How Wall Street quietly profits from expensive car loans

Wall Street has found another way to cash in on the financial struggles of Americans: subprime auto bonds.

The combination of higher interest rates and elevated prices has made cars much less affordable today, but that hasn’t stopped consumers from taking out expensive car loans they can barely afford.

Though a burden for borrowers, subprime loans can turn into a lucrative investment when packaged into an asset-backed bond—a lesser-known process called securitization.

Think of it as a bond ETF, except that it comprises car loans issued to average Joes who can hardly repay them.

As Bloomberg reports, subprime auto loans backed $37 billion of bonds in 2022 and more than $45 billion the year before. That’s more than twice the value of a decade prior.

A prime example of these bonds is Drive 2019-3, a giant pool of 75,375 auto loans assembled by the U.S. arm of Banco Santander. Even if one or several thousand of these subprime borrowers couldn’t repay their loans, investors would still make a killing.

That’s because subprime borrowers pay much higher interest and fees than other borrowers. As CreditNews reported in October, subprime borrowers pay an average rate of 11.53% for new cars and 18.55% for used vehicles.

But the loans packaged in these subprime bonds can charge even higher interest, allowing investors to pad their pockets before borrowers start to buckle.

In the case of Drive 2019-3, Santander estimated that a staggering 42% of borrowers would fail to repay their loans in full. The bank fully expected that thousands would ultimately default. Even with these eye-watering numbers, Drive 2019-3 generated market-beating returns.

The subprime auto loan market is clearly working for investors. Not so much for the consumer.

Auto payments hit record high

Regardless of their credit scores, Americans are on the hook for record auto loan payments each month.

According to Edmunds, an auto industry research company, the average monthly payment reached $736 in the third quarter, with nearly one in five Americans paying at least $1,000.

“Spiked interest rates remain the biggest impediment to affordability in both the new and used car markets today,” said Jessica Caldwell, Edmunds’ head of insights.

With payments and interest rates peaking, auto delinquencies are also rising. According to Cox Automotive, the number of Americans at least 60 days behind on their payments rose in September for a fifth consecutive month and was up 13.3% compared to a year ago.

While defaults were down by nearly 10% compared to August, they were up a staggering 32% year-over-year.

Cash-strapped Americans are drowning in debt

When it comes to consumer credit, auto loans are just the tip of the iceberg.

Earlier this week, the New York Fed reported that household debt rose 1.3% to $17.29 trillion in the third quarter, a new all-time high. Credit card balances also set fresh records, climbing from $1.03 trillion to $1.08 trillion.

It’s estimated that one in four Americans goes deeper into credit card debt each month just to afford basic necessities like food, rent, and utilities.

At the same time, pay gains are slowing and disposable income after inflation and taxes have declined for three consecutive months, according to the Bureau of Economic Analysis.