By Aman Sharma
Having flown into London’s Luton Airport late one Friday evening, I decided to take a direct train to St. Pancras International. I sat next to a young Brit who seemed roughly my age. He looked dapper in his suit and I guessed he was an upstart in finance.
I’m prone to striking conversations while traveling to feel the pulse of the people and consumer markets. Britain had recently voted on Brexit. One wasn’t sure whether David Davis’ ministerial title ‘Secretary of State for Exiting the European Union’ was a humorous gag or a very-foolish-sounding truth.
Darting towards St. Pancras, I placed the book I was reading on my lap. Nothing works as well as The Big Short: Inside the Doomsday Machine, when you’re looking to break the ice with a stranger. This book is a gem when it comes to conversation starters. I hadn’t counted till five when my soon-to-be-pal said, “I love that book ! I’ve read it nine times.” Soon enough, we dove into its contents and the portrayal of its characters in the eponymous hit movie. My new mate told me that a whole new subprime crisis had emerged in America lately. I was taken aback by the imminent disaster of subprime loans. I couldn’t fathom how such a catastrophe had befallen us so soon after the 2008 financial crisis.
Stars and stripes
Weeks later, I visited America and spent a month in California. Over a decade had passed since my last visit, so fresh opinion and judgment were a given. Frankly, I was thrilled to observe and absorb ‘The Zenith of Capitalism’ as an economist.
There’s so much to tell. Americans love their cars. Not sweet little European hatchbacks but brawny gas-guzzling vehicles from manufacturers like Chevrolet. Unsurprisingly, the appeal for electric vehicles shrank in the past year as the price of oil has halved since 2014. About 86% of America’s workforce gets to their workplace by car. Public transport, you ask? Non-existent. Los Angeles earlier boasted having the second best public transportation in America, but lobbying efforts from rubber and tire manufacturers killed it. Now, anyone living in LA spends one-third of their waking hours stuck behind the wheel on a freeway.
Cars are expensive – people typically draw loans to pay for them. Today, individuals with low FICO scores aren’t given loans anymore. Instead, used-car dealerships are now financiers and are giving out subprime auto loans. These schemes will sell you a car even if you have bad credit.
Generally, subprime borrowers don’t have any other means of purchasing a car. Any tardiness can, therefore, jeopardize their job. Such quagmire is a reality – it isn’t an enviable position to be in.
Subprime lending markets
The surprising amount of crowding and competition in subprime lending markets makes matters more precarious.
Large organizations like GM Financier have expanded their subprime lending divisions and others have followed suit. A quarter of all car loans in America are already high-risk. In order to compete with bigger players, smaller schemes have to issue long-term loans with less money, at higher costs. The economics of money tells us that when you’re poor, everything will be more expensive. The astounding price of money for these loans is an average 19%. Unsurprisingly, the average default rate on the same loans is 30%.
Remember the mortgage crisis, when they bundled all high-interest loans together and sold them on Wall Street? That is precisely what is happening here. While Wall Street insists they’ve learned their lesson, the signs aren’t good and the bubble might burst. The evidence is there for all to see. Default rates are shooting up, levels of delinquency are at an all time high, while most investors aren’t protected for such a position. The situation could exacerbate if high delinquency rates push prices of cars down so far that it becomes difficult for lenders to sell repossessed vehicles in order to retrieve losses.
Struggles to pay back car loans indicate tussles with paying mortgages, education loans, and credit cards. Like a decade ago, corporations are flush with money and are seeking higher returns from charging higher interest rates to subprime borrowers.
Perhaps the main reason for them to be diverting their cash is that the economy isn’t growing quickly. It’s difficult for companies to increase their revenue and profits. The long term resolution is a genuine improvement in the financial position of individuals through higher wages. It’s imperative that we don’t encourage another debt bubble simply because it gives illusory economic growth. Meanwhile, somewhere someone will be licking their fingers, having already shorted the subprime auto loan market.
Aman Sharma has a degree in Economics from Netherlands, where he currently resides. He is now working as a Business Analyst in a tech firm.
Featured Image Source: pixabay