Is The U.S. Car Loan Industry Set Up For A Crash?

by: Nicholas Puri (PuriCassar)

Summary

The balance of loans securitised against vehicles in the U.S. has dramatically increased since the financial crisis.

Assessing the quality of the loans reveals a very fragile situation that is showing signs of deterioration.

The risk distribution of auto financing companies is particularly concerning.

The current progression is unsustainable and can only end with deleveraging or defaults - the latter is more likely.

By Nicholas Puri and Lorenzo Beriozza, PuriCassar AG

In our earlier article titled "The Deleveraging Myth and The Revival Of U.S. Real Estate Concerns", we brought up the issue of household debt and, in particular, how this may affect the U.S. real estate market. However, if household debt is to become a key issue, there are other industries that may also suffer. One major area of concern for the U.S. is the increase in car-related debt and the deterioration of its quality.

In a similar fashion to the real estate industry, the current situation with car loans leaves the automotive industry extremely vulnerable to any possible downturn or catalytic event, which would leave companies and individuals exposed to unmanageable levels of risk.

Unfortunately, the idea that equity markets are due a correction has been gaining traction, as can be observed in recent financial media. Could the knock-on effects of a market reversal cause unwelcome pressure on this area of fragility?

How much is too much?

Taking "vanity" metrics on face value, the auto industry appears to be in a healthy situation with vehicle sales currently higher than pre-financial crisis levels. This mirrors the situation we found with the housing industry, where new home sales had been steadily increasing and looking in great shape.

Even when we consider the potentially concerning levels of credit linked with vehicle purchases, our initial reaction is not necessarily one of alarm. The parallels with the housing industry continue in this area since consumers tend to satisfy these financial payments ahead of any other obligations. The dependence on these purchases for managing aspects of everyday life, including the ability to generate an income, means the prospect of repossession is not a realistic option. In this regard, it is a relatively safe issuance of credit.

(Chart source: Experian Information Solutions)

(Source: Experian Information Solutions)

Of course, this assumes that the current data is being presented in a situation that is stable. However, deeper analysis shows that this may not actually be the case. In fact, the Office of the Comptroller of the Currency in its "Semi-annual Risk Perspectives" stated:

"Auto lending risk has been increasing for several quarters because of notable and unprecedented growth across all types of lenders".

As you would expect, when you consider an increasing percentage of financing on an increasing level of sales, the overall outstanding securitised loans has dramatically increased since 2010.

The situation depicted thus far shows an industry enjoying positive demand, resulting in increased credit issuance to facilitate the increased demand. These surface level metrics certainly appear positive, but unfortunately it is often the figures buried deeper that unveil the reality.

Is this sustainable?

If there are vast quantities of loans being issued, this does not necessarily represent a problem. If the loans are being serviced adequately, it is simply enabling the purchase of more vehicles without necessarily creating a cause for concern.

The more important question is regarding the quality of the loans being issued. We do not need to cast our minds far back to observe how the deterioration in the quality of lending can not only create fragility in an industry, but can also cause its demise.

In the case of the automotive industry, a worrying picture unfolds as you begin to delve into the details of the financing taking place. To give this some context, we want to focus on the loan amount, the duration of the loans, and the distribution of the risk.

(Source: Experian Information Solutions)

As we can see from the chart above, the average loan amount is increasing across all purchase types. This obviously means that capital repayments will be higher, but also that interest payments will increase too. Fortunately, the finance rate on consumer installment loans have been in a decreasing trend since the financial crisis, which has allowed these interest payments to be more affordable.

The actual rate to be paid by a borrower will depend largely on their credit score. Although the financial institutions will receive larger incomes from clients on the lower end of the scale, they are also increasing their risk exposure and will therefore want to keep their distribution in balance. This does not appear to be the case with car loans, with the current risk distribution showing around 45% being made to non-prime borrowers.

(Source: Experian Information Solutions)

Since the end of 2009, auto loans to non-prime borrowers have tripled to $60 billion. In 2016, approximately $30 billion per quarter was going to borrowers with a credit score below 620, which is sub-prime.

The balances of sub-prime borrowers are now above the pre-recession level.

In addition to this, the exposure to these high-risk borrowers is extended, due to the higher average term length. Experian reports that the average payback period for prime borrowers is 66 months while non-prime and sub-prime both have an average of 72 months. Despite the low finance rates we have seen since the financial crisis, these term lengths still ensure that the money owed by borrowers will outweigh the value of the car as the loan matures.

One method borrowers adopt to avoid any negative situations is to "trade in" their vehicle. This involves agreeing with the car dealership for any residual amounts owed on the trade-in vehicle to be rolled over onto the new car's loan.

The amount of trades with negative equity (car loan higher than the value of the vehicle) has increased to 30%.

(Source: Edmunds.com)

With these factors in mind, one must determine whether the current situation is sustainable. On paper, it clearly does not appear to be a trend that can continue ad infinitum and there will surely need to be a reversal; either positively or negatively. In other words, either deleveraging or defaults.

Deleverage or Default?

Looking at the latter scenario, there are statistics that we can already start to monitor for key indications of a potential decline. Of particular interest are the delinquency rates, which appear to be on the rise.

90+ day delinquency rates for auto loans increased in 2016 to 3.6%. The New York Federal Reserve note that 6 million auto borrowers with low credit scores are at least 90 days late with their loan payments.

If we separate these figures to their core components, we get a mixed picture. On one hand, banks and credit unions have seen an improvement in the delinquency rate last year, but auto finance companies have suffered with an increase of 1%.

Looking at the distribution of overall lending activity across lender type, we can see that auto finance companies account for over half of all loans. However, more concerning is their involvement in sub-prime lending, where they account for 75% of loan originations. This divergence in delinquency rate and lending type shows clear parallels to the situation discussed in our recent real estate industry article, where non-bank lenders are seen to be taking large risks.

The geographical distribution of the 60-day delinquency balance suggests there is a heavy concentration in the Sunbelt states.

Interestingly, it appears there may be a correlation of some form with the slowdown in fracking and shale productions in these areas.

(Source: Environment America Research & Policy Center)

(Source: Zero Hedge)

This is arguably a minor correlation, but it certainly shows the breadth of potential catalytic events that could impact the delinquency rates and add pressure to this fragile situation.

Although it is unclear at this point what the trigger for a reversal will be, it is certain that the industry is in a precarious situation. We will be paying close attention to the statistics outlined in this article over the coming quarters, especially as the wider economic and political landscapes evolve.

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company whose stock is mentioned in this article.

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