Subprime and High-Risk Consumer Debt

With more than half of American consumers classified as having subprime credit scores, it is no surprise that subprime lending is once again on the rise. Making expensive loans to the underemployed and overextended may help fuel economic growth; however, it is neither just nor sustainable.

Dependence on higher-risk subprime loans to boost spending seems to be a symptom of larger problems––low wages and income volatility. With nearly all Americans, other than the ultra-wealthy living paycheck to paycheck, families have too little savings, if any, to cushion downturns. It is a paradox.

Taking on more debt becomes necessary to afford essentials (such as a reliable car to drive to work), and increased private sector spending supports job creation, yet heavy debt coupled with unreliable income puts consumers and thus society at greater risk of insolvency.

Even if the lenders themselves can charge high enough rates to make up for the delinquencies and defaults without failing, most families cannot avoid painful losses should they fall behind. Making subprime loans less predatory and more affordable (and thus less likely to cause defaults) is only one part of the solution.

Unlike the toxic home loans that led to the 2008 global financial crisis, the recent return of subprime is not in residential mortgages, but instead in auto, credit card, and personal loans. Approximately 40 percent of these types of loans that were made in 2014 were subprime. This time is not so different, however. The pressure to make loans regardless of a borrower’s ability to pay is all too familiar. Given the attractive price that banks, private equity firms, and other financial institutions can pay for higher-yielding subprime loans, lenders who interact with consumers have incentives to engage in predatory, abusive, risky, and sometimes unlawful behavior to produce them. Of notable concern is the increasing investor appetite for bonds backed by pools of subprime auto loans.

This demand drives volume, and the quest for volume may be pushing loan originators deeper into the credit pool, encouraging fraudulent auto loan applications, and fostering other questionable underwriting practices and loan structures.

Fortunately, as advocates and the media shine light on these and other shady activities, industry is showing discipline, and federal and state regulators are taking action. Perhaps these steps can help avert unnecessary suffering and systemic risk while preserving access to fairly priced credit for low- and middle-income Americans. Meanwhile, arguably, higher wages and greater government spending for higher education and health care (which would lower business and household costs) would better strengthen the economy than continued dependence on maxed-out consumers.

Subprime consumer loans are those made to borrowers with credit scores below 640 (or 660, according to some lenders’ guidelines) out of 850. Law scholars Teresa Sullivan, Elizabeth Warren, and Jay Lawrence Westbrook characterized subprime lending in their 2000 book, The Fragile Middle Class: Americans in Debt, as “granting credit specifically to people who are living on the edge.” The authors explained that the “large new niche in the credit business” was “one much applauded on Wall Street” because it paid “such high returns that big profits still remain even after the defaults and bankruptcies are subtracted.”

Their words were prescient. As we witnessed in the run-up to the mortgage crisis, lenders bundled risky (often subprime) loans, transforming them assembly-line style into securities that were resold to investors. Selling riskier home mortgages to Wall Street earned loan originators more income than the traditional thirty-year, fixed-rate mortgage would.

As law scholars Kathleen Engel and Patricia McCoy documented in their 2011 book, The Subprime Virus: Reckless Credit, Regulatory Failure, and Next Steps, the subprime lending market started out as a “pocket of the U.S. home loan market” but later “mutated like a virus into a crisis of global proportions.” Motivated by outsized profits, “the various actors in the subprime food chain [became] ever more brazen and, with each passing year, subprime crowded out safe, prime loans, putting homeowners at risk of losing their homes and ultimately pushing the entire world economy to the edge of the cliff.”

The promise of big profits from subprime lending — at least in the short run — is just as enticing today. With regulations tighter on home mortgages, investors are seeking other subprime opportunities. Whereas in 2007, subprime comprised 20 percent of home mortgage loans originated, it accounts for less than 1 percent today. As noted above, in 2014, it accounted for more than 40 percent of non-residential consumer loans made. As the Wall Street Journal reported in June 2014, “At a time when many other revenue engines are sputtering, subprime borrowers are especially attractive to banks because they tend to pay higher interest rates and generate more revenue as long as they don’t stop making their minimum required payments.”

Subprime loans can also benefit consumers, to the extent they are offered at fair rates, and they actually have the means to pay them back. These loans also boost certain sectors of the economy, as they facilitate the purchase of vehicles and other consumer goods and services. Without access to this type of credit, consumers might resort to even more expensive, and sometimes dangerous, fringe sources of funding such as exploitative payday loans or illegal loan sharks.

As Benjamin Lawsky, superintendent of the New York State Department of Financial Services, explained, “We don’t want to totally disrupt the market and create a problem where people can’t get credit.” Similarly, economics professor Lawrence White acknowledged that although “not all subprime loans are inappropriate … no lender should put a borrower into a loan he or she can ill-afford.” And therein lies the problem. Given current incentives, and borrower profiles, some lenders appear to be doing just that.

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