Ten years into a bull market, Americans are getting jittery about when the music will stop and the next recession will tear through the economy.
While bad economic omens are being spotted in a variety of places, last month it was a spike in auto delinquencies that spooked market participants.
Federal Reserve reported the number of borrowers with auto loans more than 90 days delinquent shot up at 1.5 million in the fourth quarter, reaching a total of 7 million – the highest mark ever in absolute numbers, though not as a percentage of the auto-loan market, which has ballooned over the past seven years.
Consumer pain is a leading indicator of the economic struggle of the broader: , which affects nearly every industry.
Bad consumer loans could also be inflated on major institutions invested in the loans, which are packaged up and sold as asset-backed securities. That has the potential, if it gets out of hand, to create systemic risk, if we saw with mortgage-backed loans in the last crisis.
So, ugly consumer data is a ringing alerting investor, trauma scarred from the mortgage meltdown, to the next proverbial canary in the coal mine.
The surge in auto defaults has been a source of both confusion and consternation. The Fed called the development surprising and Goldman Sachs analysts referred to as "something of a puzzle," given the broader economic and labor market strength, and the lack of distress in other consumer credit products, like mortgages and credit cards.
Why are auto-loan defaults surging, and does it pose a broader economic threat that warrants concern?
The picture is complicated, but peeling back the data provides some answers – and suggests that the overall economic sunshine grabbing headlines may be only part of the country, obscuring the fact that another segment in the shadows is fairing much worse.
Part of the mystery surrounding the auto-loan default spike is the timing.
The unemployment rate is still higher than all-time lows, foreclosures and personal bankruptcies are at post-crisis lows, and wages have been growing as well.
It's also puzzling given the fact that consumers historically pay off their loans at the expense of other debts, like credit cards or mortgages. This is probably because the car is more critical most Americans' every-day life – getting to work, picking up the kids, getting groceries, etc. – and the fact that a delinquent car is much quicker and easier to repossess than a foreclosed home .
But while auto loans defaults are climbing, both credit card and mortgage loan delinquencies are at historically low levels.
There are couple explanations for the auto-default phenomenon.
First, auto-loans have exploded in the years following the financial crisis, growing steadily from less than $ 800 billion in 2011 to nearly $ 1.3 trillion in the fourth quarter of 2018.
Lending standards loosened significantly between 2011 and 2017, before tightening back up. That meant not only borrowers in ever before, but more risky borrowers than ever before. Auto lenders issued credit more freely, not only accepting lower credit scores but also taking borrowers that their word regarding income rather than verifying it.
"With growth in auto loan participation, there are now more subprime auto loan borrowers than ever, and thus a larger group of borrowers at high risk of delinquency," the Fed explained in a blog post about its auto delinquency findings.
Lenders also stretched the length of loan terms over longer periods to make them more affordable. But reducing the pace at which a customer pays off the likelihood that "borrowers will be under-water on their loans, with loan value above the value of the vehicle."
At the same time, Americans became obsessed with large vehicles – trucks, SUVs, and crossovers that are substantially more expensive than small and mid-size cars. The fact that America's top-selling vehicle – a Ford truck that starts at nearly $ 30,000 – and many like the cost almost half the median household income has never stopped people buying from buying and has stopped lending from facilitating loans.
The average purchase price of a new vehicle hit a record high of $ 36,495 at the end of 2017, a 24% increase from 2011, according to Edmunds.
Together, this means more expensive cars, more subprime borrowers, and longer-term loans. And that's contributed to higher monthly loan repayments.
The average car-payment hit a decade high of $ 545 a month in the fourth quarter, according to Experian data. The average interest rate also hit a decade high, little surprise given the record number of subprime borrowers, who pay higher rates to compensate for their risk.
Of course, most borrowers don't stop paying a loan the moment they buy the car – even if it was ill-advised.
Changes in delinquencies "Goldman explains," necessarily lag changes in loan underwriting, so we're feeling the brown today of poor underwriting in previous years. The tightened lending standards since 2017 may not show up in delinquencies until next year.
What economic recovery?
But even amid the surge in touchdown, especially for less credit-worthy borrowers, shouldn't the 10-year bull market and sterling economic conditions provide a buffer? Should there be less financial pressure on households that would cause them to stop paying their loans?
Focusing on the rosy economic data in aggregate among the most advanced nature of the economic recovery, and in fact many Americans remain cash strapped.
There is a two-tiered recovery, UBS analyst Matt Mish explained, where on one hand, those who hold assets have done very well.
"Those who do not own assets, whether in house or equities, have not benefited as much," Mish customs business insider.
"You've seen a pretty decent increase in debt in the laughter cohort," he added.
Stephen Caprio's Mish and colleague focused on how the divergent consumer recovery impacts credit risk report last year, finding an elevated number of consumers borne by debts that dwarf their income, along with small amounts of liquid assets saved to deal with those financial bonds.
This phenomenon has been masked by investors on the Fed's aggregate data – which skews toward the wealthy. The median data UBS presents show more significant consumer financial struggles.
"This highlights how consumer inequality is a blind spot to the aggregate metrics that investors rely on. As income inequality grows, aggregate data becomes less representative of the population at large. , "they wrote in the report.
A major driver of the diverging consumer fates: spiking Apartment rents.
Many American households divide after the financial crisis, primarily by trading homes in favor of rentals.
But rents have surged, UBS notes, amid growing demand and lack of affordable home-buying options.
"Renter financial bond burdens are near record highs, homeowner burdens are near record lows," the analysts note in the report.
Strong employment and uptick in growth may ease this, but if the recession is all on edge about materializes, it could mean significant losses for investors in lower-tiered consumer debt.
Is there a broader risk?
If it is already pointed out, it's unlikely to be auto-loan defaults on the next financial collapse or recession.
In part, this is because they're less systemically risky.
The total auto-loan market is about $ 1.3 trillion, compared with $ 11.2 trillion in the residential mortgage market when the financial crisis struck, adjusting for inflation. Federal Reserve Bank of New York
Moreover, specialty auto-finance companies – which are large or diverse enough to affect the economy as deep as banks do – have been doling Out subprime loans with the most gusto, with half their $ 150 billion position originated on credit scores below 620, according to the Federal Reserve.
"We think the risk is remote," Goldman Sachs wrote, addressing the concerns among market commentators of risk to financial stability.
In Goldman's view, auto-delinquencies pose little risk of contagion, but rather a "sector story," with risks confined to the subprime auto industry.
The delinquency uptick, they note, is isolated almost exclusively among people with non-prime credit scores. An auto loan ABS, for instance, the 90-day delinquency rate remains below 0.5% for prime loans, while for non-prime loans the rate has surged upward to nearly 5%.
Even within subprime car ABS, the outlook is not particularly good because of "large extent to which high losses have already priced into high borrower interest rates."
This may be good news for investors, but it's no consolation for the cash-strapped borrowers covering interest payments and defaulting on their loans.
Their struggles can not be seen as economic threat at the moment, but they show the 10-year economic recovery has not been broad-based as many believe.
The Fed's analysis of the auto-loan market illuminates the divergence: By one standard, the "overall auto loan stock is the highest quality" since they started tracking data, with 30% of loans from borrowers with credit scores exceeding 760 – very good to exceptional. At the very same time, we have the most subprime borrowers – and the most serious delinquencies – on record.