The New York Times recently published an article on the increase in subprime lending1 in the used auto market.
Unavoidably, but perhaps understandably, the very word ‘subprime’ immediately pulls the mind back to 2007–2008, and conjures the idea of a bubble and its attendant hysteria.
In my mind, the idea that subprime auto lending is some kind of canary in the coalmine that can be fairly compared to the subprime mortgage lending crisis is pretty farfetched.
The biggest misconception about the subprime mortgage fiasco is that markets simply erred by providing credit to a lot of undeserving borrowers, and that this alone caused a catastrophe. That’s just not the whole story. It is true that as banks expanded their balance sheets and investors looked to buy high yielding assets, the markets provided credit to a lot of unusual borrowers. This was nothing new in the credit markets—not in 2007 and not today. The credit markets have ways of dealing with those types of excesses, and by itself, that’s not what caused the global financial crisis. There were other significant factors that simply don’t exist today.
Back in 2007, the extension of credit to new borrowers was a problem, to be sure. However, three other factors transformed a problem into an existential threat for the asset class and the banking system in general:
- Mispriced credit. The markets priced the credit risk associated with subprime mortgages borrowers at a much lower level than appropriate. We didn’t fully price in the likelihood of default and loss.
- Questionable collateral value. For subprime borrowers, the value of collateral was highly inflated. House prices had risen significantly over the decade immediately prior to 2007, and any potential correction in the value of the collateral had disastrous consequences, especially since credit risk had been inaccurately priced.
- Overall credit growth. Subprime lending was booming along with credit growth for all kinds of consumers. In other words, credit growth was so rapid in all consumer channels that a problem was inevitable across the board. In the event of any glitch, the sector prone to take the biggest hit was the subprime mortgage market, for all the reasons mentioned.
Saddling today’s subprime auto lending market with yesterday’s subprime mortgage crisis doesn’t make sense. First and foremost, subprime auto lending is now growing in an environment where consumer debt growth is still very low. Consumers are much better able to service their debt today than they were in 2007. Second, as the article itself points out, today’s pricing of credit risk is not low by any measure. We could argue that it is too high. But it surely isn’t too low. Finally, the value of the collateral in the subprime auto lending business is not in question, as it is (and was) with homes. Auto prices have certainly firmed up, but are surely not in bubble territory as house prices were. Not insignificantly, repossession and liquidation of autos is far simpler than it could ever be for houses.
We could sit around debating the societal benefit and policy implications of subprime auto lending, as the article does. Instead, based on our analysis of the performance characteristics of this asset class, we see a lot of value in securities backed by the subprime auto market, especially in an environment where other credit spreads are much tighter. To be sure, given the high profitability of this type of lending, there are a significant number of new entrants in the subprime auto lending market. For investors, discerning between lenders with proven track records and less experienced new players will be critical.
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