Mind The Repo Man: The Auto Rebound Is Built On Shaky Credit

We called them “note lots.” People with terrible credit could go buy an old beater there. Ideally, it worked like this: you walked in with $500 cash. The dealer showed you a “cream puff” he’d bought for $500. You didn’t like the car, but you’d been turned down everywhere. The dealer made you a “great deal” for $2,000. He’d already recuperated his cost. Everything else was profit. You signed a note for $1,500 with 21% APR and drove off with the car.

Three months later, the brakes shot craps. You had them fixed, thereby using up the money for your monthly payment. Five days after the payment was due, the dealer called and asked for it in cash, to be handed to him. You promised. On day seven, he sent the repo man. He’d sell the same car to the next guy under the same conditions. Even if he couldn’t recuperate the car, he was still ahead. Because there is one ancient truth in the car business: you can make the most money on people with bad credit.

The opportunity was just too good. Soon, reputable new-car dealers got involved, calling it “special financing” before the word “subprime” was born, and some of them got into trouble over it, but what the heck [for the inside scoop, read my book, TESTOSTERONE PIT, an edgy, raunchy, and funny novel about car salesmen, their customers, managers, and the shenanigans at a large Ford dealership; it’s so cheap it’s almost free].

Over the years, the process moved up-market, became more sophisticated. Now deadbeats can even buy new cars, and the biggest banks are involved, and everyone is happy: manufactures because it moves the iron; dealers because they’re making a ton; and lenders, oh my!

The interest is juicy, if not usurious. They get to package these loans into asset-backed securities and sell them to mutual funds in your portfolio, and everyone is extracting money along the way. Finance companies pop up to focus on auto subprime because banks can be a little squeamish when it comes to the dirty underbelly of the business. However, banks have no problem lending to these finance companies to fund their subprime loans, and the money flows, and it all adds to retail sales, manufacturing, industrial production, a million other closely watched metrics, and GDP. And everyone is happy.

Well, not everyone.

“According to a person familiar with the matter,” at least one unnamed bank regulator is pressing banks for details on their exposure to auto loans, Reuters reported.

Auto loan balances in August soared 10.8% from a year ago to $924.2 billion, an all-time high, with a record of 65 million auto loans outstanding, according to Equifax. Of all the auto loans originated in the first half, 31.2% were to subprime borrowers. But the report pointed out soothingly that “a bubble is not occurring in that space.”

These unnamed bank regulators are fretting that reckless lending is fueling that boom. So they’re asking banks about these auto loans as well as about the loans they extended to auto-loan finance companies. They’re worried that the banks’ complex exposure to auto loans is far greater than meets the eye – reminiscent of their mortgages leading up to the financial crisis. Reuters cites an example:

Wells Fargo & Co, for example, is the largest U.S. auto lender, with $50.8 billion outstanding at the end of 2013. About $15 billion of that was subprime. It is also the largest underwriter of bonds backed by subprime auto loans, having sold $3.3 billion of these securities this year, according to industry publication Asset-Backed Alert.

In addition, since 2011 Wells Fargo has extended more than $1.5 billion of credit lines to some of the largest subprime car lenders through its Des Moines, Iowa-based subsidiary Wells Fargo Preferred Capital Inc….

As in the olden days, the profit is just too juicy. And there’s never any risk – until it all blows up.

But there are differences to the mortgage fiasco that helped take down the banking system. Car loans are much smaller than home mortgages. While their terms are getting longer every year, they’re still far shorter than the typical home mortgage. And cars are easier to repossess than homes; repo man swoops in with his tow truck, and the car is gone.

Cars have other risks. The value of cars sags the second they roll off the dealer’s lot, and it continues to depreciate rapidly. Borrowers buy cars at retail. The amount they were upside-down on their trade-in is added to the loan, along with title, tags, and license fees, extended warranties, credit life insurance, and some fluff and buff. This can bring loan-to-value ratios to 120% or more. When a bank ends up with the car, it has to sell it at wholesale usually at an auction. So even if the bank recovers the car in one piece, the loss is significant. Multiplied by a large number of cars, it adds up.

Delinquencies are already increasing. Loans that are 60 days behind rose 7% year over year, and the repossession rate, though still relatively low, jumped 70%, according to Experian. And there have already been warnings from other corners [read… Subprime Blows up on Retailer, CEO Warns on ALL Subprime, Hits Auto Sales].

But the problem isn’t that an implosion of the auto-loan bubble, or the auto-loan subprime bubble, will take down the big banks. The amounts aren’t big enough. Home-mortgage balances are about ten times larger than auto-loan balances. It would make banks bleed, and their stocks would crash, and Wall Street would shake at its foundation, and it would take down some specialized subprime auto-loan financing companies. But the banking system would survive.

The problem is that when the music stops, when this reckless lending faces reality as losses pile up, when banks have to write off billions in loans extended to finance companies, and billions more in the complex web of the auto loan business, they will curtail their lending and tighten their underwriting standards. Subprime will once again become a sinkhole instead of a profit center.

And suddenly, the over-indebted, underpaid, strung-out American proletariat – the former middle class – won’t be able to finance auto purchases, and they’ll have to drive whatever they have. Auto sales has been the one element over the last few years that has consistently boosted retails sales, consumer spending, manufacturing, industrial production, service activity, and finally GDP. Even railroads benefit as they’re hauling the 17 million new vehicles a year from plants, ports, or borders to dealers across the country. Auto sales create a lot of jobs. But when the auto-loan bubble pops, the remaining engine of the economy will slow down with a sharp screech. That’s the risk.

Bitter ironies are piling up – with very crummy consequences. Read…. What the Heck just Happened in Global Stock Markets?