The Hidden Traps in Auto Loans

so there's a lot of different um consumer protection issues where people are being given loans that they can't pay back and that are actually designed to fail and um they anticipate a car will be repoed several times over the life of the loan and then each time that happens in each delinquency you can extract uh fees out of the borrower in that sense and so you can kind of make more money by desiging a loan to fail than for it to uh to succeed my name is Thomas hearen I'm an associate professor

of Economics at the City University of New York uh John J College kind of my heris for whether a project is important or not or it's worth doing uh and that it should scare you a little bit um typically like you know our emotions and our fears and things like that they're good you shouldn't make like decisions necessarily based on emotion or fear but they can be a good indicator for things that are important and something that scares you a little bit or even terrifies you is probably something t

hat means a lot to the world uh not just to you but to the world that's usually why you're scared of it right um it's you're scared that you're on a big story and you're excited and it's a mix of like fear and excitement and the most meaningful projects I've ever been a part of um they've always scared me a little bit um because um you know they were finding things that really mattered to key debates and some of the key issues of time so for example when I worked on the Reinhardt rogoff paper um

that was terrifying I was trying to replicate a major famous paper by very high-profile High status Economist from Harvard and um it wasn't working and at first I thought that you know maybe I was just you know it was just my me being kind of uh newer to conom metrics and Empirical research right I thought I was kind of just kind of of like an idiot and I think uh actually one of my professors thought that after one of our discussions but I remember some of the initial problems I had um on that

data working with that data and reproducing the average I walked out of like my advisor's uh office hours once and he was like come on Thomas uh you have 20 countries and you're taking an average this shouldn't be that difficult and I was like oh no um but you know I kept working on it and it didn't work and I gained confidence uh in my skills but but even when I knew I was right um you know especially once we found the spreadsheet error in that paper um it was terrifying uh we went public with

it I was scared I didn't I didn't have any idea that the paper would have the viral impact that it did that' be picked up by all of the world's media from you know Krugman the New York Times The Wall Street Journal BBC lead article of Rolling Stone and certainly the co bear report um those you know I had no idea that was going to happen but I was still terrified because I figured in the community of economists I respected the word was going to get out uh and you know it's a it's a scary thing u

m one the paper I was critiquing was supporting really controversial austerity policies in the US and Europe that had caused a lot of misery to a lot of people so it really had a high impact uh and then two I was Finding Mission critical errors uh with a on a spreadsheet and then other kind of bogus assumptions um and so you know that's it's a scary thing but that was because it was important and then my other work um you know I started looking at the role of mortgage fraud in the Great Recessio

n and when you're trying to estimate how the most powerful financial institutions in the world um committed fraud that caused massive losses for uh you know households and investors um that's a big story uh it's scary it it matters to millions of people the world over and it's always kind of dealing with elements of power too so um yeah that's kind of my heris for something that matters I mean certainly like you can run you know the nth regression of schooling on or earnings on schooling and you

know I mean even if you have a really interesting method and stuff um I'm not sure if that's going to that that wouldn't personally like scare me per se right it doesn't mean it's not necessarily important but it's something that we we know pretty well already we've We've ran a lot of progressions of earnings on schooling right to kind of back out a little bit a lot of my research has been on topics connected to the political economy of financialization so uh issues about distribution and insta

bility relating to the growth of the role of financial institutions in the economy um of course there's a whole literature about deregulation and the growth of uh the financial sector and how that contributed to 0809 I think what you know a lot of my work on housing showed is that um you know very much like the classic Minsky model um large expansions in the supply of credit can mask underlying um conflicts right such things like insiders ripping off Outsiders um other forms of fraud it's Etc an

d then also just asset Bubbles and cause asset bubbles these things um have a huge relationship to economic stability but because debt itself um is also a distributional contract when these things right debt uh it debt contracts specify that the borrower takes the first losses and so whenever um these problems associated with uh the expansion of the supply of credit like bubbles or fraud Etc when these things um when those bubbles pop and the supply of credit like has a sudden stop it's always t

he borrowers in the households that are going to take the big losses and they're often the agents that are least able to Bear those losses as we saw with subprime lending in the housing thing but also in the auto market and when we concentrate losses on those that are least capable of bearing it it has bad macroeconomic consequences as well but the problem is that um you know a lot of economists in the back of their head believe the the self-correcting mechanisms of the market will get rid of th

ese principal agent conflicts and things like securitization will uh actually you know distribute risk among those most capable of bearing it who want it the most we can chop up the collateral and interest rate risks and give it to different parties who all want that um but you know uh what I found and really what I think the study of history shows is that the self-adjusting mechanisms of the Market are a lot less powerful than advertised I guess uh they're not really capable of self-correcting

this so what we found with mortgages right is that um you know uh across three easy to measure uh measures you know like um whether it's uh LTV appraisal value inflation unreported second leans on the home or misreported owner occupancy status half of the loans that were bundled and packaged Securities from 02 to' 06 had one of those three flags and we're not even talking about income overstatement yet and really there's was a whole cottage industry of Finance professors who was able to identify

fraud at the loan level that's what my research was one of many papers in this but a good overview of that is the John Griffin paper um asking was fraud a force in the financial crisis 10 years of evidence and so there's been a decade of Empirical research that basically shows that every way a mortgage application could be falsified it was and then those falsifications were then concealed from all the major investors by every single one of the reputable financial intermediaries and so the idea

that the reputation of a Wells Fargo um or Goldman Sachs or JP Morgan they would be scared of their reputation so that they wouldn't commit fraud that just that mechanism was not strong enough and there was a Gres Dynamic where uh everyone committed and the problem is the more the bad practices spread the more everyone has to do them to be competitive there's that old saying there's nothing worse than being an honest uh card player in a crooked game right and that's very much the style and so I

think understanding uh this Noir side to our economy and the limits of the self-adjusting mechanisms and how serious problems can happen is very important the principal agent models give us those tools but often times economists have been scared to point those tools at the most powerful institutions in our society and I think that level um I think that's that level of fearlessness is required by honesty because you know often times with the most powerful institutions uh they they have the most c

apacity to do harm as well and certainly there's large histories of them um I was influenced by the work of Upton Sinclair quite a bit so it's kind of taking that same Noir muck ring approach but um with empirical methods the auto market you know there's a lot of different um different elements in Sp so on the one hand um following 0809 a lot of capital flowed into securitized auto loan so we see the same huge expansion of credit there um I think this is one of the things that has helped Drive A

uto prices up that combined with the shortage of used cars um due to 07 uh the big financial crisis there was like a blip in demand and so uh cars from that a which would be the affordable use cars now just weren't made and this has massed a lot of problems now these problems are slightly different right um the issues with misrepresent so when you understand um the originate to distribute supply chain with securitizations there's uh there's capabilities to misrepresent things at all stage right

in mortgages a lot of the fraud was committed by loan officers and Underwriters at origination and then in distribution it was concealed from the end investors to a certain extent it not clear that there's a so there's a lot of fraud in origination going on if you look at this Market um almost none of the incomes are verified Employments aren't verified there's a lot of issues with inflating the value of the car um because when you have a loan to value ratio right um you want it to be lower uh s

o that the loan is a lower part of the value but you know there's two components to that there's the loan and then there's the value of the car and if the value of the car is based on the Sal sales price of the car there's all sorts of ways to bundle in all the little dealer markups and the dealer different packages to get that value up in the LTV to a low level um there's a lot of other real huge issues at origination especially um uh disperate um interest rates charged um along racial discrimi

natory lines and so there's a lot of different um consumer protection issues where people are being given loans that they can't payback and that are actually designed to fail and um they anticipate a car will be repoed several times over the life of the loan and so each time that happens in each delinquency you can extract uh fees out of the borrower in that sense and so you can kind of make more money by desiging a loan to fail than for it to uh to succeed that's really bad for the consumers it

wrecks their credit these are folks that are on the margin and you know if they were given a lower interest rate they wouldn't default on the loan but then they're given these ridiculous interest rates uh way past State Usery limits Etc in the 30% range Etc and if they just had even a more modest 10% interest rate which is still outrageous um they would be able to pay the loan off but it's not there so there's the consumer protection issues and for me I think those are the biggest issues in thi

s market um in terms of distribution um the reason there was fraud in um Home Loans was because um there was very strong representations and warranties in the loan prospectuses like when you bundle a bunch of loans into a security and then you sell that security you have to um disclose the asset quality you have to say that this asset is x amount of good right so it'd be very much like you're going to Whole Foods in the bult section or just buying bulk rice and like if you're going to buy a poun

d of rice you put it on the scale it says pound but if that was the scale was short or something and you got like 08 pounds you'd be be like that's that's not right well the same thing when you buy uh Securities based on assets you got to say how good the assets are uh and then that's the representations part and then they had strong warranties too that if these representations were wrong um like there was um inflated borrower income or something like that um you know concealed second leans then

um you would have to repurchase that loan and actually in auto loans um even though there's probably more bogus happening at origination though it's hard to say that because there's a lot of bogus in the runup to 0708 I mean you know the competitions the race to the bottom it's hard to say who wins but certainly auto loans now are competitive in that in that race to the bottom but the representations and warranties are also a lot weaker but it's still not clear what degree of concealed risk are

in the loans and it doesn't appear that they're being priced into the Securities either and so even if it's not the same type of fraud problem the same type of concealed risks uh and uninsured risks uh they can add up quite big right really big especially as more and more capital is pulled into poured into the securitized auto loan Market um it's the same Dynamic of very concealed risks that can then um happen later and have stability issues now of course auto loans aren't the same uh size as s

ay the American Mortgage market and so it's not systemic in that area but you still see large buildups of risk and with the rapid growth these things can get out of control soon and so it's not clear I mean certainly the bogus and falsification and origination that there are a lot of lines crossed there it's not not clear in distribution if the same lines are crossed but the still the same economic problems so concealed risk that's being concentrated on those least able to bear bear it it's buil

ding up and these things can get out of control pretty quick too uh and then the consequence of this is there's just a lot of your normal workingclass folks whose lives are going to be a lot harder because they can't get a decent uh interest rate to get an affordable car and so they can't go to work cars are very important a lot of studies show that people default def on homes before they default on cars because you can sleep in your car and at least you can still get to work right whereas if yo

u lose your car you lose your job you lose your house as well these things are really uh First Rate issues for workingclass Folk