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Is Nonprime About to Cave?

June 2007, F&I and Showroom - Feature

by Jim Bass - Also by this author

Largely due to a Standard & Poor (S&P)’s Research report, entitled, “U.S. Auto Loan Static Index and Collateral Trends Report: The Subprime Mortgage Crisis Could Affect Auto Loan Deals,” I have fielded quite a few inquiries similar to the article’s title. Actually, once you read a little past the title of the article, you realize that S&P was not intending it to be an alarmist article, as it points out that “the majority of subprime auto borrowers are renters, and thus are not subject to the vagaries of the mortgage market.” That being said, it is understandable why investors would worry about the subprime auto market, as well as the mortgage market.

I have always believed that the “other-than-prime” auto market is much more sensitive to the amount of capital available (i.e., the marketing pressure on this borrowing group) than the general economy. With the exception of a few cities in the United States — New York, Chicago, Washington, D.C., perhaps San Francisco and a few others — most working people really do need a vehicle in order to be able to function in their daily lives. History doesn’t support investors’ fear that borrowers will suddenly and voluntarily default on their loan just because the car payments become inconvenient.

Fortunately, we haven’t had anything approaching an economic depression in this country for many decades, but there have been a few recessions since the 1980s. Even though the stock market was having its troubles earlier this year, or some businesses were failing, there hasn’t been any meltdown in the nonprime/subprime auto finance industry. The closest thing to it was in the mid-’90s, when there was a clear oversupply of capital in the industry. Like many endeavors that require substantial capital to flourish, an oversupply can encourage less-than-prudent business policies. Besides banking and auto finance, the insurance industry also is susceptible to the pressure induced by having too much money to put to work, and routinely experiences cycles of feast and famine.

Oversupply Problems

The phenomenon that occurs is that in order to gain or preserve market share, volume of business starts becoming more important than the quality of the business. Underwriting discipline is sacrificed in order to produce greater volume. In all of the financial businesses, defaults typically follow the granting of credit by at least several months. Therefore, early performance data seems to support the wisdom of putting all that money to work and generating greater income. However, if this increased volume was being put on the books as a result of marketing pressure and at the expense of prudent underwriting, then higher than anticipated defaults will inevitably follow. For a period of time, the companies can outrun losses due to the lagging effect of defaults. But if volume levels off or decreases, the defaults will catch up and losses will become unacceptably high.

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