"The bear case always sounds more intelligent." - Peter Lynch
The purpose of this article is to supplement a recently published article on General Motors (NYSE:GM) and take a look at the risks associated with GM's $54.3 billion financing debt contained within GM Financial. The story of subprime lending in the automotive sector is not new; and the facts are rather alarming. Many of the warning signs which preceded the subprime housing bubble are popping up in the subprime auto space. The purpose of this article is not to look at the industry as a whole, but specifically subprime risks surrounding GM.
What is GM Financial?
In 2010, General Motors (NYSE:GM) purchased AmeriCredit and created a wholly owned subsidiary called GM Financial. In 2011, GM Financial acquired FinanciaLinx, a Canadian leasing company. In 2012, GM Financial acquired Ally Financial's international loan assets, including a 35% interest in Chinese joint venture GMAC-SAIC Automotive. GM Financial provides consumer financing and leasing as well as commercial lending for GM-franchised dealerships.
Based on the most recent quarterly filing (page 48 of 10k), the contribution of each segment is as follows:
Percentage of Total
What is a Subprime Auto Loan?
GM Financial defines a subprime lender as a consumer with a FICO credit score of 620 or less. Presently, 64.7% of GM Financials loans are categorized as subprime (page 50 of 2015 10K and page 8 of the September 2015 10Q)
Obviously, GM Financial is improving its mix of prime and near-prime loans to subprime loans. The percentage of subprime loan and lease originations is down to 20.8% in 2015 from 63.1% of the overall mix in 2013 (page 15 of 10K). At the same time, prime loan and lease originations are up to 64.3% in 2015 from 25.3% in 2013 of the overall mix.
What is the Risk?
Almost 60% of GM Financial's consumer lending book is comprised of subprime borrowers. This is an alarming number considering in 2006 and 2007 subprime lending rates were around 20%. Without understanding the quality of the underwriting, this number is meaningless. If GM Financial is properly compensated for taking on the additional risks of subprime borrowers, then the risk of excessive credit loss is minimized. Up to this point, the annualized net credit loss rate has consistently been around 3%, while the recovery rate has been around 50-60%. The problem is this is based on a relatively small data set that has not been properly stress tested by an actual credit crisis.
GM Financial securitizes its loans and creates Asset Backed Securities (ABS). It uses these packaged securities as collateral to issue corporate bonds to finance operations. These corporate issues are covered by all of the major credit ratings agencies, and are considered investment grade by all ratings agencies. Additionally, GM Financial is subject to SEC oversight like any other publicly traded company. GM Financial debt issues are rated as investment grade by all major ratings agencies. But as a minority investor with no access to "the books," why should I trust the same system that failed previously?
Rather than assume that GM Financial is managing risk with its underwriting, let's see what GM's balance sheet is capable of withstanding in a potential credit crisis.
Let's assume that an automotive credit crisis occurs and is accompanied by a recession. What type of losses would GM Financial be capable of withstanding?
In the recent earnings report, GM stated that it would break even at a SAAR of around 10-11 million units. The chart below illustrates that there have only been three instances in the past 40 years where auto sales have dropped below 10 million units.
Source: FRED Database
GM reported $8.8 billion associated with the automotive business. Subtracting this debt from GM's cash position of $20.3 billion yields $11.5 billion of cash and current marketable securities (slide 24 of chart set). This cash balance equates to approximately 20% of GM Financial's total earnings assets. In other words, if GM Financial were to take an immediate 20% loss on its asset base, it could be covered by GM's cash position.
In reality, nothing is this simple. GM Financial will not lose 20% of its asset base overnight, and GM's balance sheet strength will buy more time than other domestic auto makers. Some GM's cash may be needed for pension liabilities; and it's possible that a severe recession brings the automotive sales rate below GM's break-even point.
Comparisons to Subprime Mortgage Meltdown
Many investors were not in the market (or even born) when automotive sales fell below 10 million units in the early 1980s. However, most investors are aware of the subprime lending meltdown in the housing market in 2007-2008 and are looking for comparisons in the automotive lending market. Is this a rational assessment, or is this an example of recency bias? I think it may be a little bit of both.
A major concern surrounding automotive lending is the duration of the loans. Six and seven-year loans have become common in order to make affordable monthly payments. This is definitely red flag for the industry as a whole. However, it could also be argued that cars built in the past several years tend to hold value better due to higher build quality. Nonetheless, it will be difficult to avoid getting upside down on a 7-year loan for a car.
Although the housing credit bubble and the apparent automotive lending bubble share many similarities, the underlying assets are fundamentally different. During the real estate bubble, people were buying houses with the expectation that they would go up in value. I've never met a person that purchased a car and expected it to go up in value. Also, real estate is illiquid; especially during a panic selloff. Automobiles are much more liquid and may be repossessed with less hassle. Lastly, most rational people will downgrade their car if money gets tight. It is much easier to downgrade a car than to downgrade a house.
GM is currently priced at a 21% earnings yield. This means investors are willing to pay less than 5 years of earnings flow for GM. Either GM faces a credible threat to its survival in the next few years, or GM investors haven't left their fallout shelter since 2008. Many will argue that we are at the peak of the auto cycle, and the low earnings yield is justified. While prognosticators debate about peak auto sales, GM is rapidly buying back shares, decreasing debt, paying a healthy dividend, and financing an increasingly higher percentage of prime and near-prime loans. I'll take my chances with GM.
Disclosure: I am/we are long GM.
I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.