Borrowers Beware

The subprime mortgage bubble that exploded in 2008, causing bailouts of banks and automakers alike, should have taught us something about irresponsible lending and unaffordable loans. But, another bubble of similar substance is about to burst next. Consumer advocates like the lawyers at Kemnitzer, Barron & Krieg, have cautioned for years that the subprime auto lending bubble is just as fragile in the aggregate as home loans were a decade ago.

In an excellent article this week, New York Times writers Jessica Silver-Greenberg and Michael Corkery report, "Auto loans to people with tarnished credit have risen more than 130 percent in the five years since the immediate aftermath of the financial crisis, with roughly one in four new auto loans last year going to borrowers considered subprime — people with credit scores at or below 640." That overall lending pattern is just not sustainable.

High interest rates and excessive loan periods mean that people who are most desperate for inexpensive transportation are least able to obtain it. They end up having to make loan payments long after the life of the car. They get saddled with repair costs, even while they are still trying to pay off the purchase price. They lose the equity they have in the vehicle when they fall behind and the car or truck is repossessed. And then their credit sinks lower in a downward spiral.

Used car dealers employ a wide variety of deceptive practices including the hard sell, bait and switch advertising, and sometimes outright forgery. Sad to say, many used car dealers, who know they can't get a loan funded by a responsible bank, falsify the credit application. Unscrupulous car dealers convince prospective purchasers to sign a credit app in blank, and they fill it in after the fact. Sometimes buyers allow themselves to be duped into exaggerating their income. Fudging on income is always a bad idea. An accurate credit application should be a reflection of the borrower's ability to repay the loan.

Generally, a lender does not offer the dealer a single interest rate, but rather a range called the "spread." If the dealer can get the buyer to agree to the higher end of the spread, the dealer keeps all or some of the yield spread premium. The buyer is never told that the dealer pocketed the markup.

Another common practice is called a yo-yo, where the dealer allows the buyer to take delivery, conditioned on the loan documents being approved; and when the bank balks, the buyer is called back to "re-sign" a contract with less favorable terms. This may include a higher downpayment, or a longer period of repayment, or other deceptive practices imbedded in the fine print. In the worst cases, a car dealer has already sold the trade-in vehicle and the buyer feels he or she has no choice but to sign off on the new deal. This is illegal in California, and yet many consumers report significant bullying at this stage of the process.

What is driving this new interest in subprime lending? The same thing that drove the mortgage crisis before. Wall Street financing has replaced the local bank, whose loan officers had a personal relationship with the borrowers they served. That sounds almost quaint in this economic climate, like something out of "the olden days." Now, automotive debt is bundled, securitized, and sold to Wall Street investors and private equity companies, who neither know or care whether the borrower has the ability to repay the loan.

The investigative journalists for the New York Times poured over masses of documents and court filings, and in a sober comment, found "echos of the mortgage boom." On the grand scale we should hope that financial institutions come to their senses, or the subprime auto finance industry will reverberate with echos from the bursting bubble of the mortgage bust. The hedge funds are already taking notice, but taxpayers are in no mood to help banks this time, and any echo of a bailout may fall on deaf ears.

Meanwhile, consumers with subprime credit are getting taken for a ride, with higher payments for lower quality cars. It's time for a new twist on the old phrase to urge the car buying public: Borrower Beware.