During the Great Recession, the entire economy was brought down because banks were far too eager to give mortgages to folks who couldn’t afford them. 

Banks offered subprime mortgages to riskier and riskier individuals, and they got away with this by selling bundles of these mortgages to investors. 

While any individual mortgage in the bundle was risky, when the banks bundled them together, they were able to give them safer overall credit ratings. 

Eventually, folks started defaulting on their mortgages at which point investors realized these mortgage-backed securities were full of bad investments. 

This ended up collapsing several major banks like Lehman Brothers and Bear Stearns, it caused the stock market to fall more than 50%, and it forced us into a recession. 

While we tried to make sure banks learned their lesson, it doesn’t seem they have. Our bank system is once again facing risks due to growth in subprime lending, this time in the auto sector. 

Auto loans have become the third-largest consumer lending market. And as it turns out, many of those loans are the same subprime kinds that got our economy into trouble back in 2008. Some consumers are paying more than 30% interest, and banks know they’ll never be able to afford it. 

Today, we’ll discuss how these subprime auto loans stand a chance to blow up right when the economy is already at its weakest. 

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Back in 2019, the bank bundled together about 75,000 auto loans in a bond product called “Drive 2019-3.” 

Bonds like Drive 2019-3 assume a huge portion of the portfolio will default. The banks don’t care. 

You see, they make money by collecting as much interest as possible for as long as they can. Then, if and when borrowers default, tracking technology has made it much easier to repossess cars. Santander predicted that around 42% of these loans might not be repaid.

This is a contentious model. On one side, it seems downright unethical to charge customers 20% to 30% interest rates with the expectation that they’ll default. 

Banks view it in a more positive light. Santander stated that these loans give people their only opportunity to own a car, which provides them with greater employment opportunities. 

Plus, banks feel they need to be compensated for lending to the riskiest borrowers. And investments like Drive 2019-3 delivered. As long as no more than 60% of the portfolio defaulted, all bondholders would make their money back. 

However, the same way this model bubbled up in real estate, it threatens to bubble up in the auto market.

Last year, subprime car loans backed more than $37 billion in bonds, double the amount from a decade ago, Bloomberg reports.

Drive 2019-3 is already closed. The bond managed to pay back all of its investors fully because only 25% of the portfolio defaulted. 

However, investors in these types of instruments may not be so lucky today. 

Consumers are buried under more debt than ever before. Auto loans and credit card loans both just reached record highs. 

Overdue subprime auto loans just reached a 30-year high. 

Eventually, consumers are going to crack. 

When people have to spend more on things like houses, cars, and student loans, it’s a tax on the whole economy. 

It forces people to make tough spending decisions, which slows down spending elsewhere. Eventually, folks run out of places to stop spending, and they end up defaulting. When that happens, it ripples through the entire economy. 

Businesses get less revenue, subprime lenders start panicking, and layoffs only compound the issue. If subprime auto loans start looking any worse, that could almost immediately send us into a recession. 

Best regards,

Joel Litman & Rob Spivey

Chief Investment Strategist &
Director of Research
at Valens Research