Are we nearing the next financial danger point?

Are we nearing the next financial danger point?

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Could recent economic data be showing that subprime auto loans may be the next danger zone in the economy?

I have noticed that auto loans have been getting a lot of attention lately. In a recent issue of Barron’s, two unrelated articles discussed auto loans as a potential source of worry for the economy and regulators.

Since the financial crisis, auto loans have been one of the major sources of credit. Indeed, the volume of auto loans grew steadily, until just recently.

One concern is that the standards used to make the loans were gradually relaxed in recent years. The practices helped to cause consistently strong auto sales since the financial crisis ended but also could have added credit risk.

CarMax, the used car seller, was the subject of one of the Barron’s pieces. The article reported that the company’s imminent quarterly earnings report was likely to have bad news about loans on its books. It pointed out that defaults and delinquencies on auto loans have been rising across the nation. Also, the residual values of cars are declining (as we anticipated in Retirement Watch about a year ago), and that means less collateral backing the loans.

Sure enough, when CarMax issued its earnings report, it included a higher loan loss provision. Even so, some analysts said the increased loan loss provision wasn’t high enough. The company’s stock price peaked in late January and has been declining steadily lately.

Another article reviewed the general changes in the auto loan market summarized above and cited several analysts. One analyst, Stephanie Pomboy of the MacroMavens consulting firm, said that the auto loan bubble has gone bust. A major problem is that during the boom, automakers kept raising vehicle prices. To make the vehicles affordable, lenders extended auto loans from the traditional three years to five years and then seven years. This risk is coupled with lower lending standards and that put vehicles in the hands of a lot of people who can’t afford them.

With the glut of used cars on the market, many vehicles aren’t worth enough to cover the loan balances and repossession costs after borrowers default.

One of the investors featured in The Big Short who saw the housing crisis coming and sold short mortgage securities recently said that subprime auto loans are the next crisis he sees.

There are going to be some problems in the next year or so for owners of auto loans as defaults increase and the large supply of inventory decreases used car prices. But this isn’t likely to be anything like the mortgage default crisis.

Banks and other major financial institutions don’t have nearly as many auto loans on their books as they did mortgages before the financial crisis. Most of the damage will be concentrated in specialized auto loan lenders that are mostly captives of the auto manufacturers and firms such as CarMax. Some investors, such as money market funds, also buy packages of syndicated auto loans and might suffer some losses.

Problems from increased defaults on subprime auto loans shouldn’t be widespread. We aren’t facing the kind of systemic problem that was the case with housing. Bad mortgages caused problems throughout the financial system. Banks and other institutions that were key to the financial system had severely impaired balance sheets because of mortgage losses.

That isn’t likely to be the case with auto loans. However, the situation warrants monitoring and I plan to follow it closely.

Check out my latest recommended reading on my public blog. If you want my investment recommendations, try my Retirement Watch newsletter by clicking here.

Bob Carlson wrote the book on retirement and retirement planning — twice: The New Rules of Retirement (Wiley, 2nd ed. 2016) and Personal Finance after 50 for Dummies (with Eric Tyson; 2nd ed. 20-15). He also is the lead writer for the www.RetirementWatch.com website.

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