Why Subprime Lenders Still Haven’t Learned Their Lesson

I believe that the opening of this article is the perfect time to make this confession: I have no idea how the complexities of the market fully work. Yes, that’s not a particularly pristine way to introduce one’s piece. And, for an article written by an aspiring professional, it might come across as being extraordinarily flippant or careless, but, in a lot of ways, it is the absolute truth. The market, in essence, is a recorded history of human transactions, and, like traditional history, it sputters and grows and sometimes acts in unexplainable ways. However, most of all, actions on the market tend to repeat themselves over time in the same maddeningly crazy way that actions of the course of human history tend to do. And, the nature of why people do things over and over again in the market usually boils down to a very simple but understandable reason: everyone is just looking for that extra dollar.

So, when dealing and gambling with subprime mortgages and mortgage backed-securities, it’s like sticking your finger into a shark tank and hoping that you still have that finger when you pull back. During the 2008 financial crisis, subprime loans were one of the foremost culprits of the market catastrophe as homeowners with unsatisfactory credit histories began defaulting on their loans. This, in turn, left mortgage holders and owners of mortgage-backed securities holding the bag as a domino effect ensued in which the housing market began to decline. As a result, lenders and insurance companies were pulled right into the pit of bankruptcy and disaster. Now, ten years after the crisis, some private equity firms still see it fit to issue subprime loans. This time, however, it is the auto market which has come under target of finance firms and investors looking to take advantage of rapidly changing investor demand.

Of course, while many analysts might want to point out the necessities or even benefits of issuing subprime loans, there is a really fundamental factor that needs to be established: the auto market is not the housing market. Now, while that insight seems banal at best, it is a crucial element that plays into this story. You see, if I buy a home on the market, its value does not diminish just because I bought it. The housing market varies based on a multitude of factors, but a home can still appreciate in value after it is purchased. On the other hand, the auto market (usually) does not work that way. When one buys a vehicle, it usually depreciates far below its original cost. There are some exceptions to this rule; for example, a vintage Ferrari might not depreciate like this, but this is usually not the case.

But, that should not be news to anyone, especially not to seasoned analysts and investors. So, why the interest in issuing loans to those who could possibly leave you with less-than-valuable collateral? Well, the answer, again, is pretty obvious: higher risk leads to a higher demanded return. Because the auto market, by nature, deals with assets that do not appreciate in value, it puts financiers and investors in a tight spot if loans are defaulted on. This is because the collateral that the vehicle provides will not cover the original loan value. On top of that, after the 2008 recession, some analysts felt that if new credit restrictions were too tight, economic growth could be artificially hindered. So, while many large-scale national banks – still understandably shaken by the housing crash – only dipped their feet into the auto market, auto lenders and private equity (PE) firms jumped head first into the subprime pool. As the auto market grew, this gamble appeared to pay off for them as this newfound market spurt led to a huge boost in sales and profits.

However, a different tune is now being sung. As they often do, many borrowers are defaulting on their loans. Now, some lenders and PE firms such as Ally Financial have preemptively set aside emergency funds as a means to deal with the looming problem, but for some firms, it just hasn’t been enough. Thanks to the toxic twin combination of a waning car market and rising delinquencies, operating margins for these firms have now shrunk. There is an additional wrinkle that these companies have to deal with that relates specifically to the availability of working capital. Of course, I am not really talking about the big equity lenders such as Ally. The firms who are really hit hard by this are firms that basically have been operating on a considerable amount of margin just to issue these loans. As a result, it really doesn’t help when one considers that subprime auto loan defaults for private lenders are hovering near 10% — which is a delinquency rate not seen since the recession of ten years ago. As such, with soaring loan defaults on the horizon, there is no guarantee that these smaller firms that dove head-first into this pool can even survive, and, like the 2008 crisis, lenders to these finance firms might end up feeling a bit of a pinch, too.

However, It needs to be made clear that this crisis will not reflect the seriousness or scope of the 2008 crash. For one thing, as I previously mentioned, banks and other large firms have learned their lesson from the 2008 crash and have chosen to invest in prime borrowers, which, although it has taken time to do so, has started to pay off in the form incremental revenue increases. So, this craze does not occupy a plethora of capital space on the market. In fact, overall, private firms roughy have $3 billion tied up in the auto loan market. That may sound like a significant amount, and it definitely is. But, in spite of this, it still makes for a fascinating case study that is a little funny, a little sad, and says a lot about how our markets work. It shows that, at any point in time, old things become new again, and dying trends of the past begin to rise from the ashes again.

On the one hand, it is perfectly understandable to see why small lenders and private equity firms would choose to hedge their bets on such a risky market. Of course, when one sees an opportunity to make an excess return, it is understandable to want to jump on it, especially if that opportunity has the backing of a high-demand industry like auto sales were. However, one could still make a counter argument that the impatience shown by these firms in not allowing the prime auto loan market to thrive is counterintuitive. It is the equivalent of waiting for your phone to charge and going out into a lightning storm to speed the process up a bit. However, the interesting point in all of this is that, larger firms who had the wisdom to limit the issuance of subprime auto loans instead chose to focus on creditworthy borrowers are not incurring these kinds of devastating losses. In fact, while some of these larger institutions do have some subprime loans sitting on their books, their default rates currently sit somewhere around 4.4%, which arguably does not indicate any dire level of emergency. It certainly does not sit anywhere near a recession-level.

There is one final thought to consider here, and it is really about how these events will continue to unfold. It is obvious that some of these firms will recover and some will not. But, in the end, what have businesses learned from this? Well, it’s hard to say that we’ve learned anything new because the lessons here are the same as they have always been. Sometimes, firms find an outlet for growth and take it, despite the risks involved. Sometimes, those risks work, and, at other points, firms just go too far and unintended — yet avoidable — consequences occur. Granted, one would like to think that, as history continues to move forward, we as a society become smarter in spotting these kinds of situations, and, in many ways we do. It is a long, arduous process, but mankind tends to learn from its mistakes in an incremental fashion. So, yes, some firms will learn their lesson. And, some will look at this situation, think it over, then promptly re-stick their fingers back into the shark tank. That, all in all, is just another lesson of market behavior at work.








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