The auto loan market has become a big bubble waiting for a small needle. In this report, we will answer the questions: How big is the bubble? How will we know it is ready to burst? What are the best ways to capitalize on what comes next?
Anytime a central bank lowers interest rates to nothing, creates $4 trillion out of nowhere, and does “whatever it takes” to re-inflate the world economy, there is bound to be a credit bubble somewhere.
Last decade it was housing. This decade it’s the auto industry.
Once the dust settled on the mortgage crisis of 2008, lending standards for loans on new homes tightened. Banks, desperate to start lending money, looked for places where standards hadn’t been touched.
They found autos. Armed with low interest rates, and tons of quantitative easing the Federal Reserve was force feeding the banks, securing an auto loan became easier than ever. Over 86% of Americans commute to work by car, so this proved to be a good market. Include the 1 million Americans who want to keep working in a buoyant auto industry, and you have the making of a new credit bonanza.
Starting in 2010, sales for both new and used vehicles hit new records. They have broken yearly sales records ever since. Auto manufacturers are producing more cars and trucks than before, riding the great recovery of the past half-decade.
But it is all based on financing. Auto leasing, where the buyer puts some money up front, pays a monthly amount for a number of years, and then returns the car to the dealership, has also reached record numbers. Since 2008, the percentage of auto purchases based on leases has doubled.
The total amount of auto loans outstanding has reached over $1.2 trillion, roughly the same amount of money lent out for student loans.
Given that stock markets are at record highs, interest rates are low, unemployment is at historical lows, and America is enjoying a pro-business president, what could go wrong? We may be reaching our limit. Warning signs are getting louder that the credit system in the auto industry has reached a speculative frenzy.
It all began right after the crisis when interest rates dropped to almost nothing. Normally, an auto loan would be given based on the lender paying a 6% interest rate on the money they lent. By 2010, that rate dropped to 2%.
As a result, the banks ceased to be the only lenders. Car dealerships began to issue loans. The car manufacturers expanded their finance arms, making more money available. Then came the venture capitalists, setting up auto loan lending businesses.
The more players in the field, the more they compete for new business. Prospects, or potential borrowers, were given a lot of leeway in securing new car loans. In short time, having a prime grade credit score (over 620) was no longer necessary. Eventually, having a credit score at all was no longer necessary. Subprime lending in the auto industry has sunk to dangerous levels.
The Latest Entry to the Race Soups Things Up for Everyone
As auto loans became a rare diamond in the ruff of a slowly recovering economy, lenders entered the market from outside the traditional banking system. Nonbank lenders like credit unions, or independently funded loan originators, started to issue loans, often with little to no lending standards.
As banks evaded subprime lenders, nonbank lenders came in to fill the gap. They were able to borrow money at 2%, then offer it to borrowers at well over 10% to get a car. This gave the nonbanks every reason to dole out money to subprime borrowers like it was water. A note from UBS put it all into perspective, “Greater regulation of banks coupled with excessive liquidity supplied from monetary policy has triggered an unsustainable surge in nonbank lending as lenders ease underwriting standards to boost market share.”
Nonbank lenders went from obscurity to controlling over 45% of the auto loan market. Subprime lenders now make up over a quarter of all auto loans. Weak borrowers are why default rates are skyrocketing, so much so that a New York Federal Reserve Bank warned that the problem was of “significant concern.”
Crossing the Wrong Line
The danger for subprime excess is twofold.
The first risk is credit quality. If people who cannot afford a loan get financing, eventually they will default. This is basic arithmetic we learned from the mortgage fallout. Without proper due diligence on the borrower, issuing a loan is like throwing money down a black hole.
Today, over 6 million Americans are delinquent on their car loans.
The second risk is fraud. Borrowers are now able to get financing right at the dealership. The loans require little research. Quite often, the borrower doesn’t have to produce a credit score to get a loan. Even if they have a history of defaulting on previous debts, they get financing right away. After all, the people issuing the loan are the ones selling the merchandise. If the loan doesn’t go through, the dealership doesn’t sell the car. What reason do they have to exercise caution or due diligence?
This poses a major risk for fraud.
One example is Santander Bank. They verified income on just 8% of their borrowers, then packaged all the loans into a security they sold to an investor.
According to UBS, as many as one in five auto loans may have occurred as a result of fraud.
This has not been priced into the market, which makes it especially dangerous. Markets price in everything that is known, and expected. The real shocks come when something unexpected suddenly occurs. Even if people doctor the numbers to get the loan, if they don’t have the money to make their next payment, the loan goes to default and their car gets repossessed.
If we don’t have exact figures on the extent of the fraud, we don’t know how bad things can get once people start to default en masse. This is exactly what led to the 2008 meltdown in home loans.
Santander Bank settled with Massachusetts and Delaware for issuing “unfair and unaffordable” loans to the tune of $26 million. Massachusetts Attorney General Maura Healey said, “These predatory practices are almost identical to what we saw in the mortgage industry a few years ago.”
According to Experian, almost 15% of all auto loans have been issued to borrowers with credit scores ranging from 300 to 500.
What to Watch For
As the undercurrents intensify, it takes a lot less to topple the ship. As the auto loan bubble expands, it takes much less pressure to pop it. The following are the fundamentals which set the environment for free money. If one of these assumptions were to suddenly change, you could see sudden and violent movements in the value of all auto loans.
Unemployment. Rising unemployment means more people will not be able to make payments on their loans, and default rates will rise. It also means more people won’t be able to take out new loans. This means lower sales for car manufacturers, and lower cash reserves to handle all the loans they underwrote but cannot collect.
Interest Rates. The past 5 years have made the auto industry doubly sensitive to interest rates. 80% of auto sales are made on credit. If rates go up, and the Fed has signaled at least 2 rate hikes in 2017, the terms for auto loans deteriorate and less people take out new loans. Current auto loans pegged to general interest rates will demand higher monthly payments from borrowers, adding to already high loan default rates.
Another big sensitivity to interest rates is duration. The length of the average car loan is longer than it has ever been, 70 months. The longer the loan, the more sensitive it is to interest rates. Even small movements can have huge impacts on credit quality. A couple of rate hikes in this environment can have a greater impact than a big rate increase just 10 years ago.
Another worry is “delinquencies.” Auto loans at least 90 days delinquent rose to 7.5% during the first quarter of 2017. A loan can be delinquent for a number of months before it goes into default. The ballooning number of loans that are late in payment implies a sharp rise in defaults in the coming months. A quarter of banks are forecasting a rise in delinquencies for 2017, an unprecedented event.
Of lesser import are trade issues and commodities. If President Donald Trump implements a 35% tariff on Mexican made goods, prices for cars will rise, requiring car manufacturers to up their prices, and consumers to take out more debt. If Mexico were to retaliate and a trade war ensues, the cost of producing a car can continue to rise, along with the price manufactures will have to charge to maintain profit margins. Oil and gas prices are low. However, if the proxy war between Saudi Arabia, the second largest oil producer, and Iran, the world’s fifth largest producer, were to move from Syria to their own countries, the price can go up very quickly.
Is a Collapse Imminent?
While subprime auto loans amount to over a quarter trillion dollars, the entire auto loan portfolio amounts to over $1.2 trillion. Car loans, unlike mortgages, can be paid off quickly. They are shorter loans. If a borrower defaults, it is easy to repossess the car and sell it.
Interests rates are low, inflation is in check. The economy is still expanding, and unemployment is low. In 2008, the total amount of consumer debt was 100% of household income. Today, it is only 80%. The auto industry is a lot smaller than housing, and most analysts maintain that an implosion of subprime auto loans is not big enough to expand beyond autos. In the US, $1.1tn in car-loan debt is less than 10% of the $14tn in home mortgages.
We may be seeing a slow deflating of the bubble rather than a quick pop. Defaults are rising. Less money is being invested into assets backed by auto loans. The amount of subprime auto loans has also plateaued, and even begun to decline. The money invested in nonbanks is “fickle” money. If things no longer look good, they will quickly move their money elsewhere.
As more and more cars are repossessed, used car lots are filling up. Prices for used cars are falling. 2017 saw a 5% decline in used car prices, the biggest decline ever. Used car dealers who have been in business for over 20 years are closing their doors due to too much inventory. This year, 4 million cars are coming off their lease.
This is having an impact on car sales, which are down 2% for the year.
These indicators show a definite slowdown in the auto sector, but not necessarily a crash. The situation is very serious, but not yet critical.
Echoes of Housing 2008
How does the auto loan market compare with conditions right before the 2008 credit freeze? How close are we to the edge of the cliff?
More than 1 million Americans are delinquent on their car payments. The last time the number was so high was in 2008.
Due to a glut of new cars coming on the market, and a rapid fall in car prices, most leased or credit financed cars are underwater. The loan is higher than the value of the car. Even if the car is repossessed, the borrower will have to make payments on a car they no longer have.
According to Morgan Stanley, the share of auto securities holding a bundle of auto loans with a FICO credit score below 550 has risen from 5.1 percent in 2010 to 32.5 percent today. Credit spreads are 40% higher today than right before the crisis.
Subprime delinquency rates are creeping up while the subprime market is ballooning in size. 3% of auto loans default without a first payment being made. That’s on par with the level in the mortgage market before the financial crisis
Here’s what Morgan Stanley said:
Across prime and subprime ABS, [60-plus-day] delinquencies are currently printing at 0.54% and 4.51%, respectively, with the latter approaching crisis-era peak levels (4.69%). Default rates are also picking up in similar fashion (prime: 1.52%; subprime: 11.96%), printing close to crisis levels.
U.S. vehicle sales have lagged behind 2016 levels every month this year. If that performance continues, this year will mark the first since 2009 that industrywide sales declined.
How to Play It
The obvious choice would be to short subprime auto debt. Based on packaged securities by banks, nonbank entities, and the financing arms of the major automakers, you can find the right securities and sell them short.
A great value play is to find the asset securities you believe will be paid off regardless of the financial environment and buy them at a deep discount. As the full portfolio of loans is paid off in half a decade, you will quickly see a rise in the value of your holdings, and a return of at least your investment. It’s possible to buy debt at $.30 to the dollar, only to see 75% of the money paid off.
The Equity Play
Automakers stand to lose the most from a meltdown in subprime loans.
- A huge portion of car loans come from the majors themselves. GM, Ford, and others all have financing arms which originate auto loans to help people buy their cars. If defaults rise, these companies stand to have huge write-offs.
- Lease expirations and repossessions create an inventory glut. As more cars return to the lots, prices decline. There is also a less need for new cars to be produced. Major automakers generate less by producing less and making less for each sale on depressed auto prices.
- Lending standards for autos will tighten. This will create a long-term ceiling on auto sales by tightening the limits on how many people are eligible for a new car loan.
The fact that 2017 has seen a slowdown in sales, even as the number of units delivered rivals record breaking years of the past means that dealerships are offering big discounts to customers to buy their car. This indicates that the auto industry is “buying” sales for this year at the expense of sales in future years. This implies a cyclical downturn for the auto industry right on the eve of a possible credit implosion.
Shorting the automakers is a practical play. You can short the big ones, like GM (ticker symbol GM), Ford (ticker symbol F), or Fiat Chrysler (ticker FCA). Fiat has more debt than cash on hand. GM also has huge amounts of debt, well over their current cash reserves. Their debt is so big, their cash flow after debt service last year was negative.
Ford has more debt than the size of the economy of Hungary.
You can short any of these, or short all of them. The auto ETF, ticker symbol CARZ, is tied to a basket of the major automakers.
The Great Hedge
Install an Airbag on the Fast and Furious Auto Loan Market
If car values become less than the loans, or interest rates make the monthly payments too prohibitive, borrowers may decide to stop paying. Even if they lose their car, they may decide it’s worth it just not to have to make the next payment.
This can put severe downward pressure on most bundled car loans. A credit crunch will depress all values for asset backed car loans.
Even if auto loans are unsecured, some loans are more reliable than others.
The best solution for investors of securitized debt is a portfolio heavy on cosigned loans. Cosigned loans require a lower interest rate, giving the borrower more reason to keep paying. It also puts and additional borrower on the loan. With cosigning originators like Backed, Inc., the cosigner is alerted the moment a payment is missed, enabling the cosigner to make payments before the loan goes into default.
The collateral of a cosigned loan is not just the car. It’s the relationship between the borrower and someone who put their credit on the line on their behalf. A cosigner can be a father, a brother, a friend, boss, or an army buddy. The borrower has far less reason to destroy a relationship he has his life invested into, than to let the loan go into default.
Using relationships as the ultimate human collateral is the surest investment in a volatile environment. Cosigned loans will have a higher paydown rate than all other types of auto loans. A great play is to invest in cosigned loans at depressed prices, if money leaves the entire auto market and the prices for all loans sell cheaper than a 1983 Chevy.
Gilad Woltsovitch is the Co-Founder and CEO at Backed Inc., responsible for designing the company’s first-class platform, UX and UI. Before Backed, Gilad co-founded iAlbums, a semantic curation engine for media players in 2010 where he served as the company’s CEO from 2011-2014. In 2013, Gilad also served as the entrepreneur in residence for Cyhawk Ventures and joined the Ethereum project, establishing the Israeli Ethereum meet-up group. Gilad holds a Masters of Art Science and Bachelors in Sonology from the Royal Conservatory of The Netherlands in The Hague, University of Leiden.