Move over, mortgage lending. A different type of debt is stealing the spotlight.
As North American vehicle sales soar, with Americans and Canadians pulling the trigger on the new car purchases they put off during the financial crisis, there are growing cries for caution around auto loans. And they're only getting louder.
Earlier this year the New York Times summarized the worries south of the border, where critics fear that auto lenders are extending credit to people who have insufficient financial means to be taking out such loans. Rating agency Moody's Investor Service is now waving a warning flag of its own in Canada.
Moody's main message: bank auto lending is growing at an incredibly fast clip, and the average length of these loans is only increasing. Because Canadians have already borrowed beyond belief, the booming car loan market is only making them more susceptible to trouble during an economic downturn.
"As Canadian banks have made a pronounced strategic push into auto lending, credit costs have been low, but could rise quickly in an adverse scenario of unemployment increases or rapidly rising interest rates," Moody's noted in its latest report.
Yet similar warnings have been issued about mortgages for a few years now, and somehow the banks have trudged on. Should we really be all that worried about auto loans?
The market's incredible growth suggests we should at least be concerned. Bank loans to purchase private passenger vehicles jumped to $64-billion at the end of 2013, up from $16-billion in 2007, according to the Bank of Canada. That's 20 per cent growth per year, boosted by low rates that make it easier to borrow, as well as a shift in consumer preference toward higher-valued vehicles. (Lenders such as Royal Bank of Canada have also acquired the likes of Ally Credit Canada, which specialized in auto lending, boosting bank loan totals).
Loan terms are troublesome, too. "TD, the one bank that breaks out its consumer auto portfolio separately in its financial statements, reported that loans with a term greater than five years grew from 22 per cent to 33 per cent of the total portfolio between 2012 and 2013," Moody's noted.
That matters because vehicles, unlike houses, depreciate quickly. Over the first few years of a loan, the borrower pays more interest than principal, meaning the loan can have "negative equity" – it is worth more than the vehicle itself. If the borrower defaults in the early years, the bank can't just sell the car in the used vehicle market and hope to get all its money back.
This problem can create what Moody's calls a "debt treadmill." If a borrower gets into financial trouble, he or she might take on even more debt to help make monthly payments. "The treadmill can only end in one of two ways: either the consumer maintains the discipline to keep their vehicle until it reaches a positive equity position, or they can no longer sustain it and default, creating a charge-off for the bank," Moody's said.
While these are very valid concerns, the broader market dynamics aren't nearly as troubling. Credit charge-offs are at historic lows for the Big Six banks, and inflation isn't popping anytime soon – no matter what the gold bugs say – so interest rates aren't at risk of a sudden spike. Royal Bank of Canada chief financial officer Janice Fukakusa recently told The Globe and Mail that the only major fear for the country's banks is a quick, unexpected rate hike; anything gradual can be handled – and is, in many cases, expected.
The auto market is also much smaller than the equivalent one for mortgages. Whereas loans to purchase vehicles amounted to $64-billion at the end of 2013, the mortgage market then amounted to $916-billion, according to the Bank of Canada. The size of each auto loan is also much smaller. Managing a $20,000 loan is much easier than handling a $200,000 mortgage.
By no means does that absolve us of all the macro worries. While the banks have mortgage insurance as a failsafe against a downturn in the housing market, auto loans don't come with such protection. Plus, Canadian banks haven't been active in the auto loan securitization market, so the risks remain on their own balance sheets instead of being transferred to bondholders.
The country's largest lenders have also recently acknowledged that credit losses move in cycles, and right now, it's very clear that we're at the peak of the current wave. RBC has been so flabbergasted by the low loan losses that they've double-and-triple-checked their books to make sure they aren't missing something.
Still, when it comes to auto loans, there isn't enough evidence to warrant a freak out. Moody's rightly raised the concerns, because an economic downturn could certainly create large loan losses. But fears of an auto loan-driven financial system meltdown are overdone.