Is Party Time Over for Dodgy Auto Loans?

Easy credit has allowed the auto sector to drive U.S. economic growth. That may be about to change.
See anything you like? Better have good credit. Photographer: Daniel Acker/Bloomberg

It seems like all that's needed to qualify for an auto loan these days is the ability to fog a mirror, although you may have to pay interest rates as high as 19 percent for the privilege. A recent report suggests that could soon change.

The Standard & Poor's report, "Subprime Auto Loan Performance: The Best Is Behind Us," suggests growing losses may push lenders to tighten credit standards. Although it shouldn't be enough to cause a financial crisis, that could mean lean times ahead for carmakers -- and maybe for the U.S. economy as a whole.

Spending on cars is one of the biggest drivers of the economic cycle. Spending on motor vehicles and parts fell by about a third between the summer of 2007 and the beginning of 2009, which alone was responsible for more than half the total decline in retail spending during that period.

Car sales are also highly sensitive to the availability of credit. Borrowing to buy new vehicles has increased by 22 percent since the beginning of 2011 and much of this growth has been driven by a rapid increase in subprime credit. The proportion of auto loans going to dodgy borrowers has increased to 27 percent in 2013, up from 18 percent in 2009.

Why? Well, the Federal Reserve's low interest rates encourage investors to buy anything that pays more than inflation, including securities backed by subprime auto loans. That lowers funding costs for lenders. For a time, low default rates and usurious loan terms meant those lenders could earn double-digit profit margins. But those profits eventually attracted more competitors, who offered better terms. So far, that's goosed spending and pushed up the economy.

But S&P reports that subprime auto loan delinquencies are increasing sharply. That's surprising because unemployment is still falling and wages are still growing. According to S&P, "we're at a turning point with respect to subprime auto loan performance, similar to where we were in 2006," although things aren't yet at levels that could be considered dangerous to lenders.

The concern is that this could limit future growth in auto loans and constrain consumer spending. If lenders start losing too much money, they may feel compelled to tighten standards, reducing the availability of credit. Making matters worse, this could occur at the same time as the Fed begins raising short-term interest rates, which would raise their funding costs even more. Keeping the economy growing in this environment could be a challenge.

(Matthew C. Klein is a writer for Bloomberg View. Follow him on Twitter at @M_C_Klein.)

This column does not necessarily reflect the opinion of Bloomberg View's editorial board or Bloomberg LP, its owners and investors.

    --Editors: Christopher Flavelle, Stacey Shick.

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