08/12/2014 01:42 pm ET Updated Nov 11, 2014

Is a Crisis Brewing in the Market For Sub-prime Loans on Used Cars?

In a long front-page article in the NY Times last month, Jessica Silver-Greenberg and Michael Corkery answer this question affirmatively. Their article cites numerous parallels to the conditions that led up to the crisis in the sub-prime mortgage market in 2007-08. The similarities include:

  • A surge in lending to unsophisticated borrowers with poor credit, many of whom cannot afford them.
  • Lending standards that have weakened, with increasing numbers of loans based on incorrect or falsified information that don't meet the standards that exist.
  • Interest rates (termed "exorbitant" by the authors) that are much higher than those on prime auto loans, and also higher than those on sub-prime mortgages.
  • Emergence of lenders that specialize in the riskiest loans that carry the highest interest rates.
  • High incomes earned by loan originators with strong incentives to close deals but no interest in the aftermath, who in this market are used car dealers.
  • Packaging of loans into securities that carry high ratings from credit agencies, despite the poor quality of the individual loans.
  • A strong demand for the securities by all kinds of investors looking for attractive yields.

To the authors, these add up to a "sub-prime auto bubble," and since bubbles must burst sooner or later, the reader is left to infer that a new crisis will emerge. But they don't define "bubble," and they don't explain how the parallels between the two markets will generate a similar if smaller crisis.

A bubble is a rise in prices that is unsustainable because it is based partly or entirely on expectations that prices will rise. Bubbles are vulnerable to shocks that raise questions about the validity of the price expectation.

The sub-prime mortgage market grew within a home price bubble. While the long-term rate of appreciation in home prices is about 4 percent, during the period 2000-2007 the growth rate was about 10 percent. Expectations that nothing bad could happen were supported by the fact that on a national basis, home prices had not declined since the 1930s.

Losses to lenders from defaults on home mortgages depend heavily on the value of the houses that serve as collateral. So long as borrowers have equity in their property, they have a strong incentive to make their mortgage payment, and if they can't possibly pay they sell the house and pay off the mortgage in order to retain the equity. When collateral values increase 10% a year, it is very difficult to make a bad loan, and the temptation to make more money by making more loans, by relaxing or ignoring underwriting standards, proves irresistible. But bubbles always burst and this one burst early in 2007 when home prices began to decline.

Nothing like this is happening in the sub-prime auto loan market. With the unimportant exception of the collector's market, used cars never appreciate, and the individual car begins to depreciate when the buyer drives it off the lot.

The role of collateral is very different in the market for sub-prime loans on used-cars than in the home loan market. It is common for the car purchaser to owe more than the car is worth, but that does not weaken the incentive to pay because the borrower needs the car. The importance of the collateral to the lender is mainly the power to take the car away from the borrower, and only secondarily is it viewed as the means to recover some of the unpaid balance of a loan in default.

We worry about bubbles because of the implied vulnerability to a shock, but none of the parallels to the sub-prime mortgage market indicate that the sub-prime auto market is in a bubble. The type of shock to which this sector is exposed is not the bursting of a bubble, but a major rise in unemployment that cuts the incomes of borrowers. At this point, no such shocks are on the horizon.

None of this should be interpreted to mean that all is well in the market for sub-prime auto loans. Sub-prime markets that cater to consumers with bad credit records attract the kinds of lenders who are comfortable deploying the kinds of unsavory tactics sometimes needed to deal with deadbeat borrowers. The best way to avoid such tactics is to graduate out of the sub-prime category.

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