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Subprime Loans Are Back!

And believe it or not, that’s a good thing.

Five years after the worst of the financial crisis, subprime loans are creeping back, this time primarily in the form of auto loans. As U.S. auto sales have surged, credit standards have moved lower, with more than a quarter of all auto financing now classified as subprime. That amounted to more than $100 billion last year and has continued through the first eight months of 2014.

Just as subprime mortgages were sliced, diced, and packaged (that is, “securitized”) in the mid-2000s, so too are today’s subprime auto loans. It seems like the same dangers of poor-quality loans repackaged as securities are creeping back, with nearly $15 billion worth sold so far this year.

Seems like, but is not. The searing experience of recent years has made us toss the baby with its subprime bathwater. Far from representing the kindling for new crisis, subprime loans serve a vital need, as they always did. We need not less of them but more—alongside far greater transparency and accountability.

Widely perceived as a central cause of the 2008–’09 financial crisis, subprime loans carry considerable negative baggage, which is why the recent rise in subprime auto loans has attracted attention. The Consumer Financial Protection Bureau is contemplating substantially increasing its reach and bringing auto loan issuers under its regulatory envelope. Federal prosecutors have subpoenaed units of GM Financial to assess whether or not subprime loans are being improperly packaged as securities and sold as higher-rated bonds, which was precisely the toxic brew that helped trigger the last financial crisis. Meanwhile, officials at the New York Federal Reserve are carefully monitoring this escalation.

There are also indications of a stealth revival in the subprime mortgage market. Most banks still eschew these loans, having drastically tightened lending standards in the face of regulatory requirements to hold more capital and in response to the billions in fines levied by the Justice Department for shoddy origination and securitization standards pre-2008. But those moves have frozen out millions of would-be homebuyers from credit—an unmet demand that’s precisely what led to the evolution of subprime loans in the first place.

While there is not yet a subprime revival in mortgages comparable to the one occurring with auto loans, the need for credit usually results in companies being willing to provide it. In Australia, for instance, which also had a mid-2000s housing boom, subprime mortgages have seen brisk business this year. That doesn’t mean such a return is imminent in the U.S., but in the past weeks alone, Wells Fargo, one of the largest banks in the U.S., announced that it was relaxing some of its standards to ease the flow of credit to would-be homebuyers.

Obviously, the return of subprime faces considerable obstacles. Luminaries such as William Ford of Ford Motor Co. have warned that “we have to be careful because we don’t want to get into a situation like we did before, where consumers are overextended.” The mere suggestion that subprime credit may be a net positive is met with added skepticism perhaps because the same Wall Street elites who pushed these loans in the first place are now setting up a new round of the same.

So tarnished is the reputation of subprime loans and their subsequent packaging into securities that their original purpose has been largely forgotten. Subprime loans became a meaningful portion of the mortgage and auto markets only in the mid-1990s; not until the early 2000s did they account for more than a marginal share of the overall housing market. The initial impetus was not Wall Street profits, but rather a political and societal imperative to increase homeownership.

One of the primary obstacles to that imperative had been the unwillingness of banks to lend to riskier buyers—which meant low-income and often nonwhite buyers. After decades of banks redlining lower-income neighborhoods and potential borrowers, subprime loans represented an expansion of credit to buyers who couldn’t qualify for traditional loans. The ability of banks to securitize and package them, along with the role of government-sponsored Fannie Mae in providing a backstop, further enabled the extension of credit.

The result was a growth of the subprime market from $35 billion in the mid-1990s to $600 billion in 2006, representing more than a fifth of all mortgages. By 2007 there was more than $1.3 trillion in outstanding subprime home loans. That amount vastly exceeds the current levels of subprime auto loans, which should allay some fears that today’s subprime auto loans are creating a systemic risk. But the larger question shouldn’t be whether or not subprime loans are a little or a lot toxic; the question is whether they are at all toxic.

For a while, the expansion of credit via subprime loans was widely seen as a virtuous marriage of policy, technology (which made complicated securitization possible), and the financial sector. Then it spun out of control, fueled by the greed of originators, by speculators using subprime loans to justify building millions of new homes, and by investors taking advantage of derivatives to magnify these loans and sell them throughout the world.

The fact that subprime loans became the germ of a global financial crisis does not mean that these instruments are inherently poisoned. They were misused and formed the bottom of a corrupt pyramid, but good ideas gone bad are a challenge of human nature, not of recent financial history. Unsupervised origination, zero due diligence of buyers, and opaque packaging of securities can be systemically dangerous. But those are abuses. Financial tools such as subprime financing were designed to be constructive.

In the aftermath of 2008–’09, tight lending standards and even tighter regulations resulted in an unfortunate return to the era before the 1990s, when a low income might mean you were shut out of homeownership, from simple ownership of a car, or from starting a small business. It also meant difficult access to credit for minorities and neighborhoods suffering from some of the industrial decline that started in the 1970s. Subprime was an answer to those challenges and still can be.

We can’t keep a permanent lid on subprime. We need credit to lubricate the workings of our economy, and access to credit in today’s world has become far too unequal. The risks of subprime going forward are not that there will be too much of it; the danger is that there will be too little.

This article first appeared on Slate.

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Zachary Karabell
Head of Global Strategies, Envestnet, Inc., Consultant to Investment Committee*

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