Subprime Loans are Back Again

It was just six years ago that the world was at the brink of economic Armageddon.  The crisis was brought on by the cheap loans made available to borrowers including those rated as subprime with credit scores below 640.  The cheap mortgages to those with limited assets helped create a huge bubble in the housing market.  When the economy slowed down and home values began to depreciate, many borrowers began to default on the mortgages, which placed at risk major financial institutions worldwide that invested in these bundled mortgages.

Banks and others that owned the collateralized mortgages then required bailouts from the government to stave off failure.  This did not eliminate the debt, but merely moved it from the private sector to governments; i.e. taxpayers.  In addition, the bailouts inordinately benefited companies and their shareholders who made the imprudent loans.  Without the bailouts they would have encountered substantial financial losses.

There is also been a more incipient result of the bailouts of investors who made imprudent loans in the subprime market.  Without suffering losses investors have had short memories and in fact they are back at it again in the subprime financing business, once again supported by low interest rate central-bank policies with interest rates worldwide remaining at artificially and historic lows.

Last month, the Wall Street Journal highlighted the growth of subprime loans in an article titled Borrowers Flock to Subprime Loans.  Today, subprime loans are not in the housing market, but in consumer goods.  The Journal published the following:

  • Subprime loans are at the highest level since before the 2008 financial meltdown.
  • Approximately 4 out of every 10 loans for autos, credit cards and other personal borrowing in 2014 were in the subprime category.
  • During the fourth quarter of 2014, total US household debt increased by over $300 billion.

The Federal Reserve’s low interest rate policies are pushing investors to greater risk as they seek returns.  This, coupled with the availability of cheap capital has offered incentives for nontraditional lenders to enter the credit markets.  For example some venture backed funds are fueling the growth of subprime lending, such as Lending Tree, Inc., an online auto loan marketplace.  These lenders are not regulated and are likely to use leverage and other financial games to pursue even more subprime lending, a repeat of the actions behind the 2008 financial crisis.

Subprime lending is fueling economic unsustainable growth.  For example US auto sales topped 16.5 million in 2014, a nearly 6% increase from the previous year and up nearly 60% from 2009.  When the inevitable slowdown occurs, an increasing number of subprime borrowers will be unable to repay their loans, a repeat of what led to the 2008.

History has demonstrated that booms and busts, and yes bubbles, are at normal part of economic cycles.  However, major macroeconomic bubbles have generally been a once in a generation occurrence that is self-correcting and serves as a reminder to that generation of the pitfalls of imprudent economic behavior.  The collapse of 2008 was different with many investors being bailed out and equity markets returning to their highs within a relatively short period of time.  This has shortened capitalists’ memory who are now once again making imprudent loans in search of returns.  This will lead to another significant downturn in the relatively near future, a probability that investors are ignoring in the belief that when it occurs the government will again come to the rescue.  However, this time the government and the Federal Reserve are themselves deep in deep.  It remains to be seen how this huge sovereign debt will affect the outcome.

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