In praise of subprime auto loans

We've another one of those laments, over at the Guardian, for the way in which the financial markets deliver financing to people who are poor. Apparently this is very bad, allowing poor people to finance capital expenditures in the same manner that we richer people are able to. You know, how nefarious Wall Street must be if it lets the poor, we mean really, poor people!, buy a car.

Many people are buying those cars with they help of Wall Street banks, which are lending money to people with bad credit again – just as they did prior to the financial crisis of 2007. In the last crisis, it was houses.

The $26bn worth of subprime car loans is far short of the $500bn of subprime real estate securitization in 2006, at the top of the housing bubble, partly because cars are a lot cheaper than houses.

This time, like last time, Wall Street isn’t directly lending poor people money. That part is done by an array of smaller financial companies in strip malls and office parks.

The smaller financial companies sell the loans to Wall Street. Wall Street puts them into big piles, sorts them from weakest to strongest credit scores, and then sells the pieces and parts of them to their customers. The customers can be hedge funds in Greenwich, Connecticut, or other banks. No part of the loan goes unsold: from the highest rates to the lowest-rated, buyers are always there.

This process is called subprime securitization, and about $26bn of it will be done this year in auto loans to poor people.

This is, according to the author, just terrible. And of course the reality is that it's just wonderful.People who would not be able to afford a car can now do so: this enables them to get to work, to the shops, and thus makes them less poor. And the miracle here is that securitisation, the securitisation that distributes the risk.

Now it is possible, of course, to associate this subprime securitisation with what happened with subprime mortgage securitisation and thus wonder whether there's going to be a replay of 2008. But there won't be for two reasons. The first being that there's just not enough of these auto loans to cause anything like a systemic crisis.

The second is that it wasn't securitisation, nor subprime, that caused the problem last time around. It was fractional reserve banking: more specifically, that the slices and dices of these loans were on the books of banks who were leveraged in their holdings of them. So, when the value of the loans slid the banks became illiquid and possibly insolvent. If those same slices and dices had been in non-leveraged hands, pension and or insurance funds for example, then there wouldn't actually have been those runs on those banks.

So, all we're left with here with these subprime auto loans and their securitisation is that poor people get to buy cars more cheaply than they would without that spreading of the risk. And maybe The Guardian thinks that's terrible but the rest of us should regard it as a pretty good idea. We are, after all, the people who are pro-poor, aren't we?

Don't kill off the only industry that provides loans for low-earners

Wonga’s decision to write off £220m worth of debt for 330,000 customers and “voluntarily” embrace new regulations will been seen by many as a form of social justice and an obvious defeat for the big, bad, payday-lending wolf. Unfortunately, the Financial Conduct Authority’s attempt to further regulate the payday lending sector may end up harming low-income earners in need of a loan.

But first, we must distinguish between the payday lending industry and Wonga as a specific organization within that industry. Payday lenders offer customers quick and easy access to short-term cash flow. Though anyone with any income size could apply to Wonga for a loan, it is mostly used by people with low-incomes, as such earners struggle to get bank loans and credit cards, and payday loans are often cheaper than using an unauthorized overdraft.

Of course, there are risks associated with payday lending, as “companies are loaning to high-risk demographics, with usually low-income averages and bad credit scores."* In order to stay profitable and protect themselves from bankruptcy, payday lending companies must factor defaults into their interest rates.

These interest rates –especially Wonga’s interest rates – tend to be the target of myths constructed by opponents of payday lending, who are either accidentally or intentionally analyzing the data badly. Most notably, critics attack Wonga for charging its customers close to an astronomical 6,000% interest rate.

That figure, however, comes from a legal quirk in British financial regulations that requires every business to express their interest rates as an annual rate. Wonga’s payday loan interest payments are capped at sixty days, so there is no scenario where anyone could come close to paying Wonga nearly 6,000% APR, as the company is forced to express as it’s annual rate.

Some of the criticisms leveled specifically at Wonga do have merit – indeed, their fake legal letter scandal from this past summer - which threatened customers with legal action if loans weren’t repaid - left everyone feeling uncomfortable with the industry.

Such behavior from any company is unethical, to say the least, and should be met with repercussions. But the FCA’s decision to crackdown on all payday lenders as a result of Wonga's actions will drive almost all payday lenders out of business and leave Wonga to dominate the industry.

From today it has introduced new lending criteria to improve its decisions. That means it will be lending to fewer people and it is unlikely to be the only firm forced to do that, as the FCA said today: "This should put the rest of the industry on notice.

This new lending criteria, coupled with previous regulation tightening – bans on payday advertising in public spaces – and future proposed regulations – like a mandatory cap on costs for all short-term loans – reduces the entire industry’s profitability and forces smaller companies, that would otherwise compete with Wonga, out of the market.

Furthermore, other indirect financial regulations continue to ensure Wonga’s dominance in the loan market. Credit unions could become competitive payday lenders and compete with companies like Wonga, but their interest cap of 3% a month prevents them from properly competing in the market.

Yes, Wonga is facing a 53% fall in annual profits partly as a result of new controls set by the FCA, but other payday lender companies, that don’t have the ethically questionable history of Wonga, are looking to be cut out of the market all together.

Critics of payday loans will be overjoyed to hear that the payday lending industry is on the rocks, but those who actually use its services and benefit from the loans should be worried. Banks and credit card companies have priced these customers out of accessing loans, and with with less payday lenders offering their services to people with low incomes, a lot of people will find themselves with no options, no loan, and no way to pay rent.

While payday lenders are by no means the perfect system to deliver loans to low-income customers, they are currently the only realistic way for such people to get their hands on necessary loans.

*This gal.