Increasing subprime auto loan defaults – the canary in the coal mine for 2023 bankruptcy filings
Experience tells us that the recent increase in subprime auto loan defaults can be a reliable predictor of an overall increase in consumer bankruptcies which, in turn, causes problems for businesses in many sectors. Recently reported data discloses that in the fourth quarter of 2022, subprime auto loan defaults increased by slightly more than 30%.
These defaults rise from a number of reasons, namely: (1) higher interest rates on the subprime loans that have a floating rate of interest; (2) inflationary increases which have pinched consumers' budgets; and (3) increased costs of rental housing.
What prior history also tells us is that consumers will wait until the last possible moment before defaulting on a motor vehicle loan obligation. Consumers will sooner risk the delayed consequences of credit card defaults, nonpayment of medical bills and other consumer obligations before defaulting on a motor vehicle loan. When the subprime lender is secured by a motor vehicle as collateral, it will repossess the vehicle once there is a default. And, since the vehicles are most times used for transportation to and from work, childcare, and other daily necessities, the loss of the use of a motor vehicle can be disastrous to any consumer household. It is statically significant that low wage hourly workers who lose their vehicles to repossession usually then become unemployed. In fact, consumers have shown that they will default on mortgages prior to defaulting on a motor vehicle loan since they know that the mortgage foreclosure process is a lengthy one. In many states, the same is true with rental defaults and the delayed and crowded eviction process.
The bottom line is that consumers who default on motor vehicle loans are in deep financial distress which will cascade into a bankruptcy filing rather quickly. If a vehicle is repossessed, prompt action needs to be taken for the protections afforded by a bankruptcy filing. Thus, the substantial increase in subprime vehicle loan defaults acts as a reliable indicator of a tsunami of consumer bankruptcy filings to shortly follow.
The consequences of this extend far beyond the consumer bankruptcy filing increase. Motor vehicle dealers, except for high-end vehicle dealers, rely on sales to subprime borrowers to maintain sales volume, and to continue to sell vehicles at a high profit margin along with the commissions for originating the subprime loans. Since most subprime borrowers/purchasers of motor vehicles are only interested in what the monthly payment will be, motor vehicle dealers tend to not need to discount the price of the vehicles for these purchasers
Beginning in September 2008 following the Lehman Brothers catastrophe, when subprime lending all but dried up, there was a flood of motor vehicle dealer bankruptcy filings. In fact, the largest Chevrolet dealer in the country at the time, and the dealer that represented 7% of all of the Chevrolet vehicle sold in the United States, sought Chapter 11 protection and was ultimately required to sell 10 of its 14 locations and close the other four. This was not an isolated instance, as many dealer bankruptcy filings followed. This, then, had a significant impact upon the lenders to the dealers, increased unemployment for those employees who lost their jobs at the closed dealerships and the suppliers and trade creditors for the dealerships recovered little, if anything, from the bankruptcy proceedings. In turn, even without the intervention of the Federal Reserve, subprime interest rates increased, which further diminished the volume of vehicles being sold by motor vehicle dealers.
To add to this domino effect, most subprime lenders seek to package and collateralize the secured subprime loans for sales to institutional investors. When the default rate increases substantially for these loans, there is less of an appetite for the purchasers of the packages of collateralize debt, and, then, the cost of the borrowing further increases.
Just as economists have demonstrated that the inversion of the yield curve for government obligations for two successive quarters is a historical predictor of a recession to follow, the substantial increase in subprime defaults has shown itself to be a reliable predictor of a domino effect for multiple parts of the economy. Unfortunately, there is very little that can be done to stop what appears to be the inevitable but to brace for a disquieting and bumpy road for parts of the economy in the near future.
