Pierre Money Mart Blog

“The average purchaser finances around 90 percent of the price of the automobile, with the average loan size being around $11,000. Repayment is highly uncertain: more than half of the loans default, and the majority of these default within the first year of repayment.”

Access to credit markets is generally considered a hallmark of developed economies. In the United States, most households appear to have substantial ability to borrow. As of September 2007, U.S. households had a total of more than $2.4 trillion in non-mortgage debt. Still, economists often point to limited borrowing opportunities, or liquidity constraints, to explain certain findings about consumption behavior, labor supply, and the demand for credit.

In Liquidity Constraints and Imperfect Information in Subprime Lending (NBER Working Paper No. 13067), authors William Adams, Liran Einav, and Jonathan Levin use unique data from a large U.S. auto sales company to study credit market conditions for precisely the population that is most likely to have a difficult time borrowing: those with low incomes and poor credit histories. These consumers, who typically cannot qualify for regular bank loans, comprise the so-called sub-prime market. The authors combine proprietary data on loan applications, transactions, and repayment records from 2001 to 2004 to provide a snapshot of the market, to analyze consumer borrowing behavior, and to document the informational problems facing sub-prime lenders.

The authors use the data to document two important facts about the market. The first is that this population of consumers appears highly sensitive to cash-on-hand, or liquidity-constrained. The second is that imperfect information substantially constrains lenders in extending credit to this population.

The loan applicants in this dataset fall toward the bottom of both the income distribution and the distribution of credit scores. The U.S. median household income is on the order of $30,000 dollars; less than half of the company’s loan applicants have a Fair Isaac (FICO) score above 500, whereas the national median is over 700. These kinds of low credit scores indicate either a sparse or checkered credit record. Nearly a third of the loan applicants have neither a checking nor a savings account.

The company’s transaction records indicate a high demand for borrowing. The average purchaser finances around 90 percent of the price of the automobile, with the average loan size being around $11,000. Repayment is highly uncertain: more than half of the loans default, and the majority of these default within the first year of repayment. Interest rates reflect the high probability of default: a typical loan in the authors’ dataset has an annual interest rate on the order of 25-30 percent.

The evidence on liquidity constraints comes in two forms. First, the authors document a striking degree of seasonality in purchasing: demand is almost 50 percent higher in February, when consumers receive tax rebate checks, than in other months. This seasonal spike in demand correlates closely with eligibility for the earned income tax credit. Second, the authors estimate that consumers’ purchasing decisions are much more sensitive to immediate down payment requirements than to changes in the price of the car, which can be financed. Without liquidity constraints, only an inordinately high degree of impatience would explain these differing sensitivities.

The authors then use the data on borrowing and repayment behavior to estimate the informational problems facing lenders. They estimate that, all else equal, extending a given buyer an additional $1000 in credit increases the default rate on the loan by around 15 percent. This kind of sensitivity of repayment to loan size is the driving force in moral hazard models of credit imperfections. At the same time, a buyer who chooses to finance an extra $1000 of her purchase (that is, who self-selects into a larger loan) has an even greater default rate, around 24 percent higher than a buyer who opts to pay the $1000 dollars upfront. In other words, the decision to finance more heavily reveals additional adverse information about the likelihood of default, as in standard models of adverse selection.

The authors do not provide a welfare analysis or specific evidence on the growth in sub-prime lending that has occurred over the last decade. The last part of their paper finds that modern credit scoring techniques can go a significant distance toward mitigating adverse selection problems in the credit market, which suggests that innovations in this area may be related to the rise in sub-prime lending. Such credit scoring is less likely to mitigate moral hazard problems in repayment, thereby still restricting credit to sub-prime borrowers.

When lenders sent a tow truck to repossess his silver 2001 Lincoln LS last month, Myles Chilcot eagerly handed over the keys.

Last year, Chilcot, 21, bought the $15,000 car – a sweet ride with tinted windows and custom chrome rims, and a loan with $370 monthly payments that he could not afford on his $12 hourly wage at Home Depot. By the fall, facing mounting credit-card debt, student loans, and rent, he stopped paying the car bills.

“I ran around smiling for 20 minutes when they took the car away,” Chilcot said. “It was a relief.”

It is also an increasingly common story as more Americans, under growing economic pressure, are deciding to surrender their rides rather than the roofs over their heads: The rate of auto-loan defaults recently reached a 10-year high of 3.4 percent. And one local auction company saw repossessions nearly triple last month compared with a year ago.

As with the subprime-loan crisis that has caused waves of home foreclosures, trouble has been brewing with car loans for years. As the economy boomed, lenders made it easy for shoppers to buy cars they couldn’t afford by stretching their loan payments to five or six years, which more than doubled the total of Americans’ auto-loan balances over the past decade to $772 billion from $282 billion in 1998. As with home buyers, lenders relaxed standards for car buyers such as Chilcot, who had blemished credit and put no money down.

With oil prices skyrocketing and the economy in a downturn, consumers are looking to downsize to cheaper, more fuel-efficient models, and reduce their payments. And many – even those with good credit and lower interest rates – are finding they can’t afford to sell their vehicles because they have more left to pay off than their cars are worth. Lenders, meanwhile, are writing off billions of dollars in defaulted loans, and some analysts worry this could escalate to a foreclosure crisis on wheels.

“The suddenness with which we saw repossessions hit the market at the beginning of the year has been unusual and appears to reflect not only the general economic slowdown, but some spillover from the mortgage crisis,” said Tom Kontos, chief economist at Adesa Inc., which runs 58 car auctions across North America. “With folks getting resets on adjustable-rate mortgages, it forces many people to decide whether to default on their home loan or default on their car loan. When they have that kind of choice, predictably, they gravitate toward defaulting on car loan.”

Nationwide, repossessions are up about 15 percent so far this year, Kontos said. At North Shore Auto Auction in Ipswich, repossessions almost tripled in February to 125 vehicles, with gas-guzzling sport utility vehicles, pickup trucks, and vans being turned over more quickly than cars at a rate of two to one. As homeowners get squeezed by rising mortgage payments, contractors are also feeling the pinch as people cut back on home-improvement projects, leading to a glut of repossessed pickups, according to Frank Iovanella, president of North Shore Auto Auction.

For two years, Carole Beausoleil, 58, of Southbridge has been trying to get rid of a black pickup, a 2003 Chevy Silverado the family bought in 2004. Beausoleil says the family was pressured by the dealer into costly add-ons the members quickly regretted, such as LoJack and an extended warranty. These services added thousands to the $21,900 sticker price and pushed up the monthly car bill to $465.

Beausoleil fell behind on payments in 2006 and debated allowing the lender to repossess the car. She reconsidered because she didn’t want to ruin her credit and her husband needed the vehicle for work. Instead, they tried to downsize to a less expensive, more fuel-efficient model. But they have been unable to because they owe $13,000, and lenders told Beausoleil the truck’s value has shrunk to $10,000.

“We got swindled and overpriced. It was a mistake, and now it’s too late,” Beausoleil said.

Beausoleil, who is trying to pay off other debts, including overdue credit card, gas, and electric bills, says she plans to use the anticipated federal tax rebate this spring to help make up the $3,000 difference so the family can finally get rid of the truck.

Lenders, meanwhile, are cracking down. GMAC Financial Services, the country’s largest auto-finance operator, recently tightened its underwriting standards to authorize fewer subprime loans and also increased its collection force to work with customers who are late on auto payments. During the last two quarters of 2007, the riskiest subprime borrowers had interest rates of about 15 percent for their auto loans, while borrowers with top credit ratings carried car loans with 5.7 percent interest rates, according to J.D. Power and Associates’ Power Information Network, a market research firm.

Jack Tracey, executive director of the National Automobile Finance Association, the trade group that represents subprime lenders, said, “The nonprime auto-financing industry is very important for the economy because it provides many economically disadvantaged consumers with the ability to own a car and have the ability to hold a job where they need to commute to work.”

But the most recent data available from a member survey showed that delinquencies on subprime loans jumped to 11.6 percent, up from 6.8 percent.

“Just as in the subprime mortgage industry, car dealers have been giving consumers with less-than-prime credit ratings car loans with rates and payments they can’t afford,” said Yvonne Rosmarin, a consumer-protection lawyer in Arlington.

Some industry analysts do not expect the problems within the auto industry to reach the crisis level of the mortgage industry. Lenders can more quickly recover, in many cases, because vehicle repossessions can occur within 90 days after a loan is past due, while home foreclosures can take up to a year. Still, some lenders, like Eastern Bank, which have seen an increase in repossessions, are taking a hit at auction, getting at least 10 percent less than last year for larger vehicles.

That means the problems for consumers may not end when their repossessed cars are towed away. They still may owe money if the lender sells the car for less than the balance owed. Moreover, the repossession typically stays on consumers’ credit reports for up to seven years.

Chilcot, who recently had his car repossessed, had initially intended to purchase an $8,000 Nissan Altima, but he couldn’t get a loan to cover the vehicle because it had too many miles. He knew he had bad credit, so when a loan offer was approved instead for the $15,000 Lincoln, Chilcot seized on what he thought was a good deal – even though it came with a 18-percent interest rate.

Since his car was taken away, Chilcot has started walking to work at his new job – as a car salesman at a dealership in Plymouth.

When asked whether he tries to caution people against buying a car they can’t afford based on his recent experience, Chilcot chuckled: “Not really. You become pretty shameless pretty quick when the paycheck comes.”

California is cracking down on bad driving habits with some tough laws.Last week, they became the fifth state to mandate that all motorists use a headset with their cellphones.

Generally, the law seems to be getting praise from many who claim they are fed up with distracted drivers on the phone. They insist that with the extremely high volume of motorists in California, this type of restriction is a necessity.

At this point, there is still no law against sending text messages while driving.

Under a separate law, drivers under the age of eighteen may not use a phone of any kind while operating a vehicle. This law regarding minors is shared with thirteen other states.

It is also now illegal for drivers in California to smoke in their cars if there are minors with them. Other bills that could possibly pass include one that would forbid driving with a dog in your lap.

Today in San Jose, California, General Motors will announce their partnership with over 30 utility companies in a project to speed commercialization of plug-in vehicles.  The Electric Power Research Institute represents more than 30 electric utilities with operations in 37 states.

The purpose of the joint project is to resolve some issues before plug-in vehicles begin appearing in showrooms in 2010.

Issues include: raising public awareness of plug-ins, ensuring places for safe and convenient vehicle charging, and working with government leaders to ease the transition from petroleum to electricity.

GM claims the project is the largest and most comprehensive between an automaker and the electric utility industry. They believe it will pave the way “for customers to realize the benefits of plug-in electric vehicles such as the Chevrolet Volt and Saturn Vue plug-in hybrid.”

The manufacturer is banking on these two models to be the forerunners in this technology.

The big advantage to utilizing electric power is a matter of economics. The estimated cost per mile is 1 cent per mile in off-peak periods and 2 cents during peak time. This is in contrast to gasoline at about 14 cents per mile and more than $4 a gallon.

After almost 20 years of putting Americans into big pickups and SUV’s, Ford is about to dramatically change its lineup.

The automaker has been struggling and is forced to respond to the rapid, and probably permanent shift in consumer choices.

Changes include converting three North American assembly plants from trucks to cars, and shifting production focus to smaller vehicles, such as the Ford Fiesta.

In addition, the company ends speculation about its Mercury division by making the brand an essential part of their new small-car strategy. Ford says it plans to realign factories to manufacture more fuel-efficient engines and produce six of its upcoming European models for the U.S. market.

Vehicles sales in the States have dropped 10 percent so far this year, and Ford sales have declined 14 percent. For at least 10 years, about 60% of Ford’s U.S. sales came from trucks and SUV’s.

“Trucks and S.U.V.’s have been so central to their strategy for so long, but the bottom line is that consumers have moved on,” said David E. Cole, chairman of the Center for Automotive Research in Ann Arbor, Mich.