The last financial crisis, in 2008, started in the U.S. housing market. The next source of credit market woes may be parked in the driveway.
There's mounting evidence North American car buyers binged on debt and are now struggling to pay back what they've borrowed. The only good news in otherwise grim statistics is that auto loans make up a relatively small segment of the overall credit market. The fact that the repo man is increasingly busy towing cars is unlikely to throw off the shock waves created when the mortgage market melted down a decade back.
The auto industry is on a tear, set to post a record eight consecutive years of record sales, and the boom is fuelled in part on easy credit: Anyone trying to finance their new ride can borrow lower for longer than they could in the past.
Wells Fargo chief economist John Silvia published a cautionary report on Wednesday that showed the average U.S. car loan is now for 67 months, or more than five and a half years, compared with a 59-month term in 2009. Six- and seven-year auto loans are commonplace, despite the dubious logic of owning a car that's worth less than what you borrowed once you drive it off the lot.
Thanks to rates that continue to bump along near historic lows, borrowers average 4.7-per-cent interest payments on car loans; in contrast, from 1990 to 2008, borrowing costs ranged from 6 per cent to 8 per cent.
"The prospect of lower monthly payments for a longer period of time attracted a large portion of auto buyers," Mr. Silvia said. "This borrowing trend has increased credit market risk."
Here's where the outlook gets grim: Wells Fargo pointed out that the rate of delinquent car loans climbed for 12 consecutive quarters and now amounts to 3.9 per cent of outstanding borrowing, or $8.3-billion (U.S.), up 20 per cent from a year ago. In the worst days of the last recession, delinquencies peaked at 5.3 per cent of all auto loans.
"Against the backdrop of a Fed that is likely to tighten policy, it should not be a surprise to anticipate that delinquency rates will continue to climb higher," Mr. Silvia said. Higher defaults on auto loans wouldn't cripple the economy – car loans are 9 per cent of total household debt, while mortgages account for 68 per cent – but would be a source of pain across many sectors.
A sharp increase in delinquencies in auto loans would weigh heavily on lenders such as Toronto-Dominion Bank, which has made a major commitment to the sector in recent years.
In a stellar set of financial results released on Thursday, TD showed it holds $21.6-billion (Canadian) of what it calls "indirect" auto loans in Canada, compared with $17.7-billion two years ago. In the U.S., TD's indirect auto loan book is $28.3-billion, up from $22.3-billion in 2015. The indirect reference reflects the fact that the bank has a lucrative franchise lending to auto dealerships, who in turn provide financing to car buyers.
Lenders are realizing the trend is not their friend on loan delinquencies, as Wells Fargo noted many banks tightened their standards on car loans in recent months.
However, the larger issue of rising defaults on car loans is what the trend implies for consumer credit of all stripes. The North American economy is humming along in part because of increased household spending, which in turn reflects binge borrowing on credit cards and home equity lines, along with mortgages and auto loans.
We're clearly late in the credit cycle. In the not-too-distant future, consumer debt will become problematic; rising delinquency rates show that is already happening in auto loans. When spending slows, the economy has to cool.