Do Subprime Auto Loans Threaten the U.S. Economy?
With partisan divisions as deep as ever, both sides can agree on one thing: Everybody wants to avoid another financial crisis. And forecasters have recently identified subprime auto loans as an existential threat to the economy.
The headlines are eye-catching and scary: “A $45,000 Loan for a $27,000 Ride: More Borrowers Are Going Underwater on Car Loans,” “Underwater: Consumers Are Treating Cars A Lot Like Houses During The Subprime Mortgage Crisis,” and more of the same. But is it true? Are subprime auto loans the new financial cancer threatening households and the economy, much like the subprime mortgage crisis did in 2007?
Worries about subprime auto loans — which offer higher interest loans to riskier borrowers — are ill-founded and based on misleading data and faulty analogies, our new research finds.
To begin, auto loans are simply not significant enough to threaten the economy. Auto loans make up only 7.4 percent of household debt, roughly the 40-year historical average. Increases in auto loans amount to less than 9 percent of the overall increase in domestic debt (excluding that of financial institutions) over the past 5 years.
And the portion of auto loans associated with “financial engineering” — the auto asset-backed securities market — is likewise dwarfed by the mortgage-backed securities market. As of the second quarter of 2019, there was a mere $264 billion in auto-related securities, which included only $55 billion in subprime auto securities. By comparison, the amount of outstanding mortgage-related securities came to almost $10 trillion.
In short, subprime auto loans are not a threat to the economy. But perhaps they are a threat to households? Wrong again. Americans are spending less of their budgets on car purchases today, including finance charges, than they were before the recession.
One reason is that cars are (relatively) cheaper. The price of new motor vehicles has risen by only 1.1 percent over the past 5 years, compared to 6.7 percent for the overall price level. This has permitted the share of consumer spending on new and used vehicles to fall from 5.4 percent of spending in 2000 to 3.6 percent.
Skeptics might argue we are missing the point. Subprime loans are tailored to low-income households, so maybe the distress lies there?
The data say no. Low-income households saw motor-vehicle purchases and finance taking a smaller share of their budgets. In the bottom quintile of pre-tax income, motor vehicle purchases and finance charges fell from 8.5 percent of household budgets in 2000 to 4.9 percent in 2018.
Delinquencies are not rising, either. Starting in 2005, 30-day auto delinquencies as a share of all auto-loan balances began to rise each quarter, from 6.7 percent to 9.4 percent at the end of 2007. By contrast, newly delinquent auto loan balances as a share of current balances fell to 6.9 percent in the second quarter of 2019, their lowest level since 2015.
Further, young borrowers (age 19 to 29) — the demographic most at risk of auto delinquency — show no special distress. The percentage of their loans that are newly 90 days or more delinquent has drifted down from 4.9 percent in the second quarter of 2017 to 4.4 percent in the second quarter of 2019, and young people have made up a steady percentage of all auto loans.
The numbers are compelling. Subprime auto loans are not a threat to young borrowers, low-income borrowers, households overall, or the economy in general. Upon reflection, this should not be a surprise. Subprime auto loans differ significantly from subprime mortgages in key respects that make them less likely to pose a serious threat to financial stability. Cars and trucks depreciate steadily over time, so the value of the collateral diminishes. As a result, lenders can't afford to offer teaser rates, or excessive levels of negative equity, to buyers with low credit scores in the hopes that higher resale values will bail them out.
Subprime auto loans are a form of risk-based pricing. Far from being a threat, this pricing means that low-rated borrowers are not frozen out of the auto-loan market. Risk-based pricing is one reason that the share of low-income households with a vehicle held steady at 66 percent in both 2000 and 2018.
That's good news, since, in many parts of the country, a car or truck is a necessity, even for low-income households. There is little or no public transit outside of densely populated urban areas, and ride-sharing services are not viable alternatives in many places. Subprime auto loans appear to be keeping low-income borrowers in the market without driving up delinquencies, while not posing the same risk that the subprime mortgage market did.
Douglas Holtz-Eakin is president of the American Action Forum and former director of the Congressional Budget Office. Michael Mandel is chief economic strategist for the Progressive Policy Institute.