BUBBLES? SUBPRIME AUTO DEBT? WHAT?

Totaled cars piled on top on each other

BUBBLE

In the world of economics, a bubble represents a significant price increase of an asset irrespective to an increase in the asset’s underlying value.

We saw it with housing prices in 2008: individuals were buying houses to “flip” rather than owning as a long-term investment.

Bubbles emerge when the value of an investment is dictated by perception & speculation, rather than the value of the asset itself.  So what does that mean for subprime auto debt?

SUBPRIME

Subprime debt indicates that the borrower has poor credit or little income. This is a classification assigned to all types of debt ranging from home loans to corporate bonds, at significantly higher interest rates.

SUBPRIME AUTODEBT

Subprime debt is offered by car dealerships that may say “No-income, No-problem!” on fluorescent signs to attract potential customers.

Borrowers with poor credit who are unable to secure traditional auto financing find this enticing. Auto dealers are able to sell more cars and offer financing at higher interest rates.

THE CURRENT SITUATION

Following the 2008 recession the government began offering subsidies to stimulate the economy. Some programs offered low interest rates to incentivize new vehicle purchases.

As new buyers emerged, automobile supply decreased. Car manufacturers also raised prices and decreased discounts, as credit requirements were more relaxed.

The higher vehicle costs were just shifted onto long-term debt. This was subprime debt to borrowers who may not understand the terms of repayment.

In 2016, a record 17.55 million vehicles moved through U.S. dealerships. Many were sold by offering long-term financing that became popular in 2008.

Just like the events that led to the 2008 recession, there’s a misalignment of interests. Salespeople are judged on quotas, rather than the customer repaying their loan. And yes, you guessed correctly: they securitize auto loans just like mortgages.

Now the issue with long-term debt (aside from the necessary interest payments) is the rising borrowing costs. This could emerge as the Federal Reserve raises the interbank lending rate.

While the value of a home remains fairly constant over long periods of time, cars are heavily depreciating assets. The second you drive off the dealership’s lot, the car loses a quarter of its value, but your debt remains the same.

WHY DOES A SUBPRIME AUTO BUBBLE MATTER?

It is easy for consumer loans to exceed the worth of the underlying vehicle as they are highly depreciating assets. The present value of future payments consumers commit to making will exceed the value of the asset they are paying for.

Disclaimer, vehicles lose 25% of their value once driven off the dealership lot.

As home prices plummeted during the Great Recession it became cheaper for homeowners to default on their debt than to continue repayment on a depreciated home. There could be a similar imbalance.

With auto loans, available in lengths of as much as 7 years, who is going to feel the pain if defaults start to rise?

In short, everyone. Borrowers will see their cars’ repossessed and credit scores plummet. Lenders will be forced to sell repossessed cars at a fraction of what is left on the debt, due to an increase in inventory.

Manufacturers will be hurt by a huge supply of one to three-year-old vehicles with low mileage. Those who can afford a new car will consider the added savings of purchasing a preowned vehicle.

BOTTOM LINE

At the end of 2016, there was $1.16 trillion in auto loan debt in the U.S. according to the Fed in New York accounting for 9.2% of household debt.

A large portion of that is subprime auto debt, as households are in a worse position to satisfy debt obligations.

For now, any good news related to automotive company’s stocks should be greeted with caution. Since the start of 2017, Ford (F), General Motors (GM), and Fiat Chrysler (FCAU) have all declined.

Conversely, markets have risen more than 10% since the start of the year.

For further reading, click here. Understanding the reasons for market moves is important in achieving financial fluency.

In case you missed it, check out our recent post about uncertainty stemming from President Trump and former FBI director, James Comey.


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