Sub-Prime Auto Isn't Going To Be Sub-Prime Mortgages

by: Tim Worstall


Yes, lots of people with bad credit are getting auto loans.

Yes, lots of people with bad credit got mortgages.

So, sub-prime auto is not going to become sub-prime mortgages and then the banks all fall over again.

Barry Ritholtz has a nice little piece explaining why sub-prime auto loans just aren't going to end up with the destruction of Wall Street once again. His argument is simply that it's just too easy to repo a car and sell it again meaning that the losses are never going to be substantial whatever happens to the orderly repayment of the loan itself. That should be enough to deal with the normal Zero Hedge nonsense on this subject but we can go a great deal further about this too.

Even if the entire sub-prime auto loan market went *poof* in some terrible implosion it's not actually large enough to do significant damage to the US economy. Dean Baker has been shouting for near a decade now that it wasn't the collapse of Wall Street that caused the recession, it was the collapse of the housing market. The wealth effect means that we happily spend more money the wealthier we think we are. House prices go up, the economy booms. That goes into reverse when house prices fall and we all start to feel (as well as be) rather less wealthy. And there was some $7 to $8 trillion of housing wealth that did just go *poof*. That's enough to cause a recession whatever happens to the banks.

A $1 trillion auto loan market, given that high recovery ratio that Ritholtz talks about, just isn't going to do that sort of damage to a $17 trillion economy such as the US has.

But there's one more stage here. Some are concerned about the way that those sub-prime auto loans are being pooled, then sliced and diced into syndicated bond issues. Isn't that what made the banks fall over? The MBS, CDO stuff? And the truth there is no, that's not what caused Wall Street to collapse. If those bonds had been sold to investors, then the banks would have been just fine. It was that the banks kept some of them which was the problem. The banks aren't keeping the sub-prime auto bonds (banks only make the same mistake again after the last person who remembers the last time retires), so even a total collapse wouldn't harm them.

The point here is that the syndication of those loan pools actually worked. They were intended to spread risk and if German banks fall over (they did) as a result of a falling US housing market (they did), then we can safely say that risk has indeed been spread. But that's not what I mean by saying that the syndication worked. Pretty much all of the AAA tranches of those MBS issues are still paying out and are just fine. The lower tranches, the equity and junior ones, sure, they blew up. But that was the very whole point of the system: concentrate the risk at one level of tranche, meaning that the ones further up the structure were safer. And that really did work as can be seen by the fact that most of those AAA tranches are still paying out, a decade after the largest housing bust in history. That's pretty good going in risk isolation in fact.

So what was it that made the banks fall over then? It was that they were leveraged in their financing of those MBS holdings. If all those bonds had been sold to end investors (insurers, pensions funds etc.), then there would have been no financial crash. But the banks decided to hold onto some of those bonds themselves. And they used large leverage to do so too. Some had holdings of 20 to 30 times their capital bases. What that means is that if prices fall a couple of percent then you've got to dump your holding for fear of being insolvent. Gearing does work both ways, up and down; it intensifies profits as well as losses. As a result of the housing bust, there was uncertainty about the assets backing those bonds, prices fell a bit and suddenly every bank everywhere was desperately trying to dump its holdings. Prices obviously slumped, and they all were pretty much bust, or at least enough of them were that they were infecting everyone else.

One of the great trades was in fact to buy them after the banks dumped them: as up above almost all are still paying out and as this has become clear the prices have rebounded. In some cases the same bank selling them would lend you the money to buy them.

However, the point of this story is not just to tell old tales. Rather, it's to clarify what did in fact happen so that we can compare it to the sub-prime auto market. And at the end of that, we can see that the auto market just isn't large enough to cause us macroeconomic problems even if it does implode. As Ritholtz points out, it won't implode because recovery values are higher and it's a lot quicker to do a repo. And finally it won't be the death again of Wall Street simply because there's no leveraged holders of the bonds out there. This time they really are all placed with end investors.

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.