Time for the Market to Check its ABS
*Alex Trebek* In this year the S&P 500 was at 683, the Dow Jones at 6,626 and unemployment at 10%. What is 2009? I’m sure most of us remember this time period, and if not Steve Carell and Christian Bale did a fine job of reminding us of the 2015 hit movie The Big Short. It was in these years when the biggest financial crisis since Y2K and the DotCom Bubble hit the United States and other countries worldwide. The Sub-Prime Mortgage Crisis.
The most appealing aspect of The Big Short was its ability to take a fairly technical and involved event and make it understandable to the average citizen. It all started in the early 2000’s, the American Dream was alive and well as people started buying “that house with that white picket fence.” The housing market was soaring, house prices were going up and bringing fantastic value. The way to buy these houses: mortgages. Mortgages are at the crux of the housing market, as I don’t know many people that have the cash available to purchase a home.
Leading up to the crisis, banks were lending, and lending and lending to just about anyone; even if you had a FICO score below 600. Most financial institutions usually lend upwards of a FICO of 700. While the banks were giving out all these loans, almost $10 trillion, the banks were protecting themselves. How does a bank protect itself against a mortgage loan you ask? Securitization. This is when companies package collateral, in this case, a loan, into a “diversified” portfolio that can be sold to investors. The banks no longer internalize the risks associated with default.
These securitized mortgages were called mortgage-backed securities (MBSs) and collateralized debt obligations (CDOs). In total $7 trillion of the original mortgages were packaged and sold to a wide variety of institutional investors. Why would these investors buy loans the banks didn’t want? Because of credit rating agencies, like Moody’s and S&P, said they were safe; even though they clearly were not. In addition, whatever sub-investment grade CDOs were repackaged as a CDO2, and received a higher credit rating due to this apparent diversification. Still with me? So far we far we have every American citizen taking out first or second mortgages and the banks are selling these mortgages as CDOs and MBSs to every investor with a buck because Moody’s said it’s safe.
Now, where this gets interesting is that what goes up must come down. The stellar housing market slowed down, and people became unable to make payments on these mortgages. After a plethora of defaults on the loans, the MBSs and CDOs became worthless. The economy tumbled, millions of Americans became unemployed and some of the most reputable financial institutions collapsed due to the exposure on these loans.
Why does this matter now? The economy has recovered exponentially, the S&P recently broke 2,500, the Dow Jones is at an all-time high at 22,100 and unemployment is at 4.3%. This is important to recognize because something similar could be happening right now. On the same scale as the mortgage crisis? Not a chance, but still could have some serious effects. We could see the same bubble in a totally different industry: automotive.
Automotive debt is at $1.2 trillion, 25% of which is sub-prime (low credit score) loans. Now, this may not be the $10 trillion in mortgages but is still a substantial amount. These loans are given out to just about anyone, but they have to pay interest rates in the range of 10-20%. In 2015, there were 108 million auto loan accounts and only 80 million mortgages, clearly, people are more interest in buying cars than houses. As we saw with the housing crisis, these auto loans were securitized by banks into auto loan asset-backed securities (ABS) and sold to investors. Again, the ABSs weren’t to the tune of $7 trillion but instead only $97 billion. But half of these ABSs have subprime collateral packed inside them, this is where all the risk is. There are over 6 million Americans who are over 90 days delinquent on their auto loans totaling over $22 billion dollars, a pittance in the total $1.2 trillion in outstanding loans but still concerning. Delinquency rates rising to almost 4% and total household debt near pre-2009 levels creates a slippery slope.
The biggest impact of a subprime automotive bubble would be a hit the nations GDP. Automotive sales comprise about 3% of our nation’s GDP, therefore a large drop in auto sales could put a reasonably sized dent in the GDP. This could also harm automotive jobs, which would be especially bad since President Trump made a large point about bringing manufacturing jobs back the United States. On the upside, we won’t see a large hit on financial institutions since the $97 billion in ABS’s isn’t close to as large as the mortgage exposure.
Do I think that there is a serious problem with securitized subprime auto lending? Yes. Do I think it will be even close to that of the mortgage crisis? No. I’m not saying these ABSs aren’t safer than a Smart Car, but I still wouldn’t take my chances.
Dickler, Jessica. “Auto loan delinquencies rise as drivers splurge on pricey cars” CNBC.com. https://www.cnbc.com/2017/06/12/auto-loan-delinquencies-rise-as-drivers-splurge-on-pricey-cars.html (accessed September 10 2017)
Guilford, Gwynn. “American car buyers are borrowing like never before-and missing plenty of payments, too” Quartz. https://qz.com/913093/car-loans-in-the-us-have-hit-record-levels-and-delinquencies-are-rising-fast-too/ (accessed September 10 2017)
LeBeau, Phil. “Lenders hit the brakes on subprime auto loans”. CNBC.com. https://www.cnbc.com/2017/06/07/lenders-hit-the-brakes-on-subprime-auto-loans.html (accessed September 10 2017)
Pritchard, Justin. “The Mortgage Crisis Explained”. The Balance. https://www.thebalance.com/mortgage-crisis-overview-315684 (accessed September 10 2017)
Scully, Matt. “’Deep Subprime’ Auto Loans Are Surging” Bloomberg. https://www.bloomberg.com/news/articles/2017-03-28/-deep-subprime-becomes-norm-in-car-loan-market-analysts-say (accessed September 10 2017)