Does Anybody See a Pattern?
The financial crisis of 2007-2008 was caused in no small part by a housing market full of questionable mortgages. Loan qualifications were stretched beyond reason to accommodate eager homebuyers trying to deal with rapidly increasing prices.
The resulting "subprime" loans were packaged inside vast mortgage pools (such as government-backed Fannie Mae and Freddie Mac bonds), and the true risks of these securities were largely hidden from investors. As mortgage fraud and default rates soared — due largely to this spike in subprime lending — and foreclosures began to flood the market, property values fell sharply in many areas. Millions more homeowners were pushed into default as this decline in home values steepened, and the economy fell into one of the worst recessions ever, taking years to recover.
Today's auto-loan market is showing disturbing parallels to the pre-recession housing market. Total securitized auto loans have topped $1.1 trillion, an increase of some 60% over the third quarter of 2010, and a 35% increase over the previous peak in 2005. The share of subprime auto loans considered Deep Subprime (weighted average FICO scores below 550) have shot up from 5.1% in 2010 to 32.5% in 2016. Subprime default rates are near 12%, approaching the 2009 peak encountered during the Great Recession. How would your credit score be classified? You can check your credit score and read your credit report for free within minutes using Credit Manager by MoneyTips.
Add recent information from data analytics group Point Predictive that as many as 1% of auto loan applications have some form of misrepresentation and fraud, and the parallels are clear: a market that is stretched is extending credit to people who are unqualified, and increasingly bending rules in order to do so.
Learning From Our Mistakes
In a way, it's comforting that parallels are being drawn to the housing crisis. This means that people are paying attention.
Steps are underway to get ahead of the situation before it becomes unmanageable. Unlike the climate during the housing crisis, lending institutions appear to be less willing to look the other way. According to a Federal Reserve survey, banks are beginning to tighten underwriting standards for auto loans. This should reverse the trend of increasing percentages of deep subprime loans – assuming that higher standards are combined with an active effort to defeat loan fraud.
Pressure should also increase on auto dealers and lenders catering to the subprime market – but will they have the strength to avoid crossing the line?
Dealers understand the details of the auto loan process and are better equipped than consumers are to execute fraud if they choose to be unscrupulous, either with or without a customer's knowledge. Lenders in the subprime market segment are, by definition, the gatekeepers for preventing excessive risk. Both become the logical focal points for preventative action, because of their need to maintain a customer base while staying within guidelines.
Point Predictive is doing its part by establishing a consortium of 13 lenders in the auto loan field to share data on dealers and loans in order to identify potential fraud patterns. Looking back at the housing crisis, it appears that as little as 3% of mortgage brokers were responsible for the majority of the fraud uncovered in mortgage loans. Auto loans will likely follow the same path. Efforts to weed out the worst offenders will have the greatest effect in shrinking a potential debt bubble before it can burst.
Won't these actions affect consumers who are in the greatest need? Yes, but is it better to saddle consumers with loans that they can't afford in the long term for short-term convenience? If you can't afford a car, don't buy one. It's that simple. There are alternatives.
The same principle applies if you are stretching to purchase a more expensive car that is realistically out of your reach. Understand what you can genuinely afford. Don't let envy of your neighbor's Mercedes drive you to the dark side.
The auto market shows many signs of following the same path as the pre-recession mortgage market, but the relatively small size of the auto financing market – approximately $1.1 trillion at the end of 2016 as compared to a residential mortgage market of $10.3 trillion – makes it unlikely that the auto loan market will cause a large-scale economic collapse.
An auto market collapse would still have significant consequences, especially for those in the industry. The inevitable tightening of credit will affect sales of both new and used cars, and make it more difficult for low-income Americans to deal with basic transportation issues – perhaps causing ripple effects that spill over to other industries.
The real issue is that these patterns of lending behavior occur periodically in most areas of finance. Lenders and regulators appear to be more on top of the situation than they were in the high-stakes housing crisis, but you must not let authorities substitute for your own due diligence. Take steps to assure that fraud does not enter your own purchase agreements. Research the dealers and financing groups that you use for any major purchase before completing the sale. Do they have a history of questionable dealings? If you are interested in an auto loan, visit our curated list of top lenders.
Make sure you fully understand the terms of any agreement that you sign, and use common sense when evaluating any transaction. Do you seem unqualified for the terms that you are receiving? There's probably an underlying reason why. Don't let a sharp, new ride drive you to financial carmageddon.
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