Researchers Explain Why Subprime Loans Default

CAMBRIDGE, Mass. — A recent report from the National Bureau of Economic Research analyzed the trends of subprime auto defaults at a large U.S. financial institution.

The data taken into account during the analysis included applications and sales from June 2001 through December 2004. This information was combined with records of loan payments, defaults and recoveries through April 2006.

"This gives us information on the characteristics of potential customers, the terms of the consummated transactions and gives the resulting loan outcomes," officials indicated.

"We have additional data on the loan terms being offered at any given time as a function of credit score, and inventory data that allows us to observe the acquisition cost of each car, the amount spent to recondition it and the list price on the lot," they continued.

Overall, the researchers said there were more than 50,000 applications in the sample period. The average applicant was in his mid-30s with the monthly household income of $2,411.

"Just over one-third of applicants purchase a car," the writers reported. "The average buyer has a somewhat higher income and somewhat better credit characteristics than the average applicant. In particular, the company assigns each applicant a credit category, which we partition into high, medium and low risk. The applicant pool is 26 percent low risk and 29 percent high risk, while the corresponding percentages for the poof of buyers are 35 and 17.

Furthermore, the officials pointed out, "A typical car, and most are around three to five years old, costs around $6,000 to bring to the lot. The average sale price is just under $11,000 (negotiated price rather than list price). The average down payment is a bit less than $1,000, so after taxes and fees, the average loan size is similar to the sales price."

As many would suspect, researchers indicate that many purchasers would rather put down less of a down payment instead of more.

"Forty-four percent make exactly the minimum down payment, which varies with the buyer's credit category, but is typically between $400 and $1,000. Some buyers do make down payments that are substantially above the required minimum, but the number is small. Less than 10 percent of buyers make down payments that exceed the required down payment," according to the report.

Moreover, the paper discovered that more than 85 percent of the loans had an annual interest rate of more than 20 percent, with about half of the loans showing the state-mandated maximum APR. Researchers highlighted that the most states, according to the data, had a standard 30-percent cap.

"Our data ends before the last payments are due on some loans, but of the loans with uncensored payment periods, only 39 percent are repaid in full. Moreover, loans that do default tend to default quickly," the analyzers found.

In fact, they said, "Nearly half of the defaults occur before a quarter of the payments have been made, that is, within 10 months."

Another commonly known trend identified in the paper was the fact that demand for subprime auto loans tend to occur in a certain season, closely around the time tax rebates are released.

"Overall, demand is almost 50 percent higher during tax rebate season than during other parts of the year. This seasonal effect substantially varies with household income and with the number of dependents, closely mirroring the federal earned income tax credit schedule," officials said.

According to the report, applications are 23 percent more common in February than in other months, with the approval rate coming in at 40 percent, as opposed to 33 percent during the rest of the year.

"These seasonal patterns cannot be attributed to sales or other changes in the firm's offers. In fact, required down payments are almost $150 higher in February, averaging across applicants in our data, than in other months of the year," the paper said.

"Indeed, we initially thought these patterns indicated a data problem until the company pointed out that prospective buyers receive their tax rebates this time of year," officials mentioned.

Breaking it down further, the analysts discovered that households with monthly incomes below $1,500 and at least two dependents, meaning the rebate could be about $4,000, the number of applications doubles during February, with the number of purchases tripling.

On the other hand, for households with incomes above $3,500 and no dependents, meaning the rebate is likely zero, the number of applications and purchases shows no increase whatsoever.

"About 65 percent of February purchasers make a down payment above the required minimum, compared to 54 percent in the rest of the year," writers said. "Moreover, we estimate that after controlling for transaction characteristics, the desired down payment of a February buyer is about $300 higher than that of the average buyer. This is an enormous effect given that the average down payment is under $1,000.

"Second, we find that the demand is highly responsive to changes in minimum down payments. A $100 increase in the required down payment, holding car prices fixed, reduced demand by 7 percent. In contrast, generating the same reduction in demand requires an increase in car prices of close to $1,000."

The paper found that a $1,000 increase in loan size ramps up the rate of default by more than 16 percent.

"This alone provides a rationale for limiting loan sizes because the expected revenue from a loan is not monotonically increasing in the size of the loan. We find that borrowers who are observably at high risk of default are precisely the borrowers who desire the largest loans," the researchers described.

"The company we study assigns buyers into a small number of credit categories. We estimate that all else equal, a buyer in the worst category wants to borrow around $200 more than a buyer in the best category, and is more than twice more likely to default given equally sized loans," they pointed out.

The analysts found that risk-based pricing can only help a lender within "observably different risk groups."

"We also look for, and find, evidence of adverse selection within risk groups driven by unobservable characteristics. Specifically, we estimate that a buyer who pays an extra $1,000 down for unobservable reasons will be 8 percent less likely to default than one who does not given identical cars and equivalent loan liabilities," the writer explained.

Offering a word of caution, the paper highlights, "So, while there are limits to what we can conclude with data from a single lender, we think that our results highlight the empirical relevance of informational models of consumer credit markets."

Returning to the company at hand, the officials said, "Almost all buyers finance a large fraction of their purchase with a loan that extends over a period of several years. What makes the company an unusual window into consumer borrowing is its customer population."

More specifically, the customers are generally low-income workers, and most are subprime borrowers. Fewer than half of the company's applicants display a FICO score above 500, the paper noted.

Furthermore, given the low credit quality of many of the applicants, researchers indicated that the company has invested heavily in proprietary credit-scoring technology.

Turning to another fact, researchers wrote, "Within credit category, buyers who have higher incomes, have bank accounts, do not live with their parents and have higher raw credit scores are all less likely to default. However, the fact that these characteristics predict default and are not directly priced does not necessarily imply a serious adverse selection problem in financing choices.

"For example, buyers who live with their parents tend to make larger down payments, but have a greater likelihood of default later on," they indicated.

Editor's Note: The report goes into much more detail, including mathematical equations and other conclusions. For the link to access the paper, e-mail Jennifer Reed at [email protected].

TODAY'S TOP REMARKETING NEWS HEADLINES