The Next Subprime Debt Crisis Waiting To Happen

That’s it. The case appears to be closed. The US economy is rebounding, and consumers are spending.

That’s just what the US Federal Reserve wanted. And it’s just what the Fed, and a whole host of mainstream experts, said would happen…provided the Fed cut rates to record lows, kept them there for years on end, and printed trillions of dollars in fresh money.

Stimulus works. Money printing works. And going further into debt, in order to solve a debt crisis, works too.

OK, you’ve got us. We’re not entirely serious. In fact, we’re not serious at all. But that’s the spin being spun right now.

As the Financial Times reports:

Americans lifted spending by the most in more than six years in April, confirming signs of an economic bounceback and adding to the case for a second increase in short-term interest rates this summer.

Household spending increased by 1 per cent over the previous month, the biggest rise since August 2009 and higher than analyst forecasts, and incomes rose 0.4 per cent. Adjusted for inflation, spending was up by 0.6 per cent on the month.

Following a languid start to the year consumer spending is beginning to gather momentum, as household sentiment is boosted by strong hiring, solid income growth and a boost to household wealth from higher equity and home prices.

Ah! The ‘wealth effect’. Of course, they tend to forget that the ‘wealth effect’ can disappear quicker than it arrived.

What they also forget is that the ‘wealth effect’ is really just a ‘paper wealth effect’. And further, in order for consumers to draw on the ‘wealth effect’, they need to go into debt.

That’s because, unless someone sells their home, the only way they can access the increased value of the home is to take out a loan against the increased value.

In our lingo, we call that ‘going into debt’. But in the world of fancy finance and retail banking, they call it ‘withdrawing equity’.

It’s a nice play on words. And unfortunately, many folks fall for it. The ‘wealth effect’ isn’t so much of a boost to your wealth, as it is a boost to your debt…and a boost to the bank’s wealth for that matter.

But there’s another reason to be cautious about the flag-waving for a US economic recovery. Further down, the FT article reveals:

The higher spending number were driven by a 2.2 per cent surge in outlays on durable goods, mostly fuelled by motor vehicles. Spending on non-durable goods rose 0.7 per cent, driven by clothing, food and petrol, according to the data from the Bureau of Economic Analysis.


We’ve seen this story play out before. The ‘wealth effect’ is due to an increase in the ‘paper’ value of housing. Homeowners borrow against the increased value (sorry, they ‘withdraw equity against the increased value’) and then buy a depreciating asset — a car.

Precisely how much has the individual’s wealth really increased?

We’ll argue that it hasn’t increased by anything close to the increase in their ego as a result of driving a nice new car.

But regardless, there’s another reason to be cautious about the increase in US consumer spending.

Because it’s not just home refinancers buying new cars. Much of the growth is coming from car loans, including a specific class of car loan – subprime car loans.

As Bloomberg reported several weeks ago:

Last week it appeared the chickens had come home to roost for some subprime auto lenders and investors, with Fitch Ratings warning that delinquencies in subprime car loans had reached a high not seen since October 1996. The number of borrowers who were more than 60 days late on their car bills in February rose 11.6 percent from the same period a year ago, bringing the delinquency rate to a total 5.16 percent, according to the credit rating company.

In fact, we’re not sure what to make of the fact that, when we search for the term ‘auto loans’ on the Bloomberg terminal, the first search result offers the definition of ‘Subprime Auto Loan’:

auto loan

Source: Bloomberg
[Click to enlarge]

However, if you’re looking for an imminent problem — the proverbial ‘smoking gun’ — full disclosure causes us to advise caution…for now.

The latest S&P/Experian Consumer Credit Default Composite index still appears to show overall defaults trending downwards…for now:

S&P/Experian Consumer Credit Default Composite index

Source: Standard & Poor’s
[Click to enlarge]

But that’s really only to be expected. As notes:

Auto loan rates were mixed today. The average rate on a 60-month used car loan fell, the average rate on a 60-month used car loan rose and the average rate on a 48-month used car loan rose.

Even though rates fluctuate daily, they are currently near historic lows overall. That makes it a great time for anyone in the market for a new or used vehicle. It’s important to shop around for the best auto loan rates available.

Yes it is. Yes…it…is.

Especially when according to a buyer can secure a new car loan for 60 months (five years) at 3.25%.

With interest rates this low, we wonder how anyone can get into trouble making repayments. But then again, the interest rate charged is only part of the story.

Unlike a long term housing mortgage, where interest is the lion’s share during the early years, with a short term car loan, the principal amount takes up the lion’s share.

At the moment, due to low interest rates, the proportion of interest to principal is relatively small. A US$30,000 car loan will include interest charges (assuming the low rate of 3.25%) of around US$1,300 per year.

But remember, as notes, car loan interest rates are ‘near historic lows’.

What happens when, or if, the rate increases to 5%, 6%, or even 7%? At 7%, the interest charge increases to US$2,800 per year. That’s a significant difference.

If an extra $1,500 doesn’t seem like much, maybe it isn’t to you. But it probably is a big deal to the car buyer with a subprime credit rating.

According to the reports quoted, there are already some problems in the subprime auto loan market. And that’s with historic low interest rates. If the US Federal Reserve increases interest rates, the problems will only likely increase.

And don’t for a moment think that the problems will be isolated to subprime loans. The bigger problems will arise when, or if, the problems seep into non-subprime loans — just as they did during the housing market crash.

We advise watching these developments with keen interest.

What’s all the fuss about?

All told, if you’re a habitual bull, or even if you’re a market neutral, we can understand if you’re worrying what all the fuss is about.

As Bloomberg reported yesterday:

Australia’s economy grew at the fastest pace in four years last quarter — underpinned by an export bonanza — even as diminishing inflation spurred the central bank to cut interest rates in May.

Good news. And that’s not all. Bloomberg also reports:

Sydney’s home values posted the biggest rise in 10 months in May, as lower mortgage rates and a partial easing of lending standards revived buyers’ appetite.

Prices in the nation’s largest city climbed 3.1 percent in May, the fifth straight month of gains and the most among state capitals, according to research firm CoreLogic Inc. The increase, the most since July, took the advance for the past 12 months to 13.1 percent, the data showed.

We’re not sure what to say. Caveat emptor (buyer beware) are the only words that come to mind.


Kris Sayce,
Editor, Port Phillip Insider

Ed Note: This article was originally published in Port Phillip Insider.

Kris Sayce, dubbed the ‘Jeremy Clarkson of Australian finance’, began as a London finance broker specialising in small-cap stock analysis on London’s Alternative Investment Market (AIM). Kris then spent several years at one of Australia's leading wealth management firms. A fully accredited advisor in shares, options, warrants and foreign-exchange investments, Kris was instrumental in helping to establish the Australian version of the Markets and Money e-newsletter in 2005. He is the Publisher, Investment Director and Editor in Chief of Australia's most outspoken financial news service, Markets & Money.

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