Negative equity on car loans is an economic threat

Financial markets, especially the bond market, calmed down as last week ended — allowing participants a much-welcomed rest. It wasn’t that there weren’t things to worry about, though.

One worry is, or should be, about personal debt. This has naturally received less attention than the public debts run up by our federal, state, and municipal governments. Neither personal nor household debt directly appear in the bond market so there is not the same cause-effect visible in bond prices, of course, but that doesn’t mean that their impact on the economy isn’t important.

One example of worrisome personal debt is the deterioration of the credit dimension of the automobile industry. Based on information from the Edmunds car-shopping information firm, one-third of owners who trade in their cars and buy new ones have negative equity in the car they turn in. They owe more money than the vehicle it is worth. A finance company steps in and makes up the difference, though, and the customer drives off with a new car.

The response of the automobile dealerships, then, has been to fold the negative equity into a new, larger new car loan, making everybody happy. The customer is happy to be driving a new car. The dealer is happy because, as Edmunds notes, automobile dealerships make more money being the middleman on loans than they do selling the car. Only one person is unhappy: the economist who looks at what is happening and finds it worrisome.

What’s the worry? The automobile industry is beginning to take on some of the characteristics of the housing industry in its build-up to financial disaster. It is a variation in a minor key at this point but still risky for our economy.

One of the lessons we apparently didn’t learn from the home mortgage collapse is that you can’t build sound industry growth on a foundation of shaky loans. Lending money to people who can’t pay it back always leads to unhappiness. If it is done on a large scale the unhappiness can precipitate a disaster as it did in the Wall Street collapse of 2007-2008.

An automobile is a complicated mechanism and so is its economics. The purchase of an automobile is part rational to meet a real need, and part other variables such as price of the new car as well as turn-in, loan interest rate and availability, mechanical reliability of the existing vehicle, and design.

The economic setting is also significant, but with its own set of complexities. The negative equity problem in automobiles, for example, has its origins in the Great Recession, especially, of course, the increase in unemployment that made monthly payments difficult to maintain. What is surprising, though, is that the percent of underwater automobile loans continued to rise as the economy slowly recovered. In fact, it remains at record high levels even after the economic rebound.

Part of the underlying cause is embedded in the mathematics of the car sales system. Two math factors stack the deck against consumers in the weakest financial positions.

The first factor is the increasing price of automobiles and the increasing cost of automobile repair and maintenance as well as the increasing complexity of the care itself. What was once a simple matter that even a do-it-yourself (DIY) owner could handle is now often an expensive procedure by a skilled mechanic. These price increases push the vehicle replacement need earlier and earlier, and that, through the second factor, tends to reduce the owner’s equity.

The second factor is the basic mathematics of an installment loan. The early payments go mostly toward interest; only the tiniest amount of loan principal is reduced. This is true whether the loan is for a car, a house, an appliance, or anything else. It is simply in the math of the loan payoff curve.

Pushing a borrower to refinance earlier and earlier in an automobile loan time span, then, puts the buyers perpetually on the wrong end of the loan principal reduction curve, reducing the chance for the owner to accumulate any equity in the automobile. This problem only worsens with longer loan time spans, which now average over 80 months for many underwater buyers. The consumer’s first bad decision has grown into an almost inescapable financial snare.

Should we do something about this situation before it bursts its bubble? Probably, from an economic standpoint. The Federal Reserve once regulated installment loans and perhaps it would be worthwhile reexamining that course when unwise lending is a threat to our overall economy. Regulating and rationalizing that market, though, would have a slowdown impact on the automobile industry and its jobs, though, and that is a separate, complicated economic policy issue and a story in its own right.