The new subprime loan magnet: Your car

November 25, 2013: 11:52 AM ET

Delinquency rates suggests that even those with bad credit are good on their car loans, but the risks to investors are greater than you may think.


FORTUNE -- The financial crisis underscored the risks of lending to borrowers with imperfect credit, but those lessons haven't scared off investors. Subprime loans are making a comeback. Only today, they're in auto loans rather than home mortgages, which in 2007 destroyed banks and nearly brought down the global financial system.

In August, the Federal Reserve Bank of New York noted that subprime auto-lending was beginning to return to pre-crisis levels. Of all car loans for new vehicles this year, 33.8% went to borrowers with credit scores of less than 700 over the summer months, according to a report by TransUnion released Monday. That's higher than 32.6% from a year earlier and closer to the 38.04% recorded before the Great Recession during the second quarter of 2007. 

What's more, $17.2 billion in bonds backed by such loans were issued this year, just below the $20 billion issued in 2005.

The comeback may not be all that surprising, Matt Yglesias of Slate argues. Lenders have greater power if a borrower defaults on a car loan compared to a credit card bill or a mortgage, so there's a natural push toward secured credit products like auto loans. Lenders can take away your car, but they can't take away your degree if you default on a student loan. And it takes months, if not years, to take away your home if you default on your mortgage. And while other types of consumer loans are regulated under the Dodd-Frank bill's Consumer Financial Protection Bureau, auto loans are not.

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Even though more borrowers with sketchy credit have been approved for auto loans, the rate of delinquencies has remained relatively steady since 2009, according to TransUnion, a Chicago-based credit bureau. The ratio of borrowers who are 60 days or more delinquent on their auto loans edged up to 5.6% during the third quarter. That's slightly higher than the 5.3% rate from a year earlier, but still within the 5.45% to 6.59% range since 2009.

"Auto delinquencies aren't a significant risk," says Pete Turek, vice president of automotive for TransUnion. Turek adds that, unlike other consumer loans, dealers can recover from delinquent borrowers faster and avoid prolonged losses.

That may be true, but the risks of subprime auto loans are greater than the statistics suggest, consumer advocates say. And federal regulators are overlooking the risks to consumers.

Borrowers have been paying down their car before most of their other major monthly debt payments. According to TransUnion's survey of borrowers since the housing market crashed in 2007, consumers have been more likely to pay their car loan before their mortgage and credit card. That may be good news for auto lenders, but the trend masks the real delinquency rate of car loans, says Chris Kukla, a vice president at the Center For Responsible Lending. Kukla adds the rate is likely higher, since lenders are able to repossess your car faster than, for instance, your home because of laws that protect homeowners. Once they repossess your car, you are no longer delinquent.

Prior to the recession, consumers tended to pay down their mortgages first before their cars, but as countless homeowners saw their property values plummet and filed for foreclosure, many borrowers stayed in their homes without making payments, taking advantage of laws that protect homeowners. Whereas a bank could repossess your car in a matter of days, it could take months or even years before your home is repossessed.

"It's not as if these loans were performing any better," Kukla says. Subprime borrowers are vulnerable to paying higher interest rates, on top of the already high rates they would have otherwise had to pay due to their sketchy credit histories. Unlike other consumer loans, dealers often arrange car loans through third-party lenders. Dealers can decide how much they want to charge for that service -- they often tack their fee onto the lender's interest rate -- but the costs usually go unnoticed to borrowers since dealerships aren't required to disclose what portion of the interest payment goes to them.

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All of this leaves borrowers with little bargaining power. And minorities are especially vulnerable, as they makeup a disproportionate share of subprime borrowers. After all, the sad reality for those who have put their car ahead of their mortgages has been "I can live in my car, but I can't drive my house to work."

Kukla points to a 2011 study that suggests subprime borrowers are usually charged higher interest rates and more likely to default on their cars. Analyzing 2009 auto industry data, the consumer advocacy center found the average interest rate markup cost $714 per consumer. What's more, markups increased for borrowers with weaker credit, according to the study, which also found that rate markups raised the odds of delinquency.

So while investors may see riches in the relatively unregulated subprime market for auto loans, a closer look says they're a riskier bet than they may first appear.

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