Sub-Prime Credit Bubble Ready to Burst(No,Not on Houses)

I can vividly remember driving around in 2005 and 2006 looking at more and more huge houses being built, sometimes entire developments of monstrosities, and wondering to myself, “What in the hell do all these people do that they can afford these humongous money pits?” And yet, on seemingly every corner there was a mortgage company, screaming “Come on in, the water is fine! You too can have your very own McMansion!”sub-prime-car-loans

We now know why. In October 2007 everything came crashing down in the sub-prime mortgage boondoggle. Whew. We dodged a bullet on that one right? Everything is finally getting back to normal, right?

In the inimitable word of master debater Donald J. Trump…”Wrong.”

Now when I venture out in my 2009 Hyundai, I see nothing but new, newer and newest cars everywhere I go. And just like a decade ago when looking at houses in growing perplexity, I know what these vehicles cost. Only now I’ve gained a decade of study and research in macroeconomics that I did not have then.

With more and more computerized “driver assistance” being programmed into vehicles, even the price of base models have skyrocketed. And worse, the wave of easy credit and increasingly longer auto loans has left a record percentage of consumers trading in vehicles that are worth less than what they owe on their loans.

In auto finance vernacular, these folks are underwater…and they have changed the market. Automakers jack up incentives, and subprime lenders are still lurking behind the scenes with a giant wad of Dubble Bubble being stretched to the limit. Right. There’s that word again. Sub-prime.

So far this year, a record 32%, or nearly one-third, of all vehicles offered for trade-ins at U.S. dealerships are in this underwater class according to; so when these buyers go to purchase a new vehicle they must add the difference between their loan balance and the vehicle’s value to the price of the one they want to buy.Thirty years ago buyers paid off their current loan before acquiring a new one in an effort to lower the cost, payment, or both on a new vehicle. Not anymore.

For perspective, the lowest the vehicle underwater percentage since the last sub-prime crash (2007), was 13.9% in 2009, at the hull-crushing depths of the Great Recession when credit was tighter than the jacket hanging in my closet that I tried on a few weeks ago—that I wore to my 10-year high school reunion—(okay, okay, I’ve never gone to my high school reunions, but you get the idea). The previous high was 29.2% in 2006, just about the time the sub-prime housing market was at its Dubble Bubbliest.

So all those people who walked away from mortgages that they couldn’t afford, are now behind the wheels of new vehicles they can’t afford…still with lousy credit, still using sub-prme lenders. I think you know how this will end, but let me elaborate…just to ease my conscience.

The average new car loan is for 68 months, according to Experian Automotive, which tracks the auto finance market. But subprime borrowers, generally those with FICO credit scores in the low 600s or lower, are borrowing over an average of 72 months, or six years…some are extending to a previously unheard of, 84 months.

While this kind of loan reduces monthly payments, they also ensure that the buyer’s equity, or the portion of the loan principal that’s paid off, grows more slowly than the vehicle depreciates in value.

This is an extremely precarious position for the consumer because there’s no surefire way to reduce his financial exposure unless they’re willing to stay in the car until the loan is paid off. If the car gets stolen, is wrecked or the buyer just gets a case of new car envy while upside down, the problem keeps building.

As this is happening, the average selling price of a new vehicle is a historic high of about $34,000 (McMansion, meet McVehicle). Some of that increase is driven by consumers’ preference for larger, fully equipped pickups, SUVs and crossovers because the cost of oil has been so low for so long.

The result is consumers borrow more to get the vehicle they want rather than the one they can afford. The average new auto loan was just under $30,000 in the second quarter of this year, according to Experian Automotive. That’s knocking on the door of 5% higher than just a year earlier. And we know that wages have been stagnant for most of the population much longer than that.

Moreover, leasing, which has reached record levels of 33% of all new retail vehicle transactions, has tripled since 2009. The problems with leasing?

  • You pay the depreciation of the vehicle, estimated over the life of the lease, up front. Many buyers actually borrow the money to pay this, increasing the effective debt-to-value ratio in the wrong direction.
  • The mileage allowed is usually very limited. For every mile over the total allowed under the lease terms, the lessor will owe anywhere from 10₵ to 25₵ per mile. It might not sound like much, but over a three-year period, just 10,000 extra miles (or 3,333 miles per year) would cost the lessor from $1,000 to $2,500 when the lease is up. So before they can get another vehicle, they have to pony up as much or more than they paid up front for the vehicle lease. So the consumer has no vehicle to trade, and could still owe a lot of money before even considering a replacement; whether borrowing or leasing.

Already, especially in segments such as subcompact, compact and midsize cars, used car values are falling as a wave of 3-year-old models are returned by lessees. This increased supply is pushing down the price dealers are willing to pay for them at auctions, which is where a huge percentage of trade-ins are sold by new car dealers.

Just last week, Ford Chief Financial Officer Bob Shanks told analysts that the company’s finance arm, Ford Credit, cut its forecast for 2017 pretax profits, in spite of increased new car sales, because of declining auction values for the trade-ins. (Any guesses as to what this means for the likelihood that Donald Trump can make good on his promise to bring back manually-assembled automobile jobs? How about if he slaps a tariff on imported vehicles for companies who fled to lower-wage countries? Anybody?). The only viable alternative for manufacturers would be to turn to robotics, which they are doing in record numbers.

1980 Automobile Assembly Line           2016 Automobile Asembly Line

1980-assembly-line    2016-assembly-line

Credit agencies, such as Moody’s, Standard & Poor’s and Fitch, so far, have expressed only mild concern about the trend. Their focus is on the $38-billion market for securities backed by auto loans,(tell me again the  cause of the 2007 crash? Mortgage loan backed securities…right, right). These are bundles of auto loans, similar to the tranches of mortgages that collapsed in the 2007 crash of the housing bubble. Of course these are the same credit agencies that were telling us everything was fine in the housing market right before it crashed too.

Admittedly, these loans are a little different. Lenders can repossess automobiles more quickly than it takes for mortgage holders to foreclose on a house. Even so, the consumer loses the car (and their credit rating tanks), the manufacturers and new car dealers lose customers and projected profit; meaning prices will likely rise even more unless production (and jobs) are cut back.

Fitch reported that 60-days-plus delinquencies on sub-prime auto loans rose to 5.05% in September, the second highest level since 2001, and 13.2% higher than just a year ago.

Also, the recessionary gap, when unemployment was near 10% in 2009 and late 2008, was 5.04%. Today’s is virtually the same.

Fortunately, unemployment is down to 4.9% nationally. But it’s one more indication that any promise to bring back manual-labor jobs to the Rust Belt is just nonsense.

New vehicle sales are expected to continue slightly below their record year-ago levels in November, according to J.D. Power. But their forecast also indicates troubling signs.

Discounts to lure buyers to spend on vehicles they might otherwise view as unattractive rose to $3,886 per vehicle in November, up 15% from $3,374 a year ago and the second-highest level ever behind the record $3,939 set just two months prior.

People’s monthly payments are being kept low by easily obtained, low interest rate loans that most manufacturers have been willing to subsidize to maintain the volume of sales and to keep inventories relatively lower, but any increases in manufacturing cost or consumer interest rates and most buyers at current levels won’t be able to afford new cars…or even the ones they have now, whether leased or aging, owned vehicles.

Now then, let’s talk about that $1.3 trillion in outstanding student debt…

Harvey Gold