Since the subprime crisis – as well as subsequent Hollywood portrayal of the spectacular real estate bust – there has been a lot of interest in finding the world’s next ‘Big Short’.
The leveraged auto industry is coming under scrutiny, as investors seek the next high-payoff trade.
When an industry begins to morph into something quite different from its norm, 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 and investors should take heed. The automotive industry is no longer about cars – it is about lending. Increasingly complex and high-risk financing has the potential to bring down the house.
Car makers have increasingly large finance arms – some with 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.
Also, few financial services analysts ever look at this ‘captive finance’ division, despite many being bigger than current banks. However, it is not only the lending side that is poorly analysed.
Some automotive companies have tens of billions of dollars, if not more, of outstanding derivative exposures to hedge commodity inputs, interest rates and currencies.
How big is the house of cards?
New US auto loan originations are $148bn 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. This debt, whether it is loans or leases, is ultimately supported by pricing of second hand cars.
Our calculations suggest US new car selling prices have risen by 19% since 2009, while second hand car prices have risen 27%. Furthermore, record low interest rates and the longest duration of loan maturities on record have created a perfect environment to finance cars.
Investors now have to ask serious ‘what ifs’ – what if interest rates increase? What if second hand car prices fall? What if loan maturities shorten?
Worrying signs are falls in 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 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. Any potential slowdown could be significantly magnified, as the auto industry is interlinked with a wide range of other industries – including retail, energy, finance and technology.
The rise of deep sub-prime loans
The US second-hand car market is extraordinarily dependent on the financing of non-prime, sub-prime and deep sub-prime consumers. While mortgage lending to sub-prime borrowers has virtually stopped since the financial crisis, lending in the second-hand and new car loan markets has accelerated.
It is not just the amount directed to the non-prime, sub-prime and deep-subprime market – it is that the lower end of the spectrum is the fastest growing area of auto loans. Deep sub-prime is reportedly growing at 18%, versus only 7-8% for the non-prime and above market.
We suspect ‘Buy Here, Pay Here’ dealers support the extreme tail of the used car market. Lending is at rates of 10% plus – sometimes more than 20% plus – on car valuations that are sometimes at a significant premium to ‘fair market price’. When rates rise meaningfully, default rates could rise rapidly.
Innovation leads to faster obsolescence
We are about to enter a decade of innovation and disruption – with Tesla perhaps being the first of many new entrants. Google and Apple are also potentially waiting in the wings.
Additionally, there are a number of Chinese companies seeking to expand rapidly into the West. Electric cars, autonomous/self-driving cars – as well as new business models such as ‘on-demand’ mobility from the likes of Uber – threaten the incumbents.
Rental car companies traditionally account for approximately 10% of US new car sales. Uber and others have already impacted corporate expenditure on car rentals and there is evidence of Millennials not being interested in learning to drive.
This faster rate of innovation is likely to lead to faster obsolescence and quicker depreciation, thus causing second-hand car prices to fall relative to new prices over the medium term.
In our view auto finance could well be the next ‘Big Short’, with a potentially catastrophic subprime lending issue bubbling under the surface.
It is not just select auto manufacturers facing an impending meltdown, there will also be significant headwinds felt across the entire supply chain – including original equipment manufacturers, finance companies, auto dealerships, car rental companies, tech firms and energy groups.
Randeep Grewal (pictured) is the manager of the Trium Opportunistic Equity fund.