detriment of the global economy. Now, as the hyperinflation of loan approvals in the U.S. begins to decline due to the lack of returns, we expect to see a downturn and potential ripple effect as the market appears geared for failure. Being a responsible lender ensures you gear your client for success by helping them through the loan repayment process and taking a compassionate approach to lending.

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