Since the subprime crisis and subsequent Hollywood portrayal of the spectacular real estate bust, there has been a lot of interest in finding the world’s next ‘Big Short’. Now the leveraged auto industry is coming under scrutiny, as investors seek the next high-payoff trade. In the following article, I assess the depth of problems in the auto industry and whether lax lending could bring down the house.
A good analyst looks for signs of sulphur in the water; the familiar smell of something not quite right. When we identify a potentially deep and systemic issue, we build an evidence-based hypothesis to test the validity of prevailing assumptions. If the market view does not match the facts, we take a variant or contrarian position.
Auto industry is no longer about cars
When an industry begins to morph into something quite different, it can be a sign of innovation, but it can also point to something darker. When the US sub-prime property market became more about derivatives and less about housing, investors were living on the side of a smoking volcano.
The auto industry is now displaying amorphous traits; investors should take heed. The fact is, the automotive industry is no longer about cars – it’s about lending; increasingly complex and high-risk financing with the potential to bring down the house. Car makers have increasingly large finance arms – some with their own banking licenses and access to central bank lending windows. Many auto analysts and investors look at the ‘industrial arm’ of the business and take the finance side for granted; and very few financial services analysts ever look that these ‘captive finance’ division despite them being bigger than many banks.
However, it is not merely the lending side which is poorly analysed; some automotive companies have tens of billions of dollars, if not more, of outstanding derivatives exposure to hedge their commodity inputs, interest rates and currencies.
How big is the house of cards?
New US auto loan originations are $148.4bn per quarter which is nearing the peak prior to the financial crisis. The total US auto industry consumer debt outstanding is in excess of $1.19 trillion (well in excess of pre-financial crisis levels), or 9% of total US consumer debt (according to the New York Federal Reserve quarterly report on Household Debt and Credit). This debt, whether it be loans or leases, is ultimately supported by the pricing of second hand cars.
Since 2009 our calculations suggest that US new car selling prices have risen by 19% whilst second hand car prices have risen by 27%. Furthermore, record low interest rates and the longest duration of loan maturities on record have created a perfect environment to finance cars. Investors have to ask serious ‘what if?’ questions – ‘what if interest rates increase?’, ‘what if second hand car prices fall?’ and ‘what if loan maturities shorten?’
Worrying portents are falling second-hand car values, increases in sub-prime loan duration and inflated valuations, all within a backdrop of what is likely to be a rising rate environment. A reset of the yield curve could a hurt a lot of players. When the downturn arrives, people will start defaulting and loan providers will have to deal with the consequences of toxic financing.
The auto industry is interlinked with a wide range of other industries including retail, energy, finance and technology so any potential slowdown could be significantly magnified.
‘Cash for clunkers’ is not driving the market
Our initial assumption was that ‘cash for clunkers’ (an incentive to remove old cars) was a major driver of second-hand car demand in the US, pushing residual values up. After deeper analysis, however, we found ‘cash for clunkers’ lasted barely two months (July – August 2009) and amounted to 670,000 cars being scrapped. It is important to bear in mind that there are 264 million vehicles in operation in the US; and last year over 17.5 million cars were sold.
Our analysis suggest that the biggest driver of new car sales has been finance – whether in the form of loans or leases. In most developed countries between 70% and 90% of all new car sales are linked to finance. In the US about 30% involve a lease thus exposing the finance provider to residual values. Loans, however, do not insulate lenders as ultimately the collateral for a loan is based on second hand car prices
Non-prime, sub-prime and deep sub-prime loans are growing
The US second-hand car market is extraordinarily dependent on the financing of non-prime, sub-prime and deep sub-prime consumers. Since the financial crisis, as mortgage lending to sub-prime borrowers has virtually stopped, lending in the second-hand and new car loan markets has accelerated.
It is not just the amount that has been directed to the non-prime, sub-prime and deep-subprime, it is that the lower end of the market is the fastest growing area of auto loans. According to Experian’s Q2 2017 ‘State of the Automotive Finance Market’ report deep sub-prime is growing at 18% versus only 7-8% for the non-prime and above market.
Buyer Beware: ‘Buy here, pay here’ dealers
We suspect ‘Buy Here, Pay Here’ (BHPH) dealers support the extreme tail of the used car market. Lending is at rates of 10% plus (sometimes 20% plus) and on car valuations that are sometimes at a significant premium to ‘fair market price’. When rates rise meaningfully, default rates could rise rapidly. We are still examining the extent to which this will affect listed autos, but BHPH loans are supported by a whole host of sub-industries from remote immobilisation services to bounty hunters.
The next ‘big short’
In our view auto finance could well be the next big short with a potentially catastrophic subprime lending issue bubbling under the surface. It’s not just select auto manufacturers that are facing an impending melt-down; but also there will be significant headwinds felt across the entire supply chain, including original equipment manufacturers (OEMs), finance companies, auto dealerships, car rental companies, tech companies and energy companies.
Randeep Grewal, portfolio manager of the Trium Opportunistic Equity Fund