Is That the Smell of Compounding Risk?

If you only looked at GM Financial’s origination volume last week, you would think auto finance was continuing on its boom-time ways.

GMF grew its North American originations 19% last quarter to around $11 billion, according to company earnings released last Friday. Sing Hallelujah!

Well, don’t lose your voice yet. There is a wellspring of heightening risk factors facing auto finance just as we approach the start of the Auto Finance Risk and Compliance Summit, which kicks off in two weeks in San Diego.

Let’s start with some market fundamentals. Borrowing costs for auto finance companies did climb last year, but have moderated somewhat, and the absolute cost to borrow for auto finance companies continues to be extremely low, on a historical basis.

Still, there has been deterioration in credit quality. While incentives have increased 16.2% in 2016, which is a lot, the greatest economic risk to auto finance seems to be interest rates. Here’s what JP Morgan Chase & Co. said yesterday in a research report:

Absent an unforeseen macroeconomic downturn, general interest rates increasing faster than economic fundamentals can support improved underlying demand is likely the greatest threat to the auto cycle.

That implies the auto financing market remains strong. Does the anecdotal evidence support a strong market, though? JPM had a recent get-together with Ford President & CEO Mark Fields and Ford Credit CFO Marion Harris. Fields and Harris convinced JPM that all’s well in auto finance land.

Relative to credit, we heard Ford management say in our meetings that there is no subprime bubble, that the health of auto finance market is strong and captive finance companies very strong, and that Ford Credit is ahead of the curve (not behind) in accounting for the impact of lower residual prices and has remained disciplined relative to the quality of loans and extent of leasing.

Not everyone is so positive, however. Last week, Mike Jackson, CEO of AutoNation, got vocal during his 1Q earnings call about industry “red lines” that have been crossed, as recounted by the CompetitorPro blog:

  • New car incentives surpassing an average of 10% of MSRP — Jackson noted, “To me, 10% has always been a red-line where there’s a severe diminishing return at 10%.”
  • New car leasing crossing the 30% threshold — “To me, 30% leasing has always been a red-line, where you have a massive distortion if you take it above that.”
  • Inventory supply levels surpassing 70 days — “To me, inventories above 70 days is a red-line.”

“We’re in the spiral that everything moves against the new vehicle market at a plateau — it takes higher incentives to stay at a plateau…and it will be difficult to maintain above 17 million new vehicle sales,” Jackson said.

So far this year, the new-vehicle SAAR is averaging 17.2 million units. The March SAAR came in at 16.6 million units.

Jackson’s position has weight, perhaps with the exception of his hesitation on leasing. That 30% is some sort of North Korea-esque DMZ that only finance crazies cross seems arbitrary. According to JPM, “more vehicles will come off lease in 2017, 2018, and 2019, but incremental pressure on used-vehicle prices from higher off-lease supply likely peaked in 2016.” It is equally hard to swallow this claim, that the full impact of more-robust leasing has passed.

But beyond the ambiguity around leasing, it is clearer that new car incentives and inventory levels are both corrosive to auto industry health. Average auto transaction prices are at their highest since 2008, at over $34,000. Higher transaction prices mean there is a potential for a “the harder they come, the harder they fall” type of acceleration in credit losses. Further, the Manheim Index has also been relatively flat for the past couple years (it was only 1.3% higher last month on a year-over-year basis) and there is new leasing activity that will still hit residual values. That index has got to fall in the coming years.

Yes, it is true that auto lending companies are among the most discounted consumer finance stocks today. Ally is trading at a PE of just 8.91, for example. Still, Jackson’s warnings deserve not just attention, but investigation. If there is compounding risk in auto finance as a result of incentives, inventory and leasing, it is imperative that lenders get on top of it. Before it is too late.

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