Zachary Barker

With traditional bond markets tight, investors have injected increasingly huge sums of money into the subprime auto bond market. The increase in demand for subprime auto bonds has in turn driven up demand for subprime auto loans, to a level which many observers worry is looking more and more like a bubble. In the period between 2009 and 2014 alone, subprime auto loans – loans to people with credit scores worse than 640 – increased by more than 130 percent.

Unlike mortgages, subprime auto loans are made against depreciating assets. The loans, usually originated by auto dealerships and then securitized by a financial intermediary, are often for used cars and are offered to people with meager incomes and poor credit histories. With a high risk of default and none of the creditor protection that an appreciating underlying asset would offer, subprime auto loans are instead made profitable by interest rates that can exceed 29 percent. Although defaults and repossessions are built into many auto lenders’ business model – one lender expects to repossess at least 35 percent of the cars it finances – Wall Street’s ever-growing demand for subprime auto loans has convinced lenders to drop their lending standards precipitously, with “some who fabricate or ignore borrowers’ abilities to repay” altogether. These factors have combined to make a market that critics say is eerily reminiscent of the pre-Recession U.S. housing market.

Usury Exemptions for High Interest Auto Loans

The growth of the subprime auto lending market has alarmed consumer welfare advocates who believe that, under most states’ lending laws, these high interest loans would be usurious. In New York, for example, the civil usury rate is 16 percent per annum, a rate lower than the average interest rate on a subprime loan for a used car.

Subprime auto loans are able to survive challenges under state usury laws, however, because these loans are structured not as typical lending agreements but as retail installment contracts(RICs). A RIC, which essentially functions as a sale on credit or a “rent-to-own” agreement between the seller and purchaser of a used car, is exempt from usury laws in nearly every state. New York’s Motor Vehicle Retail Installment Sales Act (MVRISA), for example, calls the time value of a given sale under a RIC as a credit service charge (CSC) rather than as interest, and allows the CSC to be set at a rate “agreed to by the retail seller and the buyer.” Courts in New York recognize the continuing effectiveness of the MVRISA, refusing to void high interest RICs, on the grounds that they are not usurious.

Like many similar state provisions, New York’s MVRISA was originally passed in 1956, in a spirit of reform. With outstanding installment debt ballooning for consumers and more goods being sold in installments in the years after the Second World War, the MVRISA and similar legislation in other states were meant to provide for the disclosure of material information, standardization of contract terms, and increased consumer protection from unfair business practices. The legal effect of the MVRISA would change radically in the decades after its passage, however. In a story repeated in many states following the Supreme Court’s 1978 decision in Marquette Nat. Bank of Minneapolis v. First of Omaha Serv. Corp. (which held that, under the National Banking Act, loans were subject to the usury laws of the home state of the lender, not where the loan originated), New York amended the MVRISA in 1980 to permit any CSC agreed to by the buyer and seller. This was, in critics’ view, part of a “race to the bottom” in which states competed to eliminate caps on interest rates to prevent lenders from relocating elsewhere.

The Risks of an Unregulated Auto Loan Market

For advocates of these financing vehicles, the uncapped usury rates on subprime auto loans serve an ugly but necessary role for credit markets. Without the promise of high interest payments, lenders would be unwilling to serve borrowers with unreliable credit histories, who would then be unable to buy cars vital to their livelihood. Likewise, many economists have argued that the subprime auto lending market is healthier than its strongest critics would suggest, and that fears of a new subprime bubble in the auto market are largely overstated.

Even if high interest RICs are legal, they present a major risk for market health. The protections for creditors  that were originally written into the MVRISA and similar state retail installment statutes were oftentimes written with the assumption that these creditors would have no access to financing, and thus bore more risk than traditional lenders. Presently, however, RICs are treated by sellers and lenders as “indirect” loans. In an indirect loan, a traditional bank provides the terms and financing to an auto dealer, who in turn presents those terms to their customers as a RIC. Once the RIC has been signed and the car has been sold, the auto dealer assigns the income stream from the RIC to the bank, who then securitizes that income for bond investors. These arrangements allow banks to skirt interest caps, circumventing the policy behind state usury laws  and exposing increasing numbers of investors to subprime risk.

There is a human cost to unregulated subprime auto loans as well. Access to a car is, of course, necessary for most peoples’ livelihoods, especially for those with tenuous employment, who are the most likely to take out a subprime auto loan. Such buyers rarely have the leverage needed to negotiate fair interest rates and more vulnerable to unscrupulous business practices, exactly the sort of situation that usury laws were originally meant to prevent. As the auto enthusiast blog Jalopnik has detailed in a series of articles, subprime auto loans have had devastating financial effects on the people who accept them, with many people paying well over the value of a new car on their loans or continuing to make payments on cars that have long since been repossessed or lost. The New York Times notes that many subprime auto borrowers have been forced into bankruptcy as a result of their loans. The high default rate on these loans is a major strain on many state court systems and threatens the health of the bond securities composed of these loans.

Current Developments and Reform Efforts

As a result, consumer welfare groups and state agencies would be wise to bring subprime auto loans back under the protections of state usury laws. At least one critic has urged courts to apply usury laws to RICs by treating them as loans on a holistic level, “rather than merely by the name or form which the parties have given it.” The New York Attorney General’s office has taken action in this regard and has sued subprime auto lenders, for “deceptive financing and sales practices.” A recent decision by the Second Circuit, Madden v. Midland Funding, LLC, has the potential to limit the Supreme Court’s holding in Marquette to chartered national banks only, potentially re-exposing many non-bank lenders to usury liability. Still others have sought legislative reform, with several New York state senators urging a reform of the MVRISA to make usury laws effective against auto dealerships.