Here’s a challenge for bankers: Come up with a better word than “subprime.”
Those dreaded subprime loans are in the news again, this time because of concerns that auto-lending companies might be doctoring details about loans to car buyers with poor credit. General Motors (GM) disclosed recently that the Justice Dept. has subpoenaed documents on its lending practices, which could indicate a broader inquiry into subprime lending throughout the auto industry.
It’s no secret that lenders have been making more subprime loans -- it's one of the reasons why auto sales have come roaring back after several dismal years. That has triggered a kind of Pavlovian response among regulators who recall the chaos caused by reckless lending during the housing boom and bust. “Lending standards have started to ease,” Yahoo Finance's Aaron Task tells Henry Blodget in the video above. “Don’t we want banks to do more lending?”
Well, yes. And President Obama himself has urged banks to ease lending standards so more people can buy cars and homes. Yet subprime loans carry a stigma because of abuses that occurred during the housing bubble of the early 2000s. Back then, many lenders basically threw out the rule book for underwriting loans and gave mortgages to anybody capable of signing their name. Brokers earned their origination and securitization fees long before strapped borrowers realized they didn’t earn nearly enough income to pay off the loan. In a few cases where prosecutors were able to prove fraud, brokers went to jail.
Subprime loans have basically disappeared among mortgage lenders, but they remain an important part of the auto industry. Still, we’re not exactly talking about an epidemic of risky lending. About 12% of auto loans are held by borrowers with a credit score below 620—the technical definition of subprime—according to Experian. That’s up a whopping 1 percentage point from a year ago.
Loans to “deep subprime” borrowers—those with a credit score below 550—have grown the most during the last year. But those borrowers pay much higher interest rates than prime borrowers to compensate for the higher risk of default. Meanwhile, Experian’s data shows delinquency rates on auto loans have dipped during the last year, even though auto sales are up and lenders have been making more loans.
There’s nothing inherently wrong with lending to consumers with weak credit, and the government isn’t investigating GM because it makes subprime loans. Instead, the feds seem to be looking into the way GM’s financing unit securitized loans and sold them to investors.
If GM or other lenders falsified or mischaracterized data about borrowers—by overstating their income, for example, or failing to include needed documentation—that would be a legitimate problem potentially warranting prosecution. During the housing boom and bust, the problem wasn’t subprime loans in themselves, but the fact that lenders vastly underestimated the risk of those loans and priced them terribly wrong. Had mortgage-backed securities packed with subprime loans been assessed correctly, they would have had to pay far higher returns to attract investors. Many investors would have simply shunned them, limiting demand for MBS instead of generating a frenzy. Prosecutors now seem to be checking whether GM and perhaps other auto lenders are making the same mistake.
The government, meanwhile, is sending mixed messages to banks and consumers. Tight credit has been one of the things holding back spending, prompting Obama and other policymakers to plead for looser lending standards. Yet the government is now threatening to punish banks that lend to less creditworthy consumers. If subprime loans were called second-chance loans or opportunity loans instead, maybe prosecutors would show less interest.
Rick Newman’s latest book is Rebounders: How Winners Pivot From Setback To Success. Follow him on Twitter: @rickjnewman.