Subprime Auto Worries Overblown: N.Y. Fed Economists

The resurgence of subprime auto lending has stoked fears about poor underwriting and drawn parallels to the subprime mortgage debacle , but a group of economists at the Federal Reserve Bank of New York say there is no reason to panic.

Yes, auto loans to borrowers with credit scores below 620 hit $20.6 billion in the second quarter, nearly double the levels in early 2010. But that's only half the picture, four New York Fed researchers wrote in a blog post Thursday. Auto loans to all borrowers, including those with strong credit, have been rising, so subprime lending remains in check on a relative basis in their view.

"Subprime auto lending is definitely on the rise in absolute terms, although the increase in prime lending makes the relative increase in the subprime share less pronounced," they write.

Warnings by regulators that the market is overheating, and reports of a Justice Department investigation, had created the sense of a new scandal in the making just as banks were starting to put the crisis behind them. The report could prompt a reassessment of the dangers.

The New York Fed economists, who posted their research in tandem with the bank's release of its quarterly "Household Debt and Credit" report, agree that auto lending has tilted toward riskier borrowers over the past five years. Originations to borrowers with the lowest credit scores have roughly doubled since the postcrisis trough, and originations to other groups have risen by about half, they write.

Yet subprime remains a smaller part of the pie than it was in the years before the crisis, they argued. As a share of total auto loans, loans to borrowers with credit scores below 620 made up 22% of the $89 billion in auto originations in the fourth quarter of last year, a lower proportion than in the years preceding the financial crisis. The percentage of subprime loans "has increased only slightly since 2010," the economists wrote.

Moreover, banks have been far more cautious than other lenders in serving less creditworthy borrowers. Banks and credit unions made $5.8 billion in loans to borrowers with credit scores below 620 in the fourth quarter, just 14% of total originations. By contrast, such loans made up 40% of originations by auto finance companies on the quarter.

Motivated by slow growth in other business lines and competition from auto finance companies, banks have been extending the lengths of their loans, which allows borrowers to buy more expensive cars.

Federal regulators and prosecutors have taken notice. In June, the Office of the Comptroller of the Currency warned that auto credit standards have been crumbling. In the past two weeks, news surfaced of a Justice Department probe of the underwriting standards of General Motors' auto-finance unit, and Santander said that its consumer-lending arm received a Justice subpoena over its subprime auto lending practices, too.

Government scrutiny should be expected given how fast the subprime auto sector has been growing, says Cristian Deritis of Moody's Analytics.

"The biggest warning sign is the growth rate — there's the old adage that if something is growing like a weed, it is a weed," he said. "We should investigate to make sure that these loans are being underwritten properly."

Yet Deritis generally concurs with the outlook of the New York Fed researchers. In a paper published Tuesday, he says that while some lenders have overextended themselves, the low level of delinquencies across the auto-finance sector does not suggest a bubble that is about to burst.

The rate of bank auto loans 30 days or more delinquent has held steady at about 1% for several years, and the rate for auto finance companies has been about 2.5% over the same period, the New York Fed economists said.

Deritis expects the growth rate to slow and delinquencies to tick up, but thinks improvement in the economy as a whole will offset the negatives.

The New York Fed's quarterly report on credit sends a mixed signal on the overall economy. Household debt declined by $18 billion from the first quarter, as mortgage balances dipped by $69 billion and home equity lines of credit by $5 billion. Auto lending was the fastest growing form of debt, with a $30 billion increase over the first quarter, reaching its highest level in eight years. Credit card debt rose by $10 billion, and student debt by $7 billion.

Overall household debt totaled $11.63 trillion, down more than 8% from its peak in the third quarter of 2008.