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Who could forget the subprime mortgage crisis of just a few years ago?
If there's one good thing that came out of that nightmare, it's that we – borrowers, lenders, financial institutions all – learned that securitizing bad loans and letting them spread like poison throughout the financial system was a bad thing.
We can look back at the subprime crisis with the wisdom of afterthought, and see all the mistakes laid bare.
We'd never let that happen again, right?
Welcome to the start of the next subprime crisis: Subprime auto loans.
The Auto Subprime Bubble
Banks have once again cast a greedy eye to the lower middle class – who are already leveraged up to their collective eyeballs. This demographic, call it the "easy prey class," is being targeted for auto loans at usurious prices, in most cases north of 20%.
Reuters recently reported the all-too-familiar story of a school bus driver in Alabama who fell into precisely this trap.
Jeffrey Nelson, of Jasper, AL, had one car repossessed, along with serious medical bills. His credit history was checkered indeed.
Yet, he was able to put up his Mossberg shotgun, worth about $700, along with $300 in cash, to come up with the $1,000 down payment that Maloy Chrysler Dodge Jeep said was needed to get him behind the wheel.
The car was not flashy – it was Japanese and had four wheels. According to Reuters, Nelson took out a $10,294 loan to buy a 2007 Suzuki Grand Vitara.
But that $10,294 loan carried a sky-high interest rate, at 21.9%. The true cost was over $12,500.
Of course, after this ill-advised deal, Nelson couldn't keep up the monthly payments.
Reuters said that, in the months that followed, Nelson and his wife divorced. Nelson moved into a mobile home. Unable to cover the rapidly mounting debts, he filed for personal bankruptcy.
His ex-wife, who assumed responsibility for the $324 car payment, said she expects to file for bankruptcy in a few months.
Reuters found that Nelson's loan was provided by Exeter Finance Corporation – a Wall Street-backed subprime lender, which is majority-owned by Blackstone Group – one of the biggest fish in the private equity sea.
According to Reuters, Exeter Finance was listed as a creditor or participant in 1,144 bankruptcy cases in 2012, up from 252 in 2011.
Jeffrey Nelson's loss was unquestionably Wall Street's gain.
If this scenario seems familiar to you, that's because it's been less than five years since the last one of these blew up.
Here's how it's done.
How the Next Subprime Bubble is Forming
Since Jeffrey Nelson was a risky borrower, the lending company, partnered with the private equity firm, bundled his subprime loan up and turned it into a marketable, asset-backed security (ABS) with a nice, fat yield for investors. The securities are sold in risk-based tranches, just as subprime mortgages were.
A riskier loan means a higher yield for speculators, so they're loading up on the riskiest tranches. In most cases, after demand works itself out and drives yields south of 2%, two-year subprime auto ABSs yield 1%.
That looks very attractive compared with 0.5% on prime auto loan ABSs and 0.3% on two-year Treasuries.
Investors can't get enough of these subprime ABSs, so the market for them has grown.
From 2011 through today, close to $36 billion worth of these securities have been sold on the market. Just this week, a few Wall Street banks announced a subprime auto loan securities deal worth $1.6 billion.
That deal, from Spain's Banco Santander's Santander Consumer USA, is the largest such ABS deal since 2007, just before the subprime mortgage bubble exploded – and poisoned the world financial system.
And on and on it goes until the music stops, just like it did in 2008. Just like the toxic mortgage-backed securities of the last decade, these are spreading all over, and spreading fast.
As with nearly all the I-can't-believe-this-is-legal financial shenanigans, you have the Federal Reserve to thank for it.
Ever since QE Infinity, when the Fed took interest rates to near zero, investors large and small have been clamoring for something – anything - with a yield above, well, zero.
William White, a former economist at the Bank for International Settlements, told Reuters, "It's the same sort of thing we saw in 2007. People get driven to do riskier and riskier things."
Looking at who stands to lose and who stands to gain shows us why this vicious subprime cycle will continue.