Reference no: EM132838871

Case 5.2 Subprime Auto Loans: Contracts with the Desperate

You may have seen the ads. "Need cash? No credit history needed. Approval within hours." You may wonder how the lenders do it. How do they make money when they are making loans to those who may not have a history or ability to pay? And how can they make the loans so quickly?

Well, welcome to the new subprime market-auto loans! The loan companies advertise on television, have toll-free numbers, and are willing to loan just about anyone at least $1,000. The reason these lenders are so comfortable in such risky lending is that they take a security interest in the borrowers' cars. The car, under Article 9 of the Uniform Commer-cial Code, can be repossessed, and the lender will get the loan repaid and then some. The reason the lenders can take the car, regardless of the amount that is due and the value of the car, is that the loans carry very high rates. Those rates climb if the borrower misses a pay-ment, and along with late payment penalties, the borrowers, already financially shaky, find themselves in a situation they almost never escape without losing their cars. Ironically, the loss of their cars usually means they have no transportation to work, something that starts a deeper financial decline.

Subprime auto loans were 27% of auto loans in 2013, a jump of 7% since 2009, and are generally made to those borrowers who have poor credit scores. The loans are gen-erally one month in length and carry interest rates that range from 80% to 500%. At the end of the 30 days, the financially strapped individuals are generally not able to repay the loans, but the lenders are willing to renew, at a higher rate, and perhaps with addi-tional fees that are added into the loan balance. The end result is either a never-ending balance, even if the borrower makes the payments, or repossession of the car. For exam-ple, a loan for $1,000 that is renewed every 30 days over a one-year period can find the borrower owing more than 10 times the original the amount borrowed. The borrower reaches a point where the only escape is surrender of the car, because the repossession satisfies their obligation in many cases. The typical number of times for renewal for these types of borrowers is nine. One in every six car title loans results in repossession of the borrower's car.

The title loan market has grown and has attracted Wall Street investors, with stock prices in the lending companies climbing as much as 47%. Car title loans are legal in 21 states, and in those states, interest rates can go up to 300%. In other states, title loans are permitted, but there are some limits passed on interest rates and other types of regulations on renewals and fees. Other states prohibit deficiency judgments on these loans. That is, if the lender repossesses the borrower's car, the lender cannot pursue any deficiency judgment if the sale of the car does not bring enough to satisfy the loan. There are a number of states that have already passed laws regulating these types of auto loans or are in the process with legisla-tive proposals pending.

The auto lending market, including prime and subprime car loans, topped $1 trillion in 2015. Mortgages are an $8.4 trillion market. Jamie Dimon of JPMorgan Chase has referred to the auto loan market as "a little stretched." Even comedian John Oliver tackled "ultraloose approval processes" for these subprime loans on his HBO show. According to Standard & Poor's, about 21% of all car loans are to individuals with credit scores below 620, with another 12% with scores of 620 to 659, the two score ranges considered the highest risk, with 660 being the credit score required to be considered good. Indeed, the boom in auto sales is largely due to loans to high-risk borrowers. Only 22% of borrowers have a credit score above 780.

Questions:

1. Describe how auto title lenders are able to make money with high-risk loans.

2. Who is affected by this type of a loan market? Are borrowers taken advantage of?

3. Is there a need for these types of loans?