Subprime Resurgence

I once had a very philosophical discussion with a McDonald’s employee that is oddly appropriate to today’s post. 

Way back when, McDonald’s offered a special deal on its cheeseburgers. On Wednesdays, cheeseburgers were $0.59, instead of their usual $0.89. My problem is that I don’t like McDonald’s cheeseburgers. I do, however, love McDonald’s hamburgers. 

So I went into a McDonald’s on a Wednesday and tried to order cheeseburgers, but without the cheese. Hamburgers cost $0.79 and I could save $0.20 per burger if I could order cheeseburgers without the cheese. I figured I was even doing McDonald’s a favor because they were saving money by not putting cheese on the cheeseburger. Alas, the clerk wouldn’t take the order. What followed was a discusion — not an argument — about what happens when a slice of cheese touches a hamburger. According to McDonald’s, once it’s a cheeseburger, it’s a cheeseburger forever. 

Equifax recently announced that lenders are originating more loans, especially auto loans and new credit cards, to subprime borrowers. The news was generally well received as yet another sign that the economy is improving and banks are willing to disperse capital to consumers, especially ones with less-than-perfect credit. 

Auto loan originations were up 9% and hit their highest level since 2007, the year before the economy cratered. As well, delinquency rates are back down to pre-recession levels, according to Equifax. 

What I’d like to know is the composition of those subprime borrowers. It’s my hypothesis that subprime borrowers can be grouped into two buckets. Long-term subprime borrowers, who had less-than-perfect credit prior to the economic downturn, and short-term subprime borrowers, whose credit scores fell because of the recession. 

I wonder whether it’s the short-term subprime borrowers, who maybe now have a new job and are slowly getting back on their feet but whose credit scores are still lagging, are receiving the lion’s share of those new originations. Subprime lending has always been a “story” industry, where a credit score usually requires an explanation (lost job, medical emergency, divorce, etc.). Is it that the new stories are compelling? Or just that the floodgates are open again in auto finance?

If anyone has learned anything in finance, it’s that the cycle is pretty much unbreakable. The spigot of credit will get turned on and turned up higher and higher until it causes another economic crisis. The only way we’ll know what the industry learned from the economic crisis is if there isn’t another economic crisis.