Bankruptcy

The Other Underwater Loans: Negative Equity in Auto Finance

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 a weak(er) 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. 

Full post as published by Credit Slips on February 12, 2009 (boomark / email).