The Auto Bubble Begins to Burst

Record auto sales have been propped for up for years by low interest rates, loosening auto lending standards with terms being stretched to the max and a wave of leases, all of which have allowed the American consumer to trade up to more expensive vehicles while maintaining low monthly payments.

Too many cars were produced. And too many expensive cars were bought by poor credit risks. Now we are beginning to see the consequences: Too many car loans going bad, too many used cars on dealer lots, too many trade-ins underwater and too many new cars in inventory requiring too many incentives. What’s wrong with this picture? Everything. The tailwinds that have propelled auto sales to record highs over the past several months are changing direction and car industry profits are turning down hard.

Let’s start with a quick look at the loans that are more than 60 days delinquent in the General Motors’ subprime securitization book. January 2017 delinquency rates have soared to the highest levels since the reaction to the Great Recession in late 2009.

Meanwhile, looking at GM’s subprime data going back to 2001, we can easily see that spikes in the 2-month delinquency rate are a good indicator of trouble ahead.

As the Financial Times pointed out last week, it’s not just subprime borrowers that are having problems making their monthly auto payments.  According Transunion, more than 1 million U.S. auto borrowers, subprime and otherwise, were behind on their payments as of Q4 2016 as overall delinquency rates have also soared to 2009 levels. The car loan market totals $1.1trillion.

The delinquency problem reflects the fact that lenders have induced borrowers to go beyond their means. They lend more for longer…up to 84 months…if you get the model with all the fancy extras. Or you can also get the 2 to 3 year lease on the expensive models. It’s a way to up the size of the ticket and increase profits but it comes with a risk. Borrowers take on too much debt and default.

Vehicle prices since 2008 are dramatically higher. A $28,000 vehicle in 2008 is now $50-$55,000, loaded down with new standard equipment features such as backup cameras, WIFI, and seat warmers to justify the higher prices. These are prices that can only be achieved with cheap credit financing on lax terms as the chart below shows.

More defaults on higher loan amounts translate into negative trade-in values and that’s putting pressure on the used car market…a big problem for dealers who typically make more on sales of used cars than new ones. It’s also a big problem for manufacturers whose customers can’t buy new if they have to sell their used vehicle for less than the equity they have in it.

In the first quarter of 2017, Ally says used-car values fell 7%, a steeper move than the company’s projection for a 5% drop in all of 2017. Morgan Stanley’s auto team, led by Adam Jonas, has just issued a report detailing why they think used car prices could crash by up to 50% over the next 4 to 5 years, mostly due to rising rates and greater off-lease volumes.

Meanwhile, vehicle inventories have swollen to a 13-year high, the highest level since 2004. Where does this inevitably lead us? To incentives, of course. As of February, OEM incentives have reached new, all-time record levels.

For March, J.D. Power and LMC Automotive have pegged incentives industry-wide at $3,768 per new vehicle sold, the highest ever for any March. The prior record was achieved in 2009 as the industry was collapsing. In June 2009, GM filed for bankruptcy. By these estimates, the incentives in March amount to 10.4% of suggested retail price, in the double digits for the first time since 2009. These are some seriously desperate incentives! Yes, dear reader, the chart below says the U.S. OEMs paid out $5.5 billion in incentives IN ONE MONTH.

What can we learn from this (AGAIN)? Cheap credit and lax lending standards create excess demand. Excess demand creates excess supply. Excess supply kills profits, creates excess inventory and leads to lay-offs, downsizing and even bankruptcy. Meanwhile, loan defaults soar and lending standards tighten at the worst possible time.

The auto industry remains the most important in the manufacturing sector. It’s in big trouble and the worst is yet to come. Stay clear.