It’s classic subprime: hasty loans, rapid defaults, and, at times, outright fraud. Only this isn’t the U.S. housing market circa 2007. It’s the U.S. auto industry circa 2017. A decade after the mortgage debacle, the financial industry has embraced another type of subprime debt: auto loans. And, like last time, the risks are spreading as they’re bundled into securities for investors worldwide. In July, 90-day auto loan delinquency rates eclipsed 3.8%, their highest levels since the financial crisis.
Subprime car loans have been around for ages, and no one is suggesting they’ll unleash the next crisis. But since the Great Recession, business has exploded. In 2009, $2.5 billion of new subprime auto bonds were sold. In 2016, $26 billion were, topping average pre-crisis levels, according to Wells Fargo & Co.
In recent years, lending practices in the subprime auto industry have come under increased scrutiny. Regulators and consumer advocates say it takes advantage of people with nowhere else to turn. For investors, the allure of subprime car loans is clear: securities composed of such debt can offer yields as high as 5%. It might not seem like much, but in a world of ultra-low rates, that’s still more than triple the comparable yield for Treasuries. Of course, the market is still much smaller than the subprime-mortgage market which triggered the credit crisis, making a repeat unlikely. But the question now is whether that premium, which has dwindled as demand soared, is worth it. “Investors seem to be ignoring the underlying risks,” said Peter Kaplan, a fund manager at Merganser Capital Management.
Asset-backed securities based on auto loans are engineered to keep paying even when some loans sour. Still, some cracks have emerged in the $1.2 trillion market for auto financing. Delinquencies have picked up, as have losses on subprime loans. Auto loan fraud, meantime, is approaching levels seen in mortgages during the bubble.Auto finance “is not going to bring down the financial system like the mortgage crisis almost did, but it does signal more stress with the consumer,” said Stephen Caprio, a credit strategist at UBS Group AG.