Is a Subprime Auto Loan Crisis Brewing?

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Wharton's David Musto and University of Utah's Christopher Peterson discuss the auto-loan delinquency crisis.

A record seven million Americans are at least 90 days late on their auto loan payments, according to a new report by the Federal Reserve Bank of New York. That’s one million more than at the end of 2010. Fed economists say that these troubling figures are a surprise given the strong economy. Half of the delinquent loans are from auto finance companies and many of those were made to subprime borrowers. Are the struggles that average Americans are having in paying that one bill a sign that trouble is brewing for the broader economy? Are we facing an auto loan subprime crisis similar to what happened in the mortgage market a decade ago? Wharton finance professor David Musto and Christopher Peterson, a former advisor to the Consumer Financial Protection Bureau and a law professor at the University of Utah, delved into the topic on the Knowledge@Wharton radio show on Sirius XM. (Listen to the podcast at the top of this page.)

An edited transcript of the conversation follows.

Knowledge@Wharton: Chris, why all of a sudden have we seen this rise in auto loan delinquencies?

Christopher Peterson: It’s a complicated problem. And I should say, too, that I’m a lawyer, not an economist. But from a lawyer’s perspective, one of the things that I’ve noticed is that a lot of the reforms that we saw after the financial crisis never really touched the auto finance market, and I’m seeing some of the same kinds of disturbing practices that we saw in the run-up to the subprime crisis. I’m seeing those same things happening in a slightly different way in the auto market. So my concern is that there are a lot of sketchy practices and unaffordable loans that are being made. And in some ways, the chickens are coming home to roost now.

David Musto: I took a look at that Federal Reserve report and what you’re seeing here is really two things. Number one, people are buying more cars. Car sales have gone up, and the fraction that they finance has been about the same, so it’s just more car loans. And then the rate of loans going delinquent — 90-plus days in a car loan is about as bad as it gets. You are going to lose your car to repossession, probably, if you’re 90-plus days delinquent. That rate has crept up a little bit — it reached its very bottom of 3.25% about 4 and a half years ago, and now it’s 4.5%. So it’s that creeping up of the rate and just the ramping up of loans because people are buying more cars.

Also, we think of subprime lending as having dropped off after the recession — and in the mortgage market, it did. But in the car loan market, it never did. The rate of subprime lending is the same now as it was 15 years ago.

“And so you might qualify for, say, a 5% interest rate. But if the dealer can get you to agree to an 8% or a 9% interest rate, then the dealer gets a very lucrative cash kickback….”–Christopher Peterson

Knowledge@Wharton: So why do you think that was not addressed when we were going through all of these issues eight to 10 years ago?

Musto: There are two different issues. One is, are there bad actors in this area who are just misbehaving in some way — maybe in the ways that people were misbehaving with mortgages. You know, taking legal actions they weren’t authorized to take, and making loans they knew weren’t going to work out, and so on. Is that what we’re talking about, or is it just that consumers are behaving in some other way that’s leading to this? One thing that has happened while the delinquency rate has been going up is people are taking out longer and longer loans.

Musto: So when the delinquency rate was lower — five years was your average loan. Now it’s five and a half years. And you think people want to buy more car — how do you buy more car with the same payment? You take out a longer car loan. Well, this is a longer car loan. You’re going to have negative equity for longer, and bad things can happen.

Knowledge@Wharton: The average car loan not long ago was 48 months — maybe 60 months in certain occasions. Now we’re well above six years. Should we be worried? Debt levels are again creeping up. We also have this problem of rising student loan debt. Are we potentially looking at a little bit of a crisis down the road?

Peterson: It’s not clear to me, and I’m not qualified to say that this is a strong signal that the national economy may be turning. But I do think it’s important to put these numbers in context. We’re talking about seven million individuals that are facing the loss of their vehicle. But these are families, so they’re living in households that have an average of 2.5 people per household. So you figure that’s probably roughly about 17 to 18 million people who are affected by this. And putting that in context, that’s about the same population as roughly the 12 or 13 smallest states. That’s bigger than the combined populations of New York City, Chicago, and Los Angeles city combined.

So for those people, it’s clear that there is currently, presently, a crisis. And why? Well, because we have a lot of dealerships and auto finance companies that I believe are fully aware that they are making loans that have a high probability of defaulting. But they are securitizing these loans, and they still make a lot of money on them. Repossession technology has become much more effective in recent years, and it’s no skin off their back if a significant portion of these families end up in crisis, because they’re still essentially running profitable businesses.

Knowledge@Wharton: A lot of these loans that are in question are with people who are younger. Does that indicate a link to the student loan debt crisis?

Musto: Well, they could be. If you think about student loans, bear in mind that a lot of student loans these days go into what’s called “income-driven repayment,” where you can limit your monthly payment to basically 10% of your disposable income. They take your income and subtract off a subsistence wage. But that subsistence wage doesn’t include your car loan payment. So you could have some feedback there from, “I’m making that 10% payment on my student loan, but that doesn’t really factor in this kind of expense of a car loan.” So there definitely could be some feedback there.

Peterson: Part of the reason that this is happening in the auto finance market is that we never really grappled with some of the same problems in this market, in the way that we did for mortgage loans. In the mortgage loaning industry, we created the Consumer Financial Protection Bureau, which has done a lot of law enforcement work and created ability to repay and qualified mortgage rules that have channeled some of the unaffordable lending practices out of the marketplace. But the CFPB doesn’t have jurisdiction over car dealerships, and there’s no ability-to-repay legislation or regulation that applies to car loans. And I think that you see that — you can really tell in the data the difference between lenders that are attempting to engage in reasonable underwriting and those that are not.

“We have a lot of dealerships and auto finance companies that I believe are fully aware that they are making loans that have a high probability of defaulting.” –Christopher Peterson

So for example, credit unions, which may have some problems here and there — but in the Federal Reserve Bank of New York’s data, the credit unions don’t have serious delinquency rates — between 1 and 2% — very, very low. We’re talking one person out of 100 loans. But if you look at auto finance companies that specialize in these kinds of loans that are typically getting their loans brokered through car dealerships — they’re the lenders that are really driving these high default rates. And my suspicion is that a lot of that has to do with their much higher interest rates and their ability to absorb losses — and the fact that they are likely shedding off a lot of this risk by selling them into securitization pools that are sold on Wall Street.

Knowledge@Wharton: When we saw the high delinquency rate a decade ago, there was 10% unemployment in the country. Right now we’re seeing around 4% unemployment. Do you see these delinquencies in auto loans having an impact potentially on the broader economy?

Musto: Remember, whenever you see a delinquency rate on any sort of financial product, this is a function of underwriting standards of a few years back. What we’re seeing in 2018 is really car loans made in 2014 or 2015. That’s when the delinquencies really start to hit, more around two or three years into it — or four years. What’s interesting looking at that same Fed data was that you’d think maybe the lenders are pushing their loans further down into the credit spectrum. But one thing that they look at there is FICO scores, he sort of go-to credit scores. And they quantify the distribution of credit scores of new car loans. And that’s not really moving. So coming out of the crisis, the distribution kind of moved up. Generally speaking, people were making somewhat less risky loans. And that has kind of stabilized over time. That really hasn’t changed. And so that’s what sort of drew my attention to the fact that people are taking out these longer loans. So I want to buy more car — maybe because I want to drive an Uber Black or something like that. And so I guess I’m going to have to take out the six- or seven-year loan.

Knowledge@Wharton: Chris, does this need to be addressed at the state or the federal level?

Peterson: It strikes me that the power of the auto dealers’ lobby in Washington, D.C., as well as in the various state legislatures is very difficult to challenge because every congressional district in the country has a bunch of relatively profitable car dealership businesses that are politically active. And so it’s very difficult to impose standards of quality and reasonable underwriting on the industry. But the problem is our political system’s inability to come to terms with that — it has serious consequences for millions and millions of Americans.

I just want to turn back to that gravity of harm that is being suffered. If you put yourself in the shoes of all these families, it’s very traumatic for a family to go through losing a car. Imagine that you’re the single mom or the dad, and you’ve got to get your kids to soccer practice that week. But you can’t tell them whether or not you’re going to go, because you don’t know if that car’s going to be there or if it’s going to be repossessed. And that’s happening for entire cities full of people in America, even though the economy is supposedly relatively strong. It seems to me that this points us in a direction that we need to find ways for our political system to make sure that the benefits of our relatively healthy economy are being spread evenly and that we have some — forgive the metaphor — but some “rules of the road,” some “safety belts” on the kinds of practices that we see in the auto finance industry.

Musto: What would a policy be? With mortgages, there’s a lot of talk about what the loan-to-value should be, debt-to-income — that kind of thing. With car loans, a lot of what happens is that the loan-to-value is 100% or more than 100%. Before this radio show, I just decided to look at some prospectuses from some of these car loan-backed securities that you were talking about a moment ago.

I was looking at one for CarMax. It’s just one of these used car dealers that will finance the purchases and securitize them. And they say, well, they limit the loan-to-value to 125%. Right? Because they’re also bundling in the title and this and that. And so you are way under water by the time you drive off the lot there. I don’t know — that’s the sort of thing you would police, if you’re going to police something, I think. Maybe the debt-to-income, also. That’s the thing to think about, I guess — what would be a policy? You’re, of course, making it difficult for people to buy cars at that point if you’re doing that. So what’s the right tradeoff? But it is an interesting question.

“We’ve all seen this. You buy a house, and they figure out what’s your debt-to-income. And they show you houses just at the edge of what you can afford, and then they push a little bit further….” –David Musto

Knowledge@Wharton: Do you think most people are aware that they could be underwater when they drive the new car off the lot?

Peterson: The potential underwriting standards that are mentioned are, I think, a good place to begin starting to talk about reform. I’d even say the reality is actually probably worse than that, because there’s a pretty widespread practice called — I think the dealerships call it “power-booking.” When they underwrite the loan, they will be creative in determining the value of the various bells and whistles associated with the car. Does it have the right rims? Does it have the right off-road package or sport package associated with it?

Peterson: And they can manage to generate a somewhat false estimate of the fair market value of the car. It’s very similar to what we saw in the mortgage crisis, where the appraisal practices were so loose that you could get very high loan-to-value ratios that, in turn, were deceptively understated because you could pad the appraisal.

That’s happening in a widespread way, especially for lenders that are not keeping the loans in portfolio. And that’s part of what might explain why credit unions that usually hold onto their own car loans and service them and do the repossession and all that in-house — credit unions are not having any trouble. But the companies that are securitizing it, just like with the mortgage market, they’re the ones that are having these really high loan-to-value ratio securitization pools. And that’s the kind of thing that law enforcement cases can make a real difference on. You go in and find some of the worst actors and show — you know what? They’re using false income for their borrower. They’re inflating the value of the appraisal.  Those are all deceptive practices, and it’s illegal.

It’s clear that the public needs to have access to auto finance, so they can buy cars. But the question needs to be — they need to buy cars, but they need to buy affordable cars. And we need to make sure that they can afford how much car they’re buying. And I think the public that’s listening to this — they really need to sort of discipline themselves and make sure that they’re not allowing sales staff at car dealerships to get them into these really longer-duration car loans in order to get a vehicle that’s a little bit nicer and newer, has more bells and whistles than what they can realistically afford.

Musto: We’ve all seen this. You buy a house, and they figure out what’s your debt-to-income. And they show you houses just at the edge of what you can afford, and then they push a little bit further, and they start talking about how you could afford that anyhow. And yes, that’s going to be what you might experience in a car lot. One thing people should bear in mind, by the way, is that the interest rate on a car loan is negotiable, just like the price of the car. You know, the dealer could make a little more money if in his pitch he says, “Oh, that’s going to be 15%.” You say, “Okay, 15% — that’s high. But whatever.” You know, you don’t realize that you could have said, “Well, I’ll pay 12%.” It’s a negotiable number, and not everyone is in the same position to negotiate. They know desperation when they see it. But that is something at least to try.

“It’s a negotiable number, and not everyone is in the same position to negotiate. They know desperation when they see it. But that is something at least to try.”–David Musto

Peterson: Yes, not only is it negotiable, in my view there’s an insidious practice that is very, very common in the auto finance industry. It used to take place in the mortgage market, but it’s now illegal there. They’re called “dealer overages.” In the mortgage market, they were called “yield spread premiums.” And the basic pattern is this: You go to a dealership, and you want to get financing through the dealership. So the dealer says, “We’ll help you find a loan.” And then they go out and shop around and find a lender that’s willing to make a loan to you. The lender provides a rate sheet that lists what interest rate they’ll offer the loan to that consumer at — based on their credit score, their income, the vehicle, et cetera. But if the dealership can convince you take out a loan that generates more revenue for the lender — increase its resale value when they securitize it — then they’ll give a kickback to the dealership called a “dealer overage.” And so you might qualify for, say, a 5% interest rate. But if the dealer can get you to agree to an 8% or a 9% interest rate, then the dealer gets a very lucrative cash kickback that is comparable to their profit margin on just selling the vehicle outright. But a lot of consumers don’t understand that. It’s a fairly deceptive circumstance. It also has had a past practice of — it turns out that Latinos and African American borrowers tend to get disproportionately high interest rates based on these kickbacks, which is illegal and also very troubling. That’s the kind of thing that really, frankly, should just be completely illegal for everyone in America. But it’s not.

Musto: I think in the short-run, educate yourself. This business about negotiating is just one piece of it. You walk onto the lot, and you’re a potential source of revenue in a lot of ways. Know what those ways are, and be ready to walk away.

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