The end of seven years of easy-money Federal Reserve policies may derail a U.S. auto boom fueled by cheap debt, a group of economists said in a recent report. One of the researchers is warning it could also push lenders into making even riskier loans in order to keep cars moving off dealer lots.
If the Fed were to raise interest rates by 1 percentage point, the higher borrowing costs would crimp demand, shrink production and trigger a decline in prices, according to George Hall, chairman of the economics department at Brandeis University in Waltham, Massachusetts, and one of three researchers who modeled how the booming U.S. auto industry would fare under such a rate increase. Lenders may respond by lengthening loan maturities, putting even more pressure on borrowers with weak credit, Hall said.
"Sales are going to fall, production is going to fall, and prices are going to have to fall," Hall said. Consumers will probably hold onto their current cars for longer, he said, resulting in tighter competition among lenders.
In the rate-rise scenario modeled by the economists, car manufacturers would may have to lower production by 12 percent, resulting in a short-term annual sales decline of 3.25 percent, according to Hall, Adam Copeland, a research officer at the Federal Reserve Bank of New York, and Louis Maccini, a professor emeritus at Johns Hopkins University, who co-published their findings last month.
Cheap funding and pent-up demand have accelerated sales in recent years. New cars and light trucks, which comprise almost a quarter of U.S. durable-goods expenditures, are on track to have the best year since 2006, boosting car-makers' profit margins also toward record highs.
That's occurred as more Americans finance their purchases. U.S. consumers took out $101 billion in car loans over the 12 months through June, outstripping the pace of growth for other kinds of consumer debt, including mortgages, recent Federal Reserve data show.
Were borrowing rates to rise one percentage point, car manufacturers could respond by lowering production by 12 percent, or 170,000 cars, leading to a short-term annual sales decline of 3.25 percent, according to Brandeis's Hall, Adam Copeland, a research officer at the U.S. Federal Reserve Bank of New York, and Louis Maccini, a professor emeritus at Johns Hopkins University, who published their findings last month.
"When borrowers see rates falling, they refinance and they look for longer terms, but when rates rise, borrowers are also willing to lengthen their terms," Hall said.
Loan lengths are already a concern among investors in bonds backed by auto debt, who are especially worried about the increase in subprime borrowers, a growing percentage of whom buy used vehicles, according to Wells Fargo data. This comes as the rejection rate for new car loan applicants falls to a record low 3.3 percent, according to the New York Fed. That increases the risk that some buyers will have loan balances that are more than their vehicles are worth.
Bond researchers have noted this issue, and they point out that auto finance companies have been extending loan maturities even as rates have remained at historic lows. This has been a byproduct of steep competition leading some lenders to accept more risk.
"Investors in those bonds are well aware of consumer behavior," according to Kevin Tynan, a Bloomberg Intelligence automobiles analyst. "To think the consumer isn't going to take that longer loan is silly. It's all about the monthly payment. They'll do whatever they can do to get that payment under their monthly budget. That is how we buy cars in the U.S."