Will the Bubble Burst be revisited?

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Clifton Gardner
5 years ago
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1 Will the Bubble Burst be revisited? PD Aditya 3/8/15

2 What happened in 2008? The debacle of financial system in the United States in 2008 has been attributed to the subprime lending in mortgage sector, securitization of these subprime mortgage loans and taking aggressive positions in the resulting mortgage backed securities (MBS) and corresponding opposite positions in credit default swaps (CDS). The subprime loans during 2008 constituted 41% of total consumer lending. Absence of regulations along with improper assessment of liquidity in the financial system fueled the ripple effect of recession across the world. Since then, many regulations have come into place across various jurisdictions thereby increasing transparency, strengthening the KYC norms and improving the regulatory oversight. What is the current scenario? However, since the start of the financial crisis (in 2008), loans to customers with low credit scores have increased drastically. This time the bubble is not in the mortgage markets, but a bubble is being formed in the Auto loans, personal loans and credit cards markets. Specifically, the rise in the subprime loans in Auto sector calls for a caution. These loans are given to customers with low credit scores by various financial institutions and non-financial institutions. A sudden increase in subprime loans in Auto sector has given room for many new companies to extend credit to low credit score customers (most of these new firms started lending via online facility). Since , an amount of more than $189 billion has been lent to more than 50 million subprime customers in consumer loans and credit cards. As per credit reporting bureau, Equifax (which publishes the credit/fico scores of customers), 40% of the total consumer credit loans made in 2014 comprises of subprime lending. Nearly 4 out of every 10

approvals for car loans, credit cards and personal loans have been given to subprime customers during the first 11 months of 2014.

3 approvals for car loans, credit cards and personal loans have been given to subprime customers during the first 11 months of As per Equifax, subprime borrowers are those whose credit score (FICO score) is less than or equal to 640 (out of 850). The number of auto loans for consumers with non-prime credit scores increased by 2.4% from 2013 to % of auto loan borrowers who took loans in 2014 missed their payments by end of the year. Default rates of borrowers of subprime loans surged to 8.5% in An increase in subprime loans has also led to an increase in securitization of these loans. Led by Santander Consumer, GM Financial, General Motors and Exeter Finance, securitization of subprime auto loans have grown 302% to $20.2 billion since 2010 (as per Thomson Reuters). Subprime securitization has increased 28% from 2013.

4 Source: Source: Goldman Sachs Global Investment Research, as of Q3 2014

Why subprime lending? The prime reason behind an increase in the subprime lending post 2010 can be the near-zero interests rates prevailing in the United States.

5 Why subprime lending? The prime reason behind an increase in the subprime lending post 2010 can be the near-zero interests rates prevailing in the United States. Even though Federal Reserve has been planning to increase the interest rates, no proper action has been taken still. These near-zero interest rates are hurting lenders thereby forcing them to look for other alternatives for increased returns on their lending activities. One such alternative is Subprime Lending. Lending to subprime borrowers (FICO scores ranging from ) would yield high interest rates ranging from 20% to 365%. Hence, firms are taking higher risks in order to rope in higher returns. Budding of a number of new non-bank lenders has led to an increase in personal loans and other types of financing with a special focus on subprime borrowers. These non-bank lenders (who lend via online facility) face far less regulatory scrutiny when compared to big banks. Such lenders are usually backed by venture capitalists or hedge funds or HNIs who seek for higher returns in low rate environment. Why this bubble doesn t burst? The subprime lending always generated a risk to the financial stability. During 2008, huge subprime lending and heavy securitization of these subprime mortgage loans has shaken up the financial system. Presently it is the same scenario in Auto and personal loans. Therefore, questions are being raised that will there be another bubble burst leading to a financial crisis soon? Equifax says the answer is NO. Equifax has all new approach to this subprime lending in consumer loans. It doesn t find this bubble causing harm to the financial system. Instead, in its recent report Equifax stated that the subprime lending to consumers with low credit scores post 2010 has led to an increase in their credit scores and improve their financial condition. As per its report, customers with credit scores less than 550 and who originated auto loans have seen an average increase of 52 points in their credit scores (25% of these customers have increased their scores by 100 or above) as compared to just 32 points increase for customers with credit scores less than 550 and who did not originate auto loans. In its survey, Equifax observed that consumers who have taken an auto loan were four times more likely to have improved their credit score above 640 compared to the consumers who haven t taken a loan. This implies that greater access to credit has improved the economic situation of consumers, thereby boosting growth and improving the entire economy as a whole.

6 Although the equation remains the same between the mortgage loan bubble and Auto loan bubble, there is a cascading effect in case of foreclosure in mortgage markets (upon payment default by customers) but in case of Auto markets there wouldn t be any cascading effect on other vehicles in case of heavy foreclosures. However, there might be chances of mortgage values to shoot up in long term, but that would not be the case with the Auto sector (as their values tend to decrease with time). So, foreclosure of vehicles upon default in payments would mostly create a loss to lenders. Conclusion This high increase in subprime lending in Auto and personal loans, credit cards brings in the same question which arose in 2006 Is there a bubble being formed? However, the bubble formed in was that of mortgage markets, the current bubble would be in Auto (consumer loans) markets. The key concerns arising are how effective are the new regulations (Dodd-Frank Act) which were brought into place post financial crisis; why aren t these regulations detecting the bubble and no proper actions are being taking against the bubble being formed; is there a need for revamping these regulations to keep a cap on subprime lending and securitization of subprime loans; what happens if this new bubble being formed bursts; would this bubble burst have the same (or more adverse) ripple effect on the financial system; and finally will there be an another bailout required if the bubble bursts. These are some of the concerns to be analyzed now and appropriate actions (if required) to be taken rather waiting for the bubble to burst. My View It would be too early to predict a financial crisis due to this subprime lending. With delinquency rates hovering around 8-10% in these subprime auto loans, this for sure calls for a review. Though it is too early to take repossession rates and derivatives positions (in corresponding ABS derivatives) of various firms into consideration, we have to wait and watch. Since an alarm has already rung, regulators/supervisors can build an armor soon. If these delinquency rates continue to increase, the auto finance firms (which have less regulatory oversight) may incur huge loss and may go bankrupt/default at some stage (since repossession of underlying vehicles would have a depreciation accounted on them). This increases the interest rates in Auto sector thereby triggering various derivatives positions (mainly CDS and IRS derivatives) taken by the firms. This in turn reduces the demand in the Auto sector thereby pulling down the US economy to some extent (affecting the Auto sales). However, taking the entire financial system into consideration, I feel the financial stability would remain intact. Recent Dodd-Frank Stress Tests conducted by the Federal Reserve reveal that most of the financial institutions are in a comfort and safe zone. So a financial crisis is unlikely to occur. Unless a financial institution manipulates its balance sheet or doesn t reveal the required data to be reported, there is no risk as such to the financial system.

7 References

The Bubble, the Burst and Now What Happened to the Consumer? Joe Mellman Vice President, Financial Services TransUnion

The Bubble, the Burst and Now What Happened to the Consumer? Joe Mellman Vice President, Financial Services TransUnion How did the financial crisis affect consumers and how have they fared since? 1 2 3