US auto sales head towards price war as subprime loans rise
on March 23, 2016

US autos Mar16

The warnings keep coming about the underlying health of the US auto market.  But, as with the subprime housing crisis, nobody wants to listen:

  • Last October, the US Comptroller of the Currency warned that some activity “in auto loans reminds me of what happened in mortgage-backed securities in the run-up to the crisis
  • Yet auto lending is now more than 10% of total retail lending, and the banks are still busy repackaging them for sale as securities to investors desperate for yield

There are 2 parts to the story, as the charts above show, both from the Wall Street Journal (WSJ):

  • Auto leasing is now at record levels at 1/3rd of total car loans, compared to pre-crisis levels of one in five
  • Manufacturers subsidise these deals to make them attractive  – currently by an average of $6432
  • These lease incentives have been rising sharply, and are up 8% versus 2015 and 29% versus 2009
  • Auto loans are also now at record levels, close to $1tn, with 20% going to subprime borrowers
  • Issuance of bonds backed by subprime loans is up 25% from 2014, and these are already going sour
  • 12% of loans in bonds only issued in November were already overdue by February

Of course, everyone insists that the Comptroller is wrong to be worried, just as they said the housing market was in great shape – until it collapsed.  But warning signs are everywhere, if one wants to look. Delinquency rates on subprime loans packaged over the past 5 years are already over 5% – and that is with an improving jobs market.

The problem is that loans are being made to people with very low credit scores, or even no credit scores.  And they are being asked to pay interest rates of around 20%.  This is clearly unsustainable, and highlights how the auto industry is gradually running out of potential new customers – just as happened with housing.

At the same time, manufacturer inventories are rising, up to around 90 days for Ford and Fiat Chrysler, whilst overall incentives have risen to 10.6% of revenue.  Ford’s car inventory is 38% above its normal level at this time of year, despite it having boosted lower-margin rental car deliveries (adding 7% to its total volume).

As Credit Suisse note, auto makers will soon have to cut production, as their current sales strategies are running out of road.  They expect a 6% cutback from Q2, meaning that 2016 production would be flat versus 2015.  But this may well prove too optimistic.

The reason is that nearly 9 out of 10 new cars are currently financed:

  • Loans are typically 6 years, so even buyers from 2012 won’t return to the showroom till 2018
  • Lease terms are typically 3 years, meaning 2016 will see large numbers low mileage cars in the used car market

Used cars are therefore going to have a very attractive value proposition for the ordinary buyer, as their average mileage is currently back to 2002 levels:

  • 3.1m cars come off lease this year, a 20% increase versus 2015, followed by 3.6m in 2017 and 4m in 2018
  • These used car sales will cannibalise new car sales, pushing down prices and volumes
  • Price wars are therefore almost inevitable over the next 18 months, and lenders will start to lose serious money

The industry has been here twice before, as the WSJ notes – and both times the story ended very badly, with lending losses running into the billions of dollars:

“The auto industry expanded the use of leasing in the mid-1990s, helping to fuel retail sales of new vehicles. Eventually, a glut of off-lease cars sent resale values down and auto lenders who had bet residuals would remain high ended up racking up billions of dollars in losses, having to sell the cars for much less than they anticipated.

“Many major banks exited leasing the early 2000s, but the practice resumed later in the decade. Lenders saw another leasing crash late last decade when resale values plummeted amid a steep rise in gasoline prices and low demand.”

Of course, all those making short-term bonuses from selling the loans and leases, or repackaging them for sale to investors, naturally claim that everything is fine.  But the rest of us know what to expect.

Past experience is normally a good guide to the future outlook.

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