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The Other Underwater Loans: Negative Equity in Auto Finance

posted by Kathleen Keest

On Tuesday Fed Chairman Bernanke announced another installment in the effort to alleviate the  credit crunch in testimony before the House Financial Services Committee. One new tool in the kit is a joint Treasury – Fed facility to lend against “AAA-rated asset-backed securities collateralized by recently originated student loans, auto loans, credit card loans, and loans guaranteed by the Small Business Administration.” 

This got me to wondering what the recent (pre-crunch) state of affairs was with respect to the practice I used to call in consumer education programs “Drive One, Pay for Two” – burying the cost of refinancing the left-over debt on the trade-in vehicle in the new (or new-to-you used) car loan docs. Here’s how that  works:  The value of the trade-in is $8000; balance on the loan for that trade-in is $10,000. That leaves a $2000 deficit that either a) the dealer eats (unlikely), or b) you have to cover with an extra cash down payment as well as the trade, or c) gets rolled into the new car loan. The last option means that you are  essentially refinancing the remaining debt on the car you just sold back to the dealer, along with the price of the new car and whatever add-ons get added on back in the F&I office.

A lot of prospective buyers might decide to wait on that new purchase if they understood that  their new car loan would include left-over balance on the car they don’t own anymore. So a lot of dealers used to (still??) fudge the numbers on the loan papers so the old loan pay-off disappeared. (Don’t even ask about the Truth in Lending rules and issues.) 

As cars get more expensive, and loan terms get longer (to keep those monthly payments affordable!) that increases the odds of negative equity caused by left-over debt from the trade-in.  In theory, the lenders financing those loans would want to know if the car was going to be underwater due to negative equity before it even drove off the lot. But in practice – just as with the mortgage industry, the only thing worse for your monthly numbers than an undersecured loan was no loan at all.

So I guess I shouldn’t have been surprised when a colleague shared a CBA survey of lenders from 2007 showing that the range of maximum permitted LTVs started at 120% and went to 140% or greater. (That would give enough room for stacking the negative equity from more than one premature trade-in: “Drive one, pay for three?”)

Estimates seem to be that about 25% of car loans are under water, and an April, 2008 BenchMark consulting report put the average amount in glub-glub territory on a new car loan at $4250. Last year Nobel economist Nouriel Roubini worried about the potential losses in the auto loan sector because of reckless lending and significant negative equity. But here’s the thing –Roubini’s (borrowed) explanation just talked about no downpayments and the fru-fru add-ons. Sounds like “Drive One, Pay for Two” wasn’t even on his radar screen. I wonder who else’s it isn’t on. 


The auto loan problem must be minimal, because no one has been able to get an auto loan. You see, prior to BAPCPA, all auto loans could be crammed down in Chapter 13, and even after BAPCPA, auto loans that were more than 2 1/2 years old can be crammed down - so while there is more auto credit available now, of course, the lingering effect of the past law allowing cram down on all vehicles is preventing affordable auto loans today. Moreover, the interest rates on auto loans are modifiable under In re Till, and cramdown is even available through redemption at the FMV in Chapter 7s.

Clearly, then, auto lending of any type is too risky for banks and finance companies to engage in because the sanctity of contract is not preserved in America's bankruptcy courts.

Thus, no auto lending occurs because all of these bankruptcy provisions apply to new auto loans, not just past loans. It follows (based on logic I have seen in another context) that there have been no affordable auto loans available since the Bankruptcy Code became effective in 1979, and the issues you discuss - while interesting mental exercises - don't actually exist.

There is another interesting dynamic about new car loans versus house loans: new car loans are underwater immediately, because the a car loses a good percentage of its value the day it is driven off the lot. New home loans are usually not underwater on day 1, exept to the extent that fees are included in the loan amount.

I am very suprised that only 25% of the car loans are under water. I would have thought the number would be much higher. Perhaps they are not because many people trade in cars, which covers the immediate loss in value

With even middle of the road new cars pricing out in the $20,000 to 40,000 range, I don't know who can afford a new car any more without a long term loan. With there being so many affordable and reliable used cars out there, I don't know why anyone buys new -- but I suppose I should be glad someone does because otherwise we would eventually run out of those good used cars. Unfortunately, from the automakers' standpoint, now is the absolutely worst time for lenders to tighten up by reducing loan terms and requiring higher downpayments.

In this regard cars and housing are similar; consumers have brought some of this on themselves via rising expectations. There is no such thing as a genuinely basic car any more. Heaven help us that we might have to turn a crank to open a window, or for that matter open that window if it is hot. We also demand the ability to drive head on into a brick wall at 45 mph and not feel any pain. And all our houses need to have four bathrooms and granite counter tops and walk in closets bigger than my first apartment. It all costs money, and we seem to have created an economy which is dependent on spending that money even if we don't have it.

Having gotten the snark out of my system in the first post - one reason I think people opt for new cars is the financing. Used car financing for people with any kind of credit problem is often in the 21.99% range, and that's after the car lot marks up the price to three times what you might pay for a comparable vehicle if you had cash and shopped the classified ads.

When you compare what you are able to get from a subprime car lot versus what you can get from a new car dealer - for the same buyer with marginal credit - the new car often looks like a better deal based on the primary factor many cash strapped car buyers look at: the monthly payment. The new car loan may be stretched over 72 months, instead of 36 for the 'buy here, pay here' sellers, but that long payout, when coupled with a lower interest rate, can make new cars more attractive on a cash flow basis.

The problem I see is that over that long new car payout period, bad things happen to the new car buyers without a safety net and they wind up with the new car repoed, and a whopping deficiency for the balance of the loan when their car is sold at auction. The deficiency balances can be eye popping when the debtors have been on the 'sure, we'll just roll it into the new loan' treadmill for a few cycles.

One important aspect of car loans being underwater is how that negative equity is treated when people trade in cars. First, depending on the car dealer's client pool, the percentage of people underwater on their cars is much higher. In industry publications I have seen some dealer's self report it as higher than 50% of buyers with trade-ins are underwater. The industry still wants to sell those people a car.

The real issue is how many of the retail installment sale contracts that are currently on the secondary market show on their face such negative equity. My experience is that the fraud on the secondary market starts with the dealer hiding the negative equity by falsifying numbers on the credit contracts. These false contracts are then evaluated in pools according to those false numbers, and repeatedly sold in the secondary market as if there was not thousands of dollars of negative equity rolled in from the beginning. Instead the credit contracts will appear like the consumer made a down payment and thus be assigned a higher value.

On a global scale, this fraud is easy to identify. Take the estimate of buyer's who were underwater on their trade-in, and then look to see if the auto loans being securitized show a similar percentage of deals that included negative equity from a trade-in. Based on the FRB data I have seen about loan to value ratio of such loans, they do not. On the small scale, the fraud usually first appears as too much value placed on a trade-in so that the value equals the lien payoff. As the federal government moves into purchasing such assets, it could choose to use the data at its disposal to start prosecuting those dealers who have been producing falsified documents to sell into the secondary market.

Tom - fraud is such an ugly word, and in your post the fraud is premised on the car loan being underwater based upon a trade-in value.

Trade-in value is way below fair market value. Kelley, NADA, etc. all reflect a big spread between a trade-in value, a private party sale value, and a retail value. I think in most cases, the auction sale value would be even lower than the trade-in value, but I am not in the car business.

IMHO, the private party value is closer to the FMV of the vehicle. The problem for those who invest in car loan backed securities is that when the loan actually defaults, they get the auction value of the car. But, in terms of the debtor's incentive to maintain payments on the vehicle, I think that is based more on a private party value. That spread is pretty much common knowledge. Plus, folks need their cars to get to work (at least they used to, back when there were jobs) so the security holders have that going for them. There are unsecured debt securities that are issued, so I can't go as far as using the f-word: 'fraud'. I mean, in comparison to vintage 2006 private label MBSs coming out of Lehman? Meh.

As far as how the government is going to pay an appropriate value for those securities - I think the securities that are out in the secondary market are now probably valued pretty fairly by the market. On the other hand, if the stimulus plan involves trying to buy auto loan based securities as they are issued, proper valuation, based on risk, is going to be a problem. But, maybe the biggest problem is that the U.S. Government, as purchaser, is not going to be able to buy up large chunks of this kind of debt without moving the price up.

The issue isn't going to be figuring out a hypothetical appropriate price, it will be reconciling the need to buy prudently (to minimize upward price movement) with the actual goal of stimulating the economy NOW. The U.S. Government won't be the usual investor, with a universe of investment choices competing for investment dollars. The USG will be forced to buy certain types of assets in a short period of time. That has to put an artificial upward pressure on the price of those assets.

BTW, there is a great new opportunity for those who invest in car loan backed securities. You may be interested in investing in my new tooth fairy based securities. Here's the deal: As I get older, I am going to probably be losing my teeth, and these securities are backed by the stream of income that I will be receiving from the tooth fairy. While there are some risks involved in this investment - do your own due diligence - S&P and Moody's have given a preliminary indications that they will be issuing a AAA rating for the first tranche of my TFBS.

Good infomation. Thanks.

AMC -- leaving aside loaded words, there is certainly some, umm, massaging of the data going on. The last time I bought a new car with a trade in (that would be in 1996, I've gotten a little less dumb in my old age), I negotiated a price of X for the car and then Y for the trade in. The contract the dealer drafted had the full sticker price of the car and a higher price for the trade in so the net was the same as what we had agreed to. I asked the dealer about that and was told something to the effect of, it looks better to the bank that way and you might get a better rate. I can see why it does. To use round numbers, if you had a $10,000 car (haha) and a $1000 trade in, your down payment is 10 percent. Add $3000 to both sides of that equation and the net cost is the same, but the downpayment or the "equity" becomes about 31 percent.

Seems to me the lenders ought to be able to figure out that all car buyers are not idiots paying full sticker, and all car dealers are not idiots paying $4K for rusty beaters running on three cylinders.

I agree - what you describe goes on in car dealerships all the time. And it has for ages. And the lenders (both banks and secondary investors) know that. And they have loss data that reflects that practice. And they still find it profitable to be in the car financing business (or, on the secondary market, they are freely deciding to invest in auto backed securities).

Are student loan backed securities 'fraudulent' because of the high number of primary obligors who don't have a job?

Some things are just part of the landscape of the lending sector.

That's all I'm saying.

What was different about the mortgage situation was that they private labels changed the landscape for MBSs. The underlying 'fraud' part of the business wasn't known - that the investment banks had set up client mortgage lenders, that there were no underwriting standards other than breathing, that the appraisals weren't just shaded higher, they were made-up numbers, that the rating agencies would rate a bucket of warm spit AAA, and the loans were rigged to not default until the private label issuers were in the clear of liability.

The buyers of those MBS securities had no idea that all the underpinnings of their assumptions were now false. That was real fraud, IMHO. Car dealers and lenders/secondary investors, in contrast, are engaging in a comfortable relationship of longstanding sharp practices, used one against the other.

Now, the way those loans have been repackaged, hedged, tranched, etc. - the conduct there may rise to the level of real fraud. But that is a Wall Street problem, not a car dealership level problem.

A couple of links - a rating agency interoffice e-mail saying they would rate a deal put together by a cow:


And, Tom The Dancing Bug (a comic) has a good explanation of how we got to this mortgage meltdown:


You crack me up AMC! Think I will purchase some insurance on that first tranche. Tooth fairy derivatives anyone?

What I see here on the ground is that people with sub-prime credit and on the wrong side of an upside down vehicle are funneled into that very scenario. My best friend is a prime example. His vehicle was conking out on him, so he goes to trade in the vehicle and is way upside down. The dealer tells him the only way we can get you into a vehicle (he was looking for a good used car at the time) with an upside down trade in is on a "Brand New" Truck.

From personal experience, I obtained a pre-approval from my local credit union for X amount. Well the wife and I found a good used Explorer for a decent price (Blue book checked). Well when we try to do the deal, the credit union would only lend the "loan value" which was like 3k less than the purchase price. Long story short we came up with the 3k. What we got from the dealer was that if we went through their lending companies we would not have to put anything down! Hello.... the NADA loan value does not change from lender to lender! "Their" lending companies were willing to take the risk apparently.

With Bankruptcy Reform and the 910 (scam! thanks vehicle lobby) lenders (& dealers) were free to take bigger risks for short term gain insulated from "cramdown". Although I have seen a few cases were debtors were "cramming down" the actual purchase price of the vehicle minus the deficiency. There was a brief "used primarily for work" loophole but I don't think anyone is using that anymore.

Patches - the nation owes you a debt of gratitude for creating a Trillion dollar industry to help get us through these troubled times: Credit Default Swaps on Tooth Fairy Backed Securities.

Hold on - AIG is on the phone, and they are HOT to get in on your idea....

If nothing else, your concept should help keep the local mom-and-pop acronym manufacturers in business.

Seems like the heart of the problem is the sustainability of the loan for consumers, which of course would only contribute to problems in bankruptcy. Investors in auto ABS have come to realize the impact of high LTV and extended term loans on defaults, espcially in the subprime tiers. Not only do underwater loans correlate to more repos and greater loss severity for the dealer, the poorly performing ABS dries up credit for future sales. According to Fitch, auto ABS defaults are the highest they've been in a decade.

Probably the only benefactors since the credit crunch are the buy here, pay here dealers that will fund anyone with a pulse. As credit deteriorates, people move further down the credit food chain. However, BHPH industry data has 1 in 4 of their loans going bad!

The model of churning high cost debt through the market only works when you have 1) funding to back it and 2) demand continually walking through your front door. As we've seen with mortgages, a shrunken secondary market and thousands of lost jobs will kill off both, leaving the model unable to stay in the black. So essentially, making neg equity loans that are not affordable or sustainable for the consumer is a chicken that comes home to roost for the dealer eventually.

BTW, I wonder if I could interest anyone in my idea for Easter Egg Backed Securities in case the Tooth Fairy thing falls through...

Always prudent to have a back up plan....

LOL! Great end to this day full of deadlines. (got my homework all done!)

Although Credit default swaps might be more the prudent choice in AMCs TFBS market due to finite resources of AMCs' teeth (and the potential for them to go bad), asset backed securities on Easter Eggs is the way to go. Heck, the Easter Bunny (like the government) "spits" them out on demand! How many teeth do you have left anyway AMC? It's cool I'm sure Moodys won't care.

In the Wall Street Journal, Todd Zywicki - a man whose level of perspicacity regarding the bankruptcy is well known, and speaks for itself - makes the interesting claim.

He states that the 910 car loan provision of his darling BAPCPA actually lowered the interest rate on auto loans - all by itself.


"In the first place, mortgage costs will rise. If bankruptcy judges can rewrite mortgage loans after they are made, it will increase the risk of mortgage lending at the time they are made. Increased risk increases the overall cost of lending, which in turn will require future borrowers to pay higher interest rates and upfront costs, such as higher down payments and points. This is illustrated by a recent example: In 2005, Congress eliminated the power of bankruptcy judges to modify auto loans. A recent staff report by the Federal Reserve Bank of New York estimated a 265 basis-point reduction on average in auto loan terms as a result of the reform."

Of course, he doesn't mention that the 910 car loan provision applies to car loans taken out after the effective date of the legislation while, in contrast, the mortgage modification bill does not apply to mortgages taken out after the effective date of the legislation. Anyone familiar with Mr. Zywicki's reputation knows he's not much of a detail man.... But my interest in his comment is: what study is this claimed reduction based on?

I kind of follow car loan interest rates and any ability to get a loan right now is problematic. But I don't think I've seen a 265 basis point reduction in auto loan interest rates. And I think I would have noticed. Any comments from CreditSlip-ers on this?

Zywicki focuses on the preservation of principal under BAPCPA but forgets that interest rates are still getting beat down hard under Till. This situation is far from "Christmas in July" for the auto lender when prime is dropping like a stone. Current Till rates (or at least the rates you can get without expensive litigation) are probably below some BHPH lenders' cost of funds. Query whether Till creates an incentive to INCREASE rates, especially for subprime borrowers who have less ability to price shop on the loan, to compensate for the risk of rate writedowns in bankruptcy.

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