Want to see the next financial crisis? Look in your neighbor’s garage.

Is the 2008 subprime home loan crisis set to repeat itself, but this time in the auto loan industry?

Throughout January, Michelle's substack will feature short essays on under-reported issues that could significantly impact Canadians in 2023 and beyond. This is the first article in this series.

There's a moment in The Big Short - a 2015 movie about the leadup to the 2008 financial crisis - where Steve Carrell's character realizes that the American housing and home loan market was epically screwed. 

In the film, Carrell plays an equity analyst for a unit of a major American financial services company. In the months before the 2008 subprime loan market collapse, Carrell's moment of full realization that poop is about to hit the fan happens when talking to an exotic dancer who confesses to holding adjustable rate mortgages on five houses and a condo, with multiple mortgages on each.

Recently, I'm becoming more convinced that the government needs a Steve Carell-esque "stripper moment of sobriety," but this time, with the auto loan industry.

The first time I felt something was seriously amiss came in early 2021. To make a long story short, I got an offer to buy my then-six-year-old Jeep Cherokee for nearly what I paid when it was brand new. It struck me as odd that a vehicle of that age would command that price.

At about the same time, we started looking for a replacement for my husband's vehicle. The offer on my Jeep started to make more sense as the lack of vehicle inventory - both new and used - became apparent. An auto parts shortage that began in 2020 saw auto manufacturers ship 8 million fewer vehicles than anticipated. Unfortunately, the lack of vehicle inventory occurred at the same time that both the Canadian and American governments were pumping massive amounts of pandemic stimulus directly into the hands of consumers. 

The result: a massive spike in prices for both new and used automobiles. 

As of September 2022, the average price of a new car in the United States nearly hit a record $50,000, up almost $5000 from the year prior and much more from 2019 levels. Figures are roughly the same for Canada.

Spending $50,000 on a car when housing costs eat big chunks of Canadian incomes is unrealistic for most. So why and how are people still buying brand-new cars and trucks?

The why of the matter is common sense. 

In Canada, vehicles aren't luxuries; they're necessities. Canada is a country that needs better-designed public transit to get people to where they need to go. Increases in housing costs have created longer commutes as people flee expensive urban centres to increasingly remote suburbs. It's brutally cold most of the year, and even when it's warm out, our suburban communities weren't designed to be walkable. People living in rural communities have it even worse.

The last two years have also seen gas and diesel prices spike, partly due to nearly a decade of policies designed to push people into electric vehicles (EVs). However, little thought was given by government to making EVs available and affordable before implementing these policies. Over the past two years, an extreme shortage of these vehicles has occurred just as demand for them has increased, and their prices have spiked to unaffordable levels.

Regarding how people were managing to afford loans on these vehicles, I asked a car salesman. 

His response, while anecdotal, scared the bejeezus out of me.

Auto-loan lenders knowingly give easy, enormous amounts of credit to people who probably can't afford it. And they're doing that for overvalued assets that quickly depreciate, using sketchy loan instruments that the government has yet to curtail. They can do this because stress testing - government requirements designed to make lenders confirm that people can afford a loan - doesn't really exist in the auto loans industry. A lot of different players in the sales and lending industries make their living this way.

My contact described the example of one of his customers to illustrate.

Most people in the market for a vehicle today still owe money on their current vehicle, and his customer was no exception. The engine on the man's current vehicle had given out, and the appraised value of that vehicle came in at $2500. However, the man still owed $13,000 on loan for it. The formal term used to describe this situation is negative equity, more commonly referred to as being "upside down" or "underwater" on an auto loan.

Despite this, a new lender approved this man for a new vehicle loan totaling $38,000. The man also had average credit and a high debt-to-income ratio and, as mentioned, already held $13,000 of outstanding debt on a vehicle now only worth $2500. After signing this new loan, the man now has two payments, one of which is on an asset whose costs can't be recovered.

The salesman said he’d seen lenders leverage up to 140%-160% of a vehicle's manufacturer's suggested retail price (MSRP) on their loan valuations. This scenario makes trade-ins where a customer is upside-down on a loan possible; lenders green-light new loans for individuals who have negative equity on existing vehicle debt.

This circumstance comes on top of another concern about the auto loan industry that has existed for years: the length of the loan term. While longer-term loans allow for a more affordable monthly payment on a higher priced vehicle, if it is financed over a period that is longer than it can retain a value higher than the amount outstanding on the loan, the consumer is underwater.

After describing the situation, the salesman concluded that the consumer unsustainability of these measures alone could lead to a wave of auto loan defaults and repossessions.

But other factors could make things even worse.

First, the value of used vehicles, which many analysts suggest are overvalued, risks collapse. What happens if/when auto part supplies stabilize and more supply comes onto the market? A vehicle leveraged on loan at 160% of MSRP upon resale would be classified as used and wouldn't be worth close to that any longer. Recent reports suggest this collapse is already happening at a rapid pace.

The second problem lies with auto sales demand forecasts that should have considered the rapid rise of interest rates. For example, a year ago, interest rates for loans on used cars were somewhere in the neighborhood of 4%. Today, it's around 8%. Before these rate increases, forecasts suggested there was pent-up demand for new vehicles among people who have a functioning vehicle but have been wanting to upgrade but have been unable to purchase a new vehicle due to the inventory shortage. However, that analysis failed to take into consideration that demand for upgrades is more price-elastic than the demand driven by those who don't have a functioning vehicle at all. Moreover, the rapid interest rate rises that North American markets have experienced in recent months, combined with rampant inflation on the necessities of life, has likely cooled some of this more elastic demand, which in turn could cause a reduction in prices if inventory levels stabilize.

The third problem is one of new regulations. The Canadian federal government announced an electric vehicle sales mandate that starts in 2026. The government has imposed this mandate with virtually no consideration for valuing this new externality in the context of the current frothiness in the used car market, which primarily consists of gas-powered vehicles. The question the federal government should now ask is what will happen to the value of gas-powered vehicles currently owned by Canadians trapped in high-interest, long-term loans? How much, and importantly, how, will they offload their gas-powered vehicles under these circumstances? What will the impact on the economy be?

And playing the scenario out even further, if repossessions do rise, then the used car market could be further depressed by increases in used, repossessed, primarily gas-powered vehicles coming onto the market. Data shows this trend is already underway in Canada, with auto loan delinquency rates hitting record levels in Q3 of 2022.

The car salesman had given me anecdotal information, so I searched for publicly available data to verify his claims. Despite disparate reports suggesting that what he said was true, I was struck by the lack of publicly available data on the extent of risk exposure that Canadian consumers and lending institutions have to the rapidly increasing volatile nature of the auto industry. I also found the financial conditions under which lending institutions are issuing auto loans and to who is opaque. As a legislator, this is enough to raise alarm bells for me.

The macro-level questions that the federal government should now be asking is how likely a potential collapse is and to what extent the economic fallout would be. The automotive industry significantly impacts the Canadian economy, be it in manufacturing, sales, service, or finance. It also has an inordinate impact on the health of consumer finance.

Suppose analysis shows that this scenario exposes Canada to high levels of economic risk anywhere in the neighborhood of the 2008 financial crisis. In that case, the government should immediately take measures to prevent calamity, and pleading from lenders for government bailouts after the house of cards folds. Unlike in 2008, the federal government has very little wherewithal left to cushion the economy from a major blow, and very little moral imperative to do so for foreseeable risks. At the very least, an urgent study of what's going on is warranted.

In 2023, the last thing the Canadian economy needs is to be further driven off a cliff. My worry is that the auto loan industry, and many Canadian consumers, are already dangling there with little being done to pull them back.