Bad carma

WHAT would you rather lose: your house or your car? In America, where a car is usually essential to get to work, many borrowers would sooner lose their house, which explains why in the years after the crisis, mortgages were more likely to go bad than car loans. It also explains why auto loans, unlike mortgages, are booming. New loans reached $371 billion in the year to June, up 7.4% from the previous year and 64% since 2009. Subprime auto loans, made to the riskiest borrowers, have grown even faster, by 93% since 2009.

This growth is due to rising car sales and ample credit as banks, finance companies and carmakers’ financing arms compete to lend to consumers, either directly or via car dealers. Those loans are then packaged into securities for yield-hungry investors. Experian, a credit-scoring agency, reckons 85% of new and 54% of used cars are now bought with loans, compared to 79% and 52% in 2007.

As volumes have soared, underwriting standards have slipped, with the average subprime loan rising to 115% of the car’s value this year from 112% in 2011, according to Standard & Poor’s, a ratings agency. The average life of a loan has grown too, to more than five years. Delinquencies, naturally, are rising: more than 3% of loans are at least 60 days in arrears, up from 2% in 2011.

There is much talk of a new subprime bubble, akin to the cavalier mortgage lending that helped spark the financial crisis. The Department of Justice has asked two big car-loan companies, GM Financial, a unit of General Motors, and Santander Consumer, controlled by Spain’s Santander Group, for details about their subprime underwriting and securitisation.

Yet the two markets are fundamentally different. Start with size. At $905 billion, total auto loans are barely a tenth of total mortgage debt. Subprime is also more established in auto lending, accounting for 20% to 30% of total loans since 2000.

The mortgage bubble fed on the delusion of both borrowers and lenders that house prices could only rise and thus a loan could always be repaid. In contrast, lenders assume cars only depreciate, and charge accordingly: annual subprime interest rates average 14%, and 25% is not uncommon. Cars are also easier to repossess and resell.

So while losses are likely to mount, lenders do not face a mortal threat. It is borrowers who have more reason to worry. A car loan is a complex transaction that hinges not just on the price of a car, but also on its trade-in value, extras such an extended guarantee or rust proofing, and most important, the interest rate. A dealer typically selects a quote from a bank or finance company via his computer and marks it up. The higher the markup, the greater the payment he receives from the lender.

Consumer advocates fret that this process leaves the unsophisticated—as subprime customers tend to be—at the mercy of unscrupulous dealers. They may be charged a higher rate despite qualifying for a lower one, sold unneeded or overpriced extras, or even told, a few days after they drive off with the car, that their loan was turned down and they must pay a higher rate. “None of the prices are fixed, and each unfixed price is a potentially abusive negotiating point,” says Tom Domonoske, a lawyer who represents aggrieved buyers. Consumer advocates would like markups replaced with a flat fee.

The Consumer Financial Protection Bureau (CFPB), a new watchdog agency set up after the financial crisis, is also worried that lots of borrowers get a raw deal. It has told banks and finance companies that it holds them responsible for the behaviour of the dealers they work with (over which it has no direct authority), and that it considers dealers’ discretion over markups an invitation to discrimination. It has already got one big finance firm to pay $98m to settle a claim that it was charging minority borrowers higher interest rates and is investigating others.

Dealers are fuming at the CFPB’s muscle-flexing. Competition, they say, ensures that customers get the best rate; dealers need discretion to compete. By raising costs, stricter regulation may actually reduce the amount of credit available.