CAR LOANS: A POTENTIAL U.S. AUTO INDUSTRY CRISIS? (EITS #12)


In our earlier video titled “The Deleveraging Myth and The Revival Of US

Real Estate Concerns” we brought up the issue of household debt and, in particular, how this may affect the US 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? 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

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 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 As we can see from the chart on screen, 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 instalment 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 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% 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

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 36% 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 research, 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 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 video over the coming quarters, especially as the wider economic and political landscapes evolve

Let's continue the discussion about this topic in the comments section If you liked this video, don't forget to hit the thumbs up button and share with any friends who might find it interesting Subscribe for more videos like this and to learn more about the financial markets As always thank you for watching and see you in the next video

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