We Know How This Ends: Central Bank Stimulates Subprime Again!

Reuters just released an excellent report under the headline, “How the Fed fueled an explosion in subprime auto loans.” Skipping the anecdotal stuff, the story also includes accurate analysis:

“The Fed’s program, while aimed at bolstering the U.S. housing and labor markets, has also steered billions of dollars into riskier, more speculative corners of the economy. That’s because, with low interest rates pinching yields on their traditional investments, insurance companies, hedge funds and other institutional investors hunger for riskier, higher-yielding securities – bonds backed by subprime auto loans, for instance. Lenders like Exeter have rushed to meet that demand. Backed by Wall Street banks and big private-equity firms, they have been selling ever-greater amounts of subprime auto loans in the form of relatively high-yield securities and using the proceeds to fund even more lending to more subprime borrowers… To make up for the risk of taking on increasing numbers of high-risk borrowers, subprime auto lenders charge annual interest rates that can top 20 percent.”

Notice that this is normally irrational behavior. Why? In a natural, non-politicized, economy poor people don’t have much money. As a result, the only way to make money off poor people is to sell them things that don’t cost much. Loaning money to people who can’t pay it back makes no sense because you will lose the money you loan out.

But in our economy, unsecured debt is made to look safe in a variety of way, while depressed interest rates make people hungry for some way of getting a return on their money. The sup-prime car industry grew by more than a third from 2011 to 2012 and the expansion continues.

With the bubble comes the same fraud we saw in the housing market that led up to the crash in 2007/2008. The company that makes the loans does not assume the risk but converts them into (inaccurately labeled!) “Securities”:

“Like subprime mortgage securities issued in the past decade, each Exeter security was divided into tranches, or layers, based on the risk and return of each. Investors couldn’t get enough of them, bidding up prices and thus lowering yields. In February, the yield on the top-rated tranche was 2.029 percent. By September, demand had increased so much that the yield was just 1.312 percent. Ratings agency DBRS gave the least-risky tranche its top rating – triple-A – in part because Exeter used a cushion to protect investors against losses and because it had a management team experienced in subprime, the agency said in its ratings reports. Exeter’s proprietary model ‘declines approximately 50 percent of submitted applications,’ the agency said.”

We know how this story ends. Politicians, desperate to claim that we are in recovery, will need this bubble in sub-prime car loans to keep expanding. Stopping it would mean an economic “hit” that they fear. So as Exeter (or a competitor) runs out of poor people to loan to, it will find ways to stop turning down half the applicants—just like the real estate market started issuing “liar’s loans” before the fall.

How much of our current alleged “recovery” is built on such froth? We can’t really be sure until the bubbles pop.