Sleepless Over Sub Prime
As we saw with the hysteria over rising credit card balances a couple of weeks ago, we have a new media inspired crisis shaping up in the form of delinquent auto loans. This article will tell you how the sausage is made.
Years ago, I remember reading about a home construction lender called First Union, who had a bit of a problem: at less than 1%, their delinquency rate was too low. How can that be? Shouldn't lenders aim for zero defaults as a goal?
Because if you're a lender with a default rate that's too low, it means you're turning away too many customers whose loans would perform. More than enough to cover the losses from the non-performing ones. Like any other business, lending is a numbers game, and you underwrite as many loans as you can, while stretching the envelope as you run out of customers with better credit- that is, until things get shaky. As they are now, according to the data we have, so the lenders have turned off the spigots for the time being. But that is the business they are in. As the old saying goes, “no one is in business to say 'no',” and they'll write the loans until they get to a certain risk saturation point. With record car sales from a solid job market, the lenders have had a pretty good time of it, and if they have to tap the brakes for awhile, don't feel sorry for them. But rest assured, they will take it to the edge.
Why is this (somewhat) important? Because of the nature of the reportage, where some are attempting to draw parallels to the 2008 credit meltdown. But there are none, and despite my own example, there aren't many parallels to mortgage underwriting either. Dozens of commentators have expressed shock that the majority of auto loans were done without verifying income, as if trying to recall the “liar loans” of the housing bubble. Except that's no surprise, because the underwriting and credit assessment for purchasing a car is not the same as for purchasing a piece of real property. Most auto loans are funded on the basis of a prior credit history, and the shakier the credit, the higher the interest rate will be (again, to minimize the risk against loss and cover the costs) and the lender may then choose at that point to demand more documentation from the borrower. But if a default rate of say, less than 2.00%, can be achieved from borrowers using only a high credit score, and the loan performance history bears this out, why even bother adding cost and complexity to the process?
The other parallel being falsely drawn is the meaning of of the term “Sub Prime.” This has become one of the most abused words in the English language. For mortgages, it (wrongly) came to describe almost any mortgage product that was not a conforming/conventional loan securitized by Fannie or Freddie. Which is absurd, because there are many shades of credit quality in mortgage loans, just as there are in corporate bonds. For example, there is a difference in the risk profile of a bond rated “B-” from one rated “BB+” although both are not considered “investment grade.” However, it doesn't mean they are destined to default either. Quite the opposite: by far, most of them mature and pay off. The same is true of almost every kind of credit offered by a lender. It does get dicey when it gets to a certain tipping point, but if the lenders exercise prudence, they won't get burned. But people with less than perfect credit need access to capital, too. And our economy depends on it.
Lastly, before we get too amped up on fear, remember that the economy is still growing jobs at a decent rate, and we're on a far more solid footing than we were in 2007-8, when we were in rickety shape, so the comparisons are not valid. It didn't take much for the dominoes to fall back then, and we're hardly in the same position now. So once again, ignore the doomsayers. One day they'll be right, however, and they'll never let us forget it.