Apr 24, 2017 | 09:30 GMT

6 mins read

Bursting Auto Lenders' Bubble

For several years, car sales have kept pace with the rise in auto loans. But now the market for new and used cars may have reached its saturation point, a development that bodes ill for the auto lending sector.
Forecast Highlights

  • The overabundance of vehicles on the used car market will make it harder for auto lenders to recoup their losses as delinquency rates rise.
  • If the auto loans sector comes crashing to a halt, depressed lending and consumption will hamper the U.S. economy's growth.
  • Nevertheless, a crash in the auto loans sector is unlikely to set off a full-blown economic crisis.

Since the dawn of the automobile, U.S. consumers have been car crazy. The 2008 financial crisis dampened their enthusiasm, as high oil prices and tightening credit deterred Americans from buying new cars, and especially the larger vehicles that had become the mainstay of U.S. automakers. Once the crisis passed and lines of credit opened back up, though, Americans returned to the auto market in full force. Larger cars started coming back in fashion, with help from improved fuel efficiency and lower oil prices, and average vehicle prices have risen by 30 percent since 2009. The result has been a seven-year boom in sales, which climbed from an annualized 9 million units in February 2009 to 18.3 million units in December 2016.

As car prices have soared, so, too, has the value of car loans — up to a record average of $29,469 per vehicle. These factors combined have contributed to a jump in consumer debt, from $698 billion in 2010 to $1.1 trillion at the end of 2016. And since automakers pushed back on the Securities and Exchange Commission's proposed 60-month cap on auto loans in 2008, lenders have been offering borrowers ever-looser terms, leading to increasing levels of riskier "subprime" loans. The tendency to package the loans into securities and sell them to investors on the open market as asset-backed securities (ABS), meanwhile, has invited comparisons with the subprime mortgages and collateralized mortgage-backed securities of the 2008 crisis. Together, these trends have prompted speculation over the past several years that auto loans will spark the United States' next economic calamity. Though the predictions have so far proved premature, the sector may finally be reaching critical mass.

An Ominous Picture

Until recently, talk of another looming economic catastrophe emerging from the auto loan industry has seemed far-fetched. For one thing, car loans are not mortgages. The risk of lender loss is lower, since vehicles, unlike real estate, can be quickly repossessed and resold into the comparatively liquid used car market. Consequently, lenders can rest assured that they will retain at least some of their investments' value. For another, new car sales have kept thriving, supporting the market and staving off creeping negativity.

But now the situation is changing. A glut of vehicles is driving down used car prices, which have dropped 8 percent since last year, according to the National Automobile Dealers Association. The chief financial officer of General Motors Co.'s financing branch expects prices on used cars in the company's leasing portfolio to drop by 7 percent this year. Auto lenders will have to bear this cost as they try to recoup their losses on the used market, especially as delinquency rates on subprime car loans, currently at 4.51 percent, rise. At the same time, the market for new cars appears to be on its way down after peaking at the end of 2016. Sales dropped off in the first quarter of this year, and the totals for March came in well below projected figures. Toyota Motor Corp. expects that the industry will sell 17 million cars this year, compared with 17.5 million vehicles in 2016. A mismatch between supply and demand is partly to blame for the slump: Inventories are at their highest level during an economic expansion since 1989. As a result, the new and used markets are at their saturation point.

U.S. Car Sales Chart

Should the auto loan sector come crashing to a halt, borrowers themselves would be most at risk — especially those in southern states such as Kentucky, Tennessee and Arkansas, where delinquency rates are high. Panicked lenders may resort to repossessing vehicles more frequently in a bid to recover at least a portion of their investment. Of course, the lenders, too, would suffer. The market is mostly divided between banks, credit unions and major automakers' financing arms, but newer arrivals to the auto loan market, such as private equity firms, are behind some of the riskier loans. They would be the first to feel the effects of an auto lending crash.

Assessing the Dangers

Even so, the rumors of another economic disaster in the spirit of the 2008 financial crisis are overblown. The auto loans sector pales next to the pre-crisis subprime mortgage industry, despite the superficial similarities between the two. Its debt burden, at $1.1 trillion, is a mere fraction of the outstanding $9 trillion in the mortgage sector and, as a result, is much more manageable. The auto loans sector, moreover, is also more straightforward than was the subprime mortgage sector with its obscure network of internationally traded bonds and the synthetic securities it supported. So compared with the fallout in the mortgage industry, whose house of cards came crashing down when the property values underlying its artificial derivatives collapsed, the auto lending sector's potential losses are much clearer. The disruptions in consumption and lending that a wave of auto loan defaults would cause would hamper growth, as would ebbing sales in the U.S. auto industry — one of the engines of the U.S. economy. (The slump could also spread to Mexico, whose own auto industry is highly integrated with that of the United States.)

Instead of a crisis, the slowdown that the auto loan sector's bust would likely precipitate should be viewed as a reflection of the United States' position in the economic cycle. Nearly a decade has passed since the financial upheaval of 2008, and for the past seven years, the U.S. economy has grown steadily at an annual rate of more than 1.5 percent. As the Federal Reserve works to normalize interest rates to stave off inflation, tightening credit is bound to pop some bubbles in debt-heavy sectors such as auto loans. Industries that have relied on their debt, such as the automotive sector, will likewise inevitably slow down.  

Other factors — most notably changes in fiscal policy — could still buoy the U.S. economy. If President Donald Trump follows through on his campaign promises to undertake extensive new infrastructure projects and slash corporate income tax, for example, the initiatives could create enough positivity to hold off the cyclical downturn, at least for a little while. But on its current course, the U.S. economy may well start showing more signs of a downturn in the years to come. 

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