I will start off by saying this, I do work in the US auto market as a sales manager of two car dealerships. I currently manage and supervise 120+ employees and am responsible for the oversight of over $100+ million in annual sales. I do not work for the manufacturers directly, however, I do work for a company who owns multiple dealerships. In this relationship, I do have contact with people who work directly for the corporations at a higher level. I am not getting compensated in any such form for writing a piece about the overall health of the US auto market or any of the companies mentioned in this article. All information in this article is easily available to the public, however, I am going to give an insider's look into the true picture of what is happening behind the scenes.
Housing Crisis = Auto Crisis Deja Vu
I am sure everyone remembers the housing crisis. But does anyone actually remember how it happened and how we got there? A lot of it had to deal with credit, poor underwriting (or lack of it all together), and a false sense that the equity in housing would cover the defaults due to rapidly rising home prices. Unfortunately, the same thing is happening today in the auto market, albeit in a smaller yet still important fashion.
My mother worked in real estate for over 30 years. Her final job was a new construction sales manager for a housing developer from 2002-2008. During the crisis, she lost her job, and the business went belly up in just one week's notice. At that point she found it was time to retire and take care of my grandmother who was terminally ill. During those six years, things were greater than they ever had been for my family in terms of wealth. Within years we went from a comfortable family of 5, to owning 3 houses, 2 quads, 2 boats, recreational land and going on multiple vacations every year. At this point I was 14, and had 3 years of stock market experience under my belt. While still learning economics and market behavior, my mother told me many things which I did not put together until my older years about the housing market. Her main take away was that it was all fake, and until someone pulled the plug, business would go on as usual. My father was a supermarket store manager for over 25 years at that point, and he was always the "bread winner" for our family before my mother's new job. Once my mother got her new job, our family dynamics changed rapidly, and we became "upper-class" by nationwide standards. But just like my father always said, "Nothing too good, or too bad, lasts too long". And just like that, the music stopped.
During the housing boom, people were able to buy homes that they simply could not afford. Besides the poor or complete lack of underwriting by larger banks, many lacked full documentation in regards to proof of income and other important factors. People were buying homes in false names, with false incomes and did not need to provide the proper stipulations that currently are required for underwriting purposes. "No or low income? No problem, we can just use a no doc loan". Nobody cared. "Oh the house did not appraise for what it's worth? That will not be a problem". These were things commonly said during the housing boom by individuals in the industry. After all, why would they really care? As long as the bank was willing to take the loan, it was the banks responsibility to properly underwrite it and take all necessary steps to minimize risks. It certainly was not the realtors fault, but more the pure underwriting process itself that was filled with false hope and a sense of security. That blanket of security was the packaging of crappy mortgage loans into CDO's that could be passed off to investors as a high quality investment with a credit risk which did not match the actual portfolio risk. After all, what is the chance all these people would default on their house right? I guess we were all wrong about that.
The auto market is in a very similar stance currently and nobody is talking about it. Everyone is too wrapped up into overall auto sales that they forget and ignore how it is actually executed at the dealership level. I do not blame them, considering most people have no idea what actually goes on "behind the scenes" at auto dealerships around the nation. I am sure someone who is reading this article is currently in the market for an automobile. Let me ask you this, how much do you actually know? I am not talking about what you have read in Consumer Reports or J.D. Power. I am not talking about your false trade-in value from KBB.com or the automobile you improperly built on truecar.com to give you a "fake" selling price. I am talking about all the other things that make the "deal" so great.
"What about the monthly payment?" That is all we hear in the industry from every customer, regardless of the manufacturer. Many customers only care about what it will cost them per month, not what it will cost them overall. While most readers on SA can determine what is a better deal in the long haul, a vast majority of consumers cannot. People want the lowest possible payment, and that is why leasing has become so popular for customers recently. The problem is that until recently, leasing was only an option for people with quality credit. Many manufacturers including Ford (NYSE:F), General Motors (NYSE:GM) and Toyota (NYSE:TM) have their own form of a in-house credit arm who handles a majority of their new and used car leases. However, there is a double edged sword with this. The financial arms of the auto manufacturers are expected to extend credit to customers that do not qualify for approval by the normal underwriting standards. In the business we call this a "tier-concession". Going by the books, a customer may have a credit score that qualifies them for a tier 4(d) (630+ FICO credit score) approval. To prevent the customer from going to another manufacturer, they will give the customer a tier-concession which brings them to a higher tier such as tier 1(a) or 2(b). This in turn, lowers the monthly payment by lowering the money factor of the lease or loan, which lowers the overall interest received by the financial arm. All of this happens without lowering the loan risk. This is a major problem that has been brushed under the carpet in the last few years. If financial arms of manufacturers are willing to receive lower interest income for high risk loans, the volume of loans that default will hurt significantly more. Normal business practice is to increase the amount of interest on a loan due to the amount of assumed risk you take on by extending the loan. The increased interest income is there to act as a buffer in case a loan defaults and a vehicle gets repossessed. At that point the vehicle is sold on the auction blocks and the difference from the loan value to the sale price of the vehicle is charged back to the original customer as a bill. This can drag on for months and further destroys the original owner's credit if they do not pay.
The problem with leasing, is that it gives people the false sense of what is actually affordable for their budget. However you wish to calculate it, average hourly incomes have been rather stagnant for the last decade, and the average US citizen cannot afford the finance monthly payment that new cars require. That is unless you extend the term, which is something we will cover later in this article. If you are not as worried about saving money in the future, and you are willing to trade some long-term savings for convenience, a lower monthly payment, and perhaps a nice business deduction, leasing is a good choice.
As you can see, the amount of leases have increased greatly as the advertised auto loan rate (non-subvented) has lowered significantly.
The Huge Loan Problem
Years ago it was common to finance a car for a short period of time. Most loans were around the 48 month mark by industry standards. Over time, vehicles became more expensive and incomes were not rising in the same fashion. Now in 2016 the auto loan market has hit all time highs on multiple fronts. The average new car auto loan has broken through the $30,000 mark. The average monthly payment has gone up to $503. The average term length is a staggering 68 months. Quite a move from the days of financing a car for 3-4 years. Vehicle prices have gone through the roof lately. Just last month alone, Toyota announced to the public that they were raising the base MSRP of all 2017 Tacomas by 2.7% from just this year. For a vehicle that is $33,000 on average, that is a $891 increase. Another problem is that cash strapped Americans are putting little to no money down on these loans. While it is common practice for people with excellent credit to not put money down, people with subprime credit are doing the same. Banks are not requiring that much skin in the game from consumers for loans. The fear is that if they require more money upfront, the consumer will go to a different bank or manufacturer for financing. Everyone is fighting for the same customer, and this is often the most used way for corporations such as Toyota , Ford and General Motors to fight the all important market share game. All of this adds up to a huge risk for both the banks who participate in auto loans, and auto manufacturers who operate in house financing arms. The entire point of money down is to keep the loan-to-value percentage down. In the old times, the maximum LTV was closer to %110. Now a 650 credit score with multiple delinquencies can secure an LTV of over %130. The reason why? People are upside down in their loans and auto manufacturers need a way to get people out to turn new product sales. And that is what repeats the cycle, over and over again.
The All Too Common Occurrence
I am going to put you through a step by step process of how it actually works from start to finish, and then you can decide if it makes sense or not. We will use Joe as our example. Joe is 32 and has had a steady job for the last year and a half. His gross income is $3,000 a month. His highest credit score is a 656 and his lowest is 632. This is rated as "fair" buy most credit standards and, this puts his approval in the tier-3 range from a pure score perspective. When we run Joe's credit, we notice that he has been late for a couple credit card payments and is currently delinquent on his student loans. His total monthly revolving and installment loan payment is around $800. This does not include his rent cost which he says is $1200 on his credit application. Joe has a trade-in that is $1000 upside down and the monthly payment is $140. This cost must be rolled into his lease payment for the new vehicle. The sales woman and Joe come to an agreement for $390 for a new loaded up 2017 Toyota Camry SE for 36 months. This is based off the assumption that the bank will give us a tier concession. As long as he did not screw over the bank we are using, we should be good. We submit Joe's credit to the bank and they come back with a tier-3 approval. This moves Joe's payment up to $445 a month, something Joe said he "simply cannot afford". Not wanting to lose Joe's business to Ford , we tell the bank this information and they give us the tier concession to tier-1. This is a usually for people who are not currently late on loans, and who have a FICO high score of 700 or higher. The only higher rating is a tier-1+ which is for the 720+ crowd only. His payment is now $390, and all is good. Joe is approved and he rolls out with his new car into the sunset.
Everything seems rather straight forward right? Wrong. You see, if you do simple math you realize that there are some major issues with this entire process. To begin with, Joe has had minimal steady work history. Also, if we add up Joe's revolving and installment debt with his monthly rent, we get a number of $2,250. We got to this number by taking the applications previous revolving installment total of $800, subtracting the loan we are replacing ($140) and adding in the new car payment ($390). Then we add in his monthly rent and poof, $2,250 a month. But Joe said he makes $3,000 gross, so we are good right? Wrong again. That monthly income figure is taken before taxes and deductions. Joe's real take home amount is closer to $2,500. All of the banks use an applicants gross monthly income for approval purposes. So now Joe has $250 left over every month to pay for food, utilities, clothes, health issues and other basic necessities. Now you understand why Joe does not make his student loan payments. Most likely, Joe will be unable to make the payments on this loan as well. The car gets repossessed and hits the auction blocks. Toyota only gets $14,000 for a car that had a loan balance of $20,000. Then Joe gets a bill from Toyota Financial Services directly for the difference which is $6000. He could either settle or let it go to collections. And the process starts over again. Toyota gave the tier concession to Joe in order to push the new vehicle sale, which lowered the money factor (lease interest) so the dealer did not lose the deal to another manufacturer. But now Toyota is left with a $6000 unpaid bill. Loan defaults happen occasionally with all type of loans however, proper underwriting can lower the occurrence of such events. Speaking from experience and as an insider, you will begin to see a sharp increase in auto loan delinquencies over next two years. If the US enters a recession, expect delinquencies to really speed up. Auto manufacturers and banks will be left holding the bill which will flood the used car market with repossessed vehicles, lowering the used car resale value even further. Just think about the laws of supply and demand.
Ignorant Yet Aware
Everyone knows that manufacturers have tons of incentives and "rebates" to entice customers. What they do not realize is that the in house financing arms have been tightening credit standards this year. They are aware that there has been an issue with quality of paper and the sudden jump in delinquencies and repossessions. The easiest way to prevent those events is to tighten requirements and give less tier concessions. At first glance, this would hurt the auto manufacturer, but in reality it does not change that much. In lieu of using a subvented APR rate of say .9% for 60, they can offer a large cash rebate to a customer if they finance through an outside bank or give a cashier's check. So for example, a customer gets an additional $2000 rebate from Toyota as a cash rebate and we submit the loan paperwork to BoA, Chase, and Wells Fargo. We know Toyota Financial Services will not give us the rate we need, so we use one of the outside banks, shop the rates and take the lowest one. The customer is happy because they "saved" $2000 off the selling price. The bank is happy because they secured another loan, and we are happy because we sold a vehicle. It's a win-win-win situation. Or so it seems.
The American consumer has been on a buying tear the last few years. New auto sales have been increasing year over year but has started to flatten out these last few months. The costs of vehicles have sky rocketed as well, and that shows in the all time highs of loan values and monthly payments. People are going longer term to make a vehicle more affordable which is a very dangerous situation. The recent rise of large truck and SUV sales has been due to low gasoline prices. People tend to have a short memory when it comes to these events, so they buy the most expensive vehicle they can afford. It should be known, these vehicles usually have the best profit margins for both the manufacturer and dealer. Buying a vehicle is the worst investment you will ever make (unless it's a collectors car) and assuming you put no money down, you will owe more than what it is worth for at least the first 4 years. Auto manufacturers are aware of the problem that was created and began to offer more "customer cash" rebates for vehicles. Toyota, Ford, GM and others all followed suit. By tightening credit standards for their in house arm, they can push the poorer quality credit to other banks which jams them with the a shaky credit portfolio when the rise in defaults come. After taking huge losses on the auction blocks the last two years, the in house financing arms are becoming smart once again. Everything that is mentioned in this article can be read directly from manufactures websites or other car buying websites. There is no secret that this is what happens, it's just most are unaware to the fact. With auto loans surpassing $1 trillion for the first time ever, now may be a good time to take notice. I suggest all people carefully watch their investments with auto manufacturers until the storm is over and the dust settles. With this little known bubble forming, all auto manufacturers look like a bad investment given the current economic environment.
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