Last week this blog argued that the subprime mortgage meltdown would spread to other aspects of the subprime lending: credit cards, auto loans, subprime consumer credit. Today we got news that even Harley Davidson’s motor hogs are being financed with subprime loans: 20% of their hogs loans are subprime and the 30-day delinquency rate on such loans has increased from a 3.6% between Q1 of 2005 and Q2 of 2006 to 5.18% in Q4 of 2006, an almost doubling of delinquency rates in two quarters.

Let us then consider the various aspects of this “Subprime Economy”.

First, notice that subprime credit cards are now in the tens of millions since their growth has mushroomed in the last six years (see this MarketPlace story on the problems and predatory practices related to subprime credit cards and subprime fast cash). If a subprime – in terms of credit score – individual has difficulty in servicing his/her various debt obligations the first default usually occurs on the credit card debt. Defaults on credit cards occur before defaults on mortgages because financially stressed households would not want to jeopardize their home ownership first. It is easier to somehow refinance credit card debt than try to avoid foreclosure on a home after default. So, the stress on balance sheets of subprime borrowers will first appear on their credit cards debt and their willingness to service such debt.

Next, defaulting on a home is more likely and earlier – for those who own a home - than defaulting on an auto loan because most individuals in the US need a car to drive to work. So facing debt servicing stress they are more likely to stop paying their mortgages than stop paying their auto loans as re-possessment of cars by creditors is faster than for homes. Again there are now tens of millions of subprime auto loans in the US. And there is now evidence that such subprime auto loans are also under distress. As reported by Bloomberg today under the title “Subprime Defaults May Spread to Auto Bonds, S&P Says” a study shows a sharp increase in defaults on auto loans:

Bonds backed by automobile loans may be hurt by rising subprime mortgage defaults as people with poor credit struggle with their household debt, according to Standard & Poor's. Capital One Financial Corp., Wachovia Corp., Wells Fargo & Co., and other lenders have lent more funds to people with bad credit scores in the past few years to sustain growth, S&P said today in a report by analysts led by Mark Risi. The loans are also for longer terms, increasing the probability of default, the analysts said. About 68 percent of 2006 subprime auto loans were due in five years or more, Risi said. ``There could be some fallout from subprime in auto loans,'' Risi said in an interview. ``We don't have much data yet. We're still in collection mode. It's probably going to be hard to say for a while.'' …S&P classifies asset-backed car loan securities as prime, non-prime, and subprime, Risi said. About 0.31 percent of the prime loans made in the first quarter of 2006 have defaulted a year later, according to S&P. That compares to 0.8 percent for non-prime and 3.02 percent for subprime car loans. Prime loans have cumulative losses of less than 3 percent with credit scores of 680 or more and current annual percentage rates of between 0 percent and 7 percent under S&P criteria.  Non-prime pools have net losses of between 3.1 percent and 7.5 percent with credit scores of between 620 and 680 and interest rates of between 8 percent and 13 percent. Subprime securities have net losses above 7.5 percent with borrowers scoring less than 620 and annual percentage rates of more than 13 percent. About 71 percent of subprime auto loans in 2006 were used to purchase used cars and 68 percent of those loans are for more than five years, S&P said. Five years before, only 58 percent of subprime loans were for used cars and 33 percent were for more than five years. Subprime auto borrowers who are also homeowners may have ``exposure to affordability products and the related payment shock,'' said Risi.

But it is not just a problem of subprime mortgages, credit cards and auto loans. As reported yesterday by Douglas Kass (who has a column on street.com) there is also now evidence of a sharp increase in delinquency on the subprime loans that finance the purchase of Harley Davidson’s famous motorcycles, or  “hogs” in Americana jargon. When default rates almost double in two quarters on Harley’s hogs you know that this subprime problem is a real hog for the economy.  As Kass put it in sarcastic but true terms:

Born To Be Wild: The Subprime Contagion Spreads 
 
Bearish HOG  
 
It remains investment community's general belief that the subprime lending mess is a fluke that will be contained…I have stressed the likelihood of contagion. After all, subprime is subprime and credit is correlated. Lower quality, more levered lending (with less collateral) is not confined to consumer loans, credit cards, homes, recreational vehicles and autos - as investors might soon find out. Even motorcycle (loans) are hitting potholes now!  
 
Indeed, it appears that growing credit losses and delinquencies are beginning to render Harley-Davidson's (HOG) motorcycle loans, well, increasingly like hogs (literally and figuratively).  
 
Thirty-day delinquencies (and loss trends) in Harley-Davidson's receivables book (courtesy of Lehman Brothers) give a clear picture that credit quality issues are broadening out as HOG's receivable experience has begun to trace a pattern of deterioration that we first began to see in subprime mortgage loans during the first half of 2006.  
 
Harley Davidson's 30-Day Delinquencies  
 
4Q2006 5.18%  
3Q2006 4.46%  
2Q2006 3.61%  
1Q2006 3.69%  
4Q2005 4.83%  
3Q2005 4.07%  
2Q2005 3.66%  
1q2005 3.60%  
 
As I mentioned yesterday, Harley's finance subsidiary (HDFS) funded almost half of Harley-Davidson's motorcycle loans. Like subprime mortgage loans, HDFS' hog loans are pooled and securitized to institutional buyers. Unfortunately -- in credit trends and terms -- HDFS is also beginning to look more and more like New Century (NCBC), Fremont and Accredited Home Lenders (LEND) did in early 2006.  
 
In 2006-07, 28% of HDFS loans in its securitized pools had FICO scores (below 650) were considered subprime, ironically very close to the 21% subprime market share of total mortgage loans made last year! During the company's investor day (Feb. 28), Harley acknowledged that several of the securitization pools have breached their credit quality metrics (and like subprime, the most recent pools' credit losses and delinquencies are rising faster than expected and more rapidly than earlier pools). This is beginning to force Harley-Davidson to fund additional cushion reserves in the triggered securitization pools, much in the same way subprime mortgage originators have to buy back bad loans. (This takes a hefty bite out of HDFS' profitability by reducing its net interest margin).  
 
Should the recent trend of rising credit losses and delinquencies in Harley-Davidson's loan receivable book and in the securitization pools of their financial subsidiary (HDFS) continue, tighter lending practices will likely be instituted and institutional buyers will be less receptive to buying HDFS' securitized pools. This could serve to reduce Harley-Davidson's sales growth and profitability.  
 
Sound familiar? …It is beginning to look like the (motorcycle) lending markets are no longer ... born to be wild. And, not surprisingly, I am still short Harley-Davidson.  
 
More importantly, the fungus of subprime is beginning to spread into asset classes other than housing and mortgages. Don't think for a moment that Harley-Davidson's dealers or the parent company were any less reluctant than the mortgage brokers to serve up loans for their product. And last time I looked, a motorcycle is far less secure and stable than a home.  
 
Vroom! Vroom!  
 
Position: Short HOG 

Kass has it right: the contagious fungus of subprime is now spreading into asset classes other than housing and mortgages, first into other types of subprime borrowing/lending and soon enough to near-prime and even some parts of prime credit markets.

Let us consider in more detail some aspects of this subprime economy and the debt trap into which millions of subprime borrowers have already fallen into or likely to fall into…