Should we worry about a crisis in subprime auto loans? That question has been asked in the financial media lately.
My answer is yes, with caveats. While there are important differences in the auto and mortgage markets, there are similar government interventions that have the potential to fuel a bubble in car loans the same way they did for home loans.
First, the differences. So far, thankfully, there is no auto equivalent of a Fannie Mae, Freddie Mac, or other government-sponsored enterprise to inflate the car loan market. Sure, there have been lots of bailouts in the auto industry in general, but the secondary market in car loans has developed largely on its own.
And without a government backstop, it is much smaller than the mortgage market ever was. An otherwise alarmist front-page story this week by The New York Times conceded, “the size of the subprime auto loan market is a tiny fraction of what the subprime mortgage market was at its peak, and its implosion would not have the same far-reaching consequences.”
Also, unlike with mortgages, there is no expectation among the vast majority of lenders of borrowers that a car’s value will appreciate. Most folks know that a car will be “underwater” the minute it is driven off the lot, and the loans are priced with that reality in mind.
Yet, there are some striking similarities. But not the ones the NYT or other nannyists point to. They are:
- The Federal Reserve’s easy money and zero interest rate policies.
The NYT repeatedly points to demand for subprime auto loans among investors but neglects to give a reason for this demand. Fortunately, a Reuters piece from March laid out the main cause: Just as with mortgage-backed securities, the Federal Reserve’s “quantitative easing” and other inflationary policies that set interest rates at essentially zero have fueled demand for yield among even the most conservative investors.“It's the Federal Reserve that's made it all possible,” Reuters reporter Carrick Mollenkamp explains in the enlightening article.
Mollenkamp continues: “The Fed's program, while aimed at bolstering the U.S. housing and labor markets, has also steered billions of dollars into riskier, more speculative corners of the economy. That's because, with low interest rates pinching yields on their traditional investments, insurance companies, hedge funds and other institutional investors hunger for riskier, higher-yielding securities – bonds backed by subprime auto loans, for instance.”
Whether it’s mortgages, auto loans, tulips, or any other product, easy money and bubbles go together like gasoline and matches
- “Liar loans” and blatant fraud by borrowers.
The NYT story begins with what the reporters likely intend to be a sob story about a man whose car was repossessed after he was put into a clearly inappropriate loan. But reading the story closely, it appears his woes are mostly his own doing.
It turns out his car loan application listed his salary as $35,000 a year as a hospital technician even though he hadn’t worked at that job or any other for more than three decades. And while he claimed to the Times that he told the auto dealer the truth about his employment his history, he apparently never disclaimed knowledge that his loan application was false.
“Liar loans” like these were ubiquitous leading up to the subprime mortgage crisis. And based on the fact that folks are not only lying to get car loans, but feel comfortable telling newspapers, they are doing so, shows that many borrowers still feel they can commit fraud with impunity.
Even the most ardent libertarian will say it’s a core function of the government to punish fraud. But for the rule of law to function, all fraud must be punished whether it is by borrowers, lenders, or those in between.
- The government’s creation of a “Community Reinvestment Act” for car loans due to bogus charges of discrimination.
Among the causes of the mortgage meltdown was the Community Reinvestment Act. In an attempt to remedy real and imagined discrimination, the law and its regulatory expansions forced banks to make loans to uncreditworthy borrowers. While many progressives have attempted to dismiss this law as a factor in the crisis, a definitive 2012 National Bureau of Economic Research study found that the CRA led to substantially riskier lending.
Now the Consumer Financial Protection Bureau, the unaccountable bureaucracy created by Dodd-Frank, may be creating a new CRA by making bogus charges of discrimination any time there is a statistical discrepancy among ethnic groups in car loans. Through a “guidance” not even subject to the safeguards of a proposed regulation, the CFPB has said that “disparate impact” among groups receiving loans and the interest rates they are charged is unacceptable, even if no actual discrimination is proven. As with the CRA, this policy could incentivize auto dealers and lenders to take shortcuts in underwriting loans to avoid having any type of “disparate impact.” The result could be similar to the mortgage disaster.
Dodd-Frank’s prohibitive mortgage rules that have choked off credit for even responsible borrowers and lenders should show us what not to do in response to heading off a potential subprime auto bubble. We should not have any impossible-to-meet “ability-to-repay” rules for auto loans, as we do with mortgages. Automobility is important for everything from getting to work to raising a family, and there should be a vibrant, competitive market for credit to responsible borrowers.
The good news is that if we correct easy money policy, stop the CFPB’s “disparate impact” mandate, and prosecute fraud from every source, the auto credit market should be firmly planted on the right road.