Douglas Holtz-Eakin, Thomas Wade, Michael
Mandel* *Michael Mandel is
the Chief Economic Strategist at the Progressive Policy Institute. January
31, 2020
Executive Summary
Some are concerned that subprime auto loans –
which offer higher interest loans to riskier borrowers – pose a threat to the
stability of the global economy in much the same way that the subprime mortgage
market contributed to the Great Recession. Democratic presidential candidate
Elizabeth Warren, in particular, has raised the warning flags as part of her
campaign. But these worries are ill-founded and based on misleading data and
faulty analogies.
In particular:
·
Auto loans account for a
relatively small percentage of the increase in nonfinancial debt over the past
five years;
·
Americans are spending
less of their budgets on car purchases today, including finance charges, than
they were before the recession;
·
Low-income households
saw motor vehicle purchases and finance charges fall from 8.5 percent of
household budgets in 2000 to 4.9 percent in 2018;
·
Over the past five
years, the share of new auto loans going to low-credit borrowers has remained
relatively constant. There are no signs that low-credit borrowers are either
being frozen out of the market or becoming too large a share of loans;
·
Newly delinquent auto
loans, as a percentage of current balances, have been falling over the past two
years; and
·
Subprime auto loans
differ significantly from subprime mortgages in key respects that make them
less likely to pose a serious threat to financial stability
Risk-based pricing of auto loans appears to be
working so far, keeping low-income borrowers in the market without driving up
delinquencies or to low-income consumers, while not posing the same risk that
the subprime mortgage market.
Introduction
To purchase a vehicle, Americans with low or
non-existent credit scores often use auto loans with higher interest rates than
loans to prime borrowers. Some market watchers have indicated concern about
“subprime” auto-loan trends and the potential for a crisis similar to the
subprime mortgage crisis that heralded the last recession.
The subprime mortgages and the related mortgage-backed
bonds remain the classic case of a poorly executed financial innovation. The
initial impetus behind the idea was a good one. Housing is a key element of
middle-class wealth, so expanding the system of mortgage finance to help
lower-income households buy homes seemed like a positive. However, the subprime
mortgages and bonds were designed in such a way that they assumed rising
housing prices. When housing prices started to fall, the subprime mortgage
system collapsed and contributed to the financial crisis.
Will subprime auto loans create the same
problems? In a recent essay, Democratic presidential candidate Senator
Elizabeth Warren raised the warning flag:
Auto loan debt is the highest it has ever been
since we started tracking it nearly 20 years ago, and a record 7 million
Americans are behind on their auto loans — many of which have similar abusive
characteristics as pre-crash subprime mortgages1 .
Warren is not alone in her worries. In late
2016, for example, the Office of the Comptroller of the Currency warned that
auto-lending risk was increasing and that banks (and other investors in
securitized assets) did not have sufficient risk-management policies in place.
Fed Governor Lael Brainard pointed to subprime auto lending as an area of concern
in a May 2017 speech, while analysts worried about “deep subprime” auto loans2.
Some groups used the term “predatory” auto lending.3
But these concerns are misplaced. As we will
show later in this paper, the statistic cited by Senator Warren does not reflect
the current state of the auto loan market, as it includes old loans from much
weaker economic times. Perhaps most fundamental to understanding the problem
with drawing a parallel between the mortgage crisis and today is the fact that
subprime mortgages and subprime auto loans are very different products.
Naturally, lower-income households with low
credit scores or limited credit history may have fewer financial resources and
be inherently riskier borrowers. Moreover, the fact that motor vehicles depreciate
over time means that the collateral for the loan becomes less valuable.
Nevertheless, the ability to own a car and,
therefore, access credit is crucial for this population. Risk-based pricing
charges low- rated borrowers higher interest rates, but in return, offers them
the opportunity to borrow money to buy a vehicle that might otherwise be
financially inaccessible.
For many lower-income households, their vehicle
is the single biggest asset they own.
While vehicles do not appreciate in value as
homes do, vehicles are income-producing assets in the sense that they are often
essential for commuting to work, especially in non-urban areas. As one report
noted, “Owning a car is the price of admission to the economy and society in
much of America.”4
In this paper, we analyze the auto loan market, paying particular
attention to auto loans made to low-income Americans and to people with bad
credit. We find that:
·
Auto loans account for a
relatively small percentage of the increase in nonfinancial debt over the past
five years;
·
Americans are spending
less of their budgets on car purchases today, including finance charges, than
they were before the recession;
·
Low-income households
saw motor vehicle purchases and finance charges fall from 8.5 percent of
household budgets in 2000 to 4.9 percent in 2018;
·
Over the past five
years, the share of new auto loans going to low-credit borrowers has remained
relatively constant. There are no signs that low-credit borrowers are either
being frozen out of the market or becoming too large a share of loans;
·
Newly delinquent auto
loans, as a percentage of current balances, have been falling over the past two
years; and
·
Subprime auto loans
differ significantly from subprime
mortgages in key respects that make them less likely to pose a serious threat
to financial stability.
Risk-based pricing of auto loans appears to be
working so far, keeping low-income borrowers in the market without driving up
delinquencies or threatening the financial system. We conclude that the
subprime auto loan market is beneficial to low-income consumers, while not
posing the same risk that the subprime mortgage market did before the financial
crisis. While it will be instructive to observe subprime auto loan trends going
forward, current trends do not indicate significant instability concerns in this
market.
Recent Patterns
in Debt Accumulation
Recent patterns in debt accumulation are very
different from those that preceded the financial crisis and Great Recession.
Non-mortgage consumer credit – including auto loans, credit cards, and student
debt – has risen by $900 billion over the past five years, according to Federal
Reserve data. While that figure sounds substantial, that increase amounts to
less than 9 percent of the total increase in domestic nonfinancial debt – that
is, all debt except borrowing by financial institutions. The rise in consumer
borrowing is dwarfed by the increase in business debt ($4.1 trillion) and
federal debt ($4.2 trillion) over the same period. Those two categories
together account for 82 percent of the increase in domestic nonfinancial debt
(Table 1). The leading contributors to business debt growth are mortgages and
corporate bonds.
Indeed, businesses have taken the greatest
advantage of low-interest rates. Nonfinancial corporations have almost doubled
their outstanding corporate bonds since the end of 2007 when the last recession
started. Meanwhile, household debt has risen by only 10 percent.
Taking home mortgages into account, households
have only accounted for 19 percent of the increase in domestic nonfinancial
debt since 2014. By contrast, in the five years leading up to the Great
Recession, households accounted for 48 percent of the debt increase. In other
words, the financial boom in the pre-recession years was heavily driven by
household borrowing, while households have only contributed a small portion to
the current debt increase.
A skeptic could argue that, given derivatives
and financial engineering, it’s possible for a relatively small portion of the
debt market to drive an outsize increase in risk for the whole system. Indeed,
that’s what happened ahead of the 2008 financial crisis. In May 2007,
then-Chairman of the Federal Reserve Ben Bernanke famously said, “We believe
the effect of the troubles in the subprime sector on the broader housing market
will be limited, and we do not expect significant spillovers from the subprime market
to the rest of the economy or to the financial system.”5 At the
time, the value of subprime mortgages was about $1.3 trillion, which was only
10 percent of the mortgage market and an even smaller share of total borrowing.
Bernanke and other policymakers figured that the problems in subprime mortgages
could be easily contained.
What Bernanke and others failed to reckon with,
however, was how the subprime mortgages had been designed to make sense only in
a rising real estate market. Subprime mortgages were constructed effectively to
subsidize interest rates with the possibility of appreciation. These financial
instruments would offer low upfront rates that enabled lower-income borrowers
to qualify. When the teaser rates eventually reset to much higher levels, the
assumption was that the borrower could refinance into a new mortgage.
Moreover, the subprime mortgages were then
securitized and used to build complicated financial derivative products. And
when the subprime mortgages failed because of declining home prices, so did the
derivatives. In other words, problems in a relatively small financial sector
could be amplified and have a much larger effect on the rest of the economy.
Despite this concern, there is evidence to
suggest that subprime auto lending is not a substantial risk to the broader
economy. Auto loans are only 7.4% of household debt, which is the 40-year
historical average.6 Moreover, the auto asset-backed securities
(ABS) market is likewise dwarfed by the mortgage-backed securities (MBS) market.
As of the second quarter of 2019, there was a mere $264 billion in auto-related
securities, which included only $55 billion in subprime auto securities. By
comparison, the amount of outstanding mortgage-related securities came to
almost $10 trillion.7
Further, subprime auto loans don’t work the same
way that subprime mortgage loans did in the pre-crisis era. Cars and trucks
depreciate steadily over time, so the value of the collateral diminishes. That
means lenders can’t afford to offer teaser rates, or excessive levels of
negative equity, to buyers with low credit scores. They must charge higher
rates, properly pricing risk. As one article put it, “the very nature of a real
estate loan is very different from an auto loan. Real estate is an investment that
typically appreciates over time. During the bubble years, consumers and lenders
falsely believed appreciation would bail them out from poor judgment. Vehicles,
on the other hand, depreciate. There is no false hope of higher values in the
future to bail out a borrower or a lender.”8
The Auto Market
Despite the relatively small role that consumer
debt is playing in the current debt expansion, some people can’t shake the idea
that Americans are over-spending and over-borrowing to maintain a particular
lifestyle. Consider this quote from an April 2019 piece from Business Insider:
The fact that America’s top-selling vehicle — a
Ford truck with a price starting at nearly $30,000 – and many like it cost
nearly half the median household income hasn’t stopped people from buying them
and hasn’t stopped lenders from facilitating loans.9
Over the past five years, the price of new motor
vehicles has risen by only 1.1 percent, according to estimates by the Bureau of
Economic Analysis (BEA).10 By contrast, the overall price level
of consumer goods and services have risen by 6.7 percent over the same stretch.11 In
other words, the relative price of new motor vehicles has fallen over this
period.
Not surprisingly, the share of consumer spending
on new and used vehicles has fallen as well. In 2000, 5.4 percent of consumer
spending went to purchases and leases of new and used vehicles. Today, that
share is down to 3.6 percent (Figure 1).12
The BLS Consumer Expenditure Survey tells the
same story. In 2000, motor vehicle purchases and finance charges amounted to
9.7 percent of household outlays. As of 2018, the last year for which full data
is available, the share of vehicle purchases and finance charges fell to only
6.7 percent of household outlays.13 In part, this decline may
represent a lengthening of the term of auto loans.14 (These
figures would not be changed much by including automobile lease-related
payments, which amount to about 10 percent of automobile purchase-related
payments in 2018.)
The State of the
Low-Income Auto Market
It’s not surprising that lower-rated borrowers
pay more for their auto loans. Table 2 below shows interest rates for a
36-month new car loan at different credit rates for December 2015, which was
close to the bottom of the credit cycle, and August 2019 (Table 2).
We can see that rates have risen for all
credit-rating levels, but more so for the low-rated borrowers.
This risk-based pricing means that low-rated
borrowers are not frozen out of the auto loan market. That’s good news, since,
in many parts of the country, a car or truck is a necessity, even for
low-income households. There is little or no public transit outside of densely
populated urban areas, and ride-sharing services are not viable alternatives in
many places. So, it is unsurprising that the share of low-income (the bottom
quintile) households with a vehicle hold steady at 66 percent in both 2000 and
2018.
At the same time, low-income households saw
motor-vehicle purchase and finance taking a smaller share of their budgets. In
the bottom quintile of pre-tax income, motor vehicle purchases and finance
charges fell from 8.5 percent of household budgets in 2000 to 4.9 percent in
2018 (Figure 2), a drop of almost four percentage points.15
Similar data from the New York Fed’s Household
Debt and Credit Report confirm that low-income households are not being
uniquely stressed financially by automobile borrowing. Figure 3 shows the share
of all auto loan originations that are going to low-rated borrowers (with a
Riskscore of less than 620). Before the financial crisis, about 30 percent of
new auto loans were going to low-rate borrowers, a startlingly high percentage.
That share fell to 20 percent after the crisis and shows no signs of rising (Figure
3).16
Similarly, auto loan delinquencies, while
drifting up, show no sign of the steady rise that foretold the financial
crisis. Starting in 2005, 2 years before the crisis hit in earnest, 30-day auto
delinquencies as a share of all auto loan balances began to rise each quarter
from 6.7 percent to 9.4 percent at the end of 2007. (Figure 4) By contrast,
newly delinquent auto loan balances as a share of current balances fell to 6.9
percent in the second quarter of 2019, their lowest level since 2015.17 It’s
hard to construe that trend as a sign of deteriorating conditions.
Further, young borrowers (age 19 to 29)-the
demographic most at risk of auto delinquency- show no sign of causing special
issues. The share of auto loans made to young buyers has hovered around 16
percent for several years. Meanwhile, the transition rate into serious
delinquency rate for young borrowers-the percentage of their loans that are newly
90 days or more delinquent-has been drifting downwards, from 4.9 percent in the
second quarter of 2017 to 4.4 percent in the second quarter of 2019.
The biggest piece of negative news has come from
the New York Federal Reserve’s well-publicized finding in February 2019:
…(T)here were over 7 million Americans with auto
loans that were 90 or more days delinquent at the end of 2018. That is more
than a million more troubled borrowers than there had been at the end of 2010
when the overall delinquency rates were at their worst since auto loans are now
more prevalent.18
This startling number, while impressive, simply
doesn’t mean what it seems to suggest. This figure includes anyone who still
has an old, bad auto loan on their credit record, even if the loan was made and
written off years earlier.19 In fact, even after the lender
writes off the loan, the loan servicer could continue to report the account to
the credit bureaus.
The recent economic history of the United States
helps to explain this figure. The number of nonfarm jobs did not return to
pre-recession levels until 2014, while the employment-population ratio for
Americans with a high school diploma but no college did not bottom out until
2015. As a result, today’s subprime borrowers are carrying around bad loans
from the days when the labor market for less-educated workers was still
struggling.
Indeed, in an August 2019 blog item, New York
Fed economists recommend that anyone interested in the current performance of
debt should look at the transition into delinquency- that is, a chart such as
Figure 4.20 And by that measure, auto loans are doing far
better than in the pre-recession years.
Conclusion
In the event of a recession or a significant
economic slowdown, auto loan delinquencies will predictably rise. Subprime auto
borrowers, who are more likely to have fewer resources, will be likely to fall
behind in their payments when times turn bad.
Nevertheless, a careful look at the data does
not suggest that either the origination of subprime auto loans or the exposure
of the broader macroeconomy to the auto loan market is a cause for concern. In
particular, the subprime auto-loan market looks nothing like the mortgage
market before the Great Recession.
Newly delinquent auto loans, as a percentage of
current balances, have been falling over the past two years, and the fact that
a record number of Americans have a bad auto loan on their credit record is a
testimony to economic history more than current loan practices and economic
conditions, particularly given the rapid rise in total car sales during this
period.
Indeed, risk-based pricing in the auto loan
market appears to be supplying a steady flow of credit to low-rated borrowers
without imposing excess stress on the financial system.
About the Authors
Michael Mandel is Chief Economic Strategist of
the Progressive Policy Institute.
Douglas Holtz-Eakin is President of the American
Action Forum.
Thomas Wade is Director of Financial Services
Policy of the American Action Forum.
References
3.
https://www.citylab.com/transportation/2019/02/subprime-car-loans-buy-automobile-lending-debt-trap/582652/
4.
https://uspirg.org/sites/pirg/files/reports/WEB_USP_Driving-into-debt_Report_021219.pdf
5.
https://www.cnbc.com/id/18718555
6.
Derived from Federal
Reserve Flow of Funds tables D3 and L222.
8.
https://thehill.com/blogs/pundits-blog/economy-budget/342969-a-dubious-doomsday-scenario-subprime-auto-lending-wont
10.
BEA NIPA Table 7.2.4B,
line 6, downloaded September 27, 2019.
11.
BEA NIPA Table 2.3.4,
line 1, downloaded September 27, 2019.
12.
BEA NIPA Table 2.4.5U,
the sum of lines 5,19,and 190, divided by line 1.
13.
BLS Consumer Expenditure
tables 55 for 2000 and 1101 for 2018.
14.
As described in “The
Seven-Year Auto Loan: America’s Middle Class Can’t Afford Its Cars,” Wall
Street Journal, October 1, 2019. https://wsj.com/articles/the-seven-year-auto-loan-americas-middle-class-cant-afford-their-cars-11569941215
15.
BLS Consumer Expenditure
tables 55 for 2000 and 1101 for 2018.
16.
New York Fed Quarterly
Report on Household Debt and Credit, 2019:Q2, “Auto Loans Origination by
Riskscore”
17.
New York Fed Quarterly
Report on Household Debt and Credit, 2019:Q2, “Transition into Delinquency
(30+) by Loan Type”
18.
https://libertystreeteconomics.newyorkfed.org/2019/02/just-released-auto-loans-in-high-gear.html
19.
https://libertystreeteconomics.newyorkfed.org/2019/02/just-released-auto-loans-in-high-gear.html?cid=6a01348793456c970c022ad3e
4e277200b#comment-6a01348793456c970c022ad3e4e277200b.
20.
To be precise, the New
York Fed economists said: “our measure of 90+ dpd debt includes “severely
derogatory “balances that loan servicers continue to report to credit bureaus
(even after that debt has been “charged off” on the lenders’ books). A large
share of 90+ dpd auto debt is reported as severely derogatory, and much of it
remains on borrowers’ credit reports for years after it becomes severely
derogatory.” (90+ dpd = 90+ days past due)
21.
https://libertystreeteconomics.newyorkfed.org/2019/08/just-released-mind-the-gap-in-delinquency-rates.html
https://www.americanactionforum.org/research/low-income-borrowers-and-the-auto-loan-market/#ixzz6CumpfuiF
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