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There has been an explosion of car finance and student loans in America since the global financial crisis. So much so that the Federal Reserve Bank of New York has sounded the alarm. And some commentators have heralded it as the start of the next subprime crisis. But is it?
This article is from our latest edition of MarketWatch, an in-depth report focusing on the Private Equity.
As sales of new cars plummeted in the aftermath of the financial crisis car manufacturers, including General Motors and Ford, had to find ways to stimulate demand. Auto companies used their balance sheets to extend credit to prospective buyers and specialist auto finance companies started to emerge. Government-backed initiatives, such as the “cash for clunkers” scheme, helped resuscitate demand in the car industry.
It worked. Last year auto sales hit a precrisis high of 18 million vehicles in the US. But many customers borrowed to fund their purchases and have overextended themselves with repayments.
In the seven years from 2009 to 2016, car loans skyrocketed from $700 billion to almost $1.2 trillion. Subprime borrowers, considered borrowers with the highest risk, with credit scores of under 620 – FICO1 - make up $220 billion of that figure.
Source: Federal Reserve Bank of New York
The same level of detail is not available for Europe but there has been a similar trend with the emergence of Personal Contract Plans (PCP). According to the Finance and Leasing Association in the UK, British households borrowed a record £31.6 billion in 2016 to buy cars, up 12% on 2015. 9 out of 10 private car buyers are now using PCP and the Bank of England warned that consumer credit, including car loans, was close to levels not seen since the 2008 financial crash.
It is not just car loans that are causing concern, student loans have experienced an even bigger increase. The surge in the number of people in education in the US is creating an education bubble. In the aftermath of the financial crisis, many young people found it difficult to get a job and opted instead to take out a student loan and go to college.
US student debt is now $1.3 trillion and in 2010 it overtook credit cards to become the largest source of American household debt other than mortgages. 44 million Americans now have student debt and many find themselves overqualified for the jobs available and struggle to command a salary high enough to justify their expensive tuition fees.
Combined loans for cars and education amount to $2.5 trillion, accounting for 20% of all household debt, and have contributed to 83% of the growth in consumer debt since the end of 2011. And delinquency rates are rising. The delinquency rate on student debt is above 10%, higher than the default rate on mortgages in 2009. 8 million students are now in default and have stopped paying over $137 billion in debt. Auto loan delinquency rates of more than 90 days in arrears are also on the rise, up from just over 3% to 3.75% at the end of last year.
As we know, credit has the capacity to pull forward future demand and amplify the magnitude of economic cycles. So is this the start of the next sub-prime crisis? Probably not, but it is alarming.
Firstly, even combined, auto and student loans do not come anywhere close to the mortgage problem in 2008. To put it into perspective, household debt in the US stands at almost $13 trillion. Mortgage debt is just under €9 trillion, which is over three times as large as auto and student loans. Secondly, there are no signs that people are starting to default on their mortgages and credit cards, and overall delinquency rates remain at cyclical lows. Finally, although some of this debt will have been securitised or repackaged in the financial system, it is nowhere near the levels of subprime mortgages before the crisis.
Source: Federal Reserve Bank of New York
So rather than this being the start of the next subprime crisis that threatens to take down the entire global financial system, it is more likely that this is just part of the normal credit cycle of expansion and contraction. There is no doubt there will be some casualties from rising delinquencies, particularly in the high-yield credit space.
However, the current situation does not imply that another subprime crisis is on the way. Instead, it should serve as a lesson that the role of credit in the economy needs to be managed, as if left unchecked, credit institutions will lend to people who cannot afford it and people will overextend themselves with debt time and time again.
1 The Fair Isaac Corporation (FICO) produces consumer credit scores that financial institutions use in deciding whether to lend money or issue credit. A higher FICO score means a better credit rating. A score below 620 is typically defined as sub-prime.
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