How To Profit From Auto Subprime Bubble?

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Because lending standards for mortgages have been mostly improved since the 2008 financial crisis some onlookers may think the banks and the consumers have learned their lesson. They haven’t learned their lesson; instead they’ve reapplied all the same methods, only this time to new sectors of the economy, in particular the auto loan market. While bubbles have and will always be a part of markets, extreme bubbles are generally caused by coordinated policy or government/central bank actions – in particular, quantitative easing. With interest rates artificially suppressed to increase risk appetite, investors are required to move up the risk curve in an effort to earn any decent return on their investments. CDs and treasuries don’t offer much return, so investors have flocked to risky debt and stocks. This is why PE (price-to-earnings) multiples have soared and junk bond interest rates have fallen with record quarterly demand.

The encouraging of risky behavior isn’t a good idea for the long term because expensive stocks eventually come back down to earth and risky loans lead to excessive defaults. Part of the reason why subprime loans were given out to borrowers who weren’t likely to pay off the loan during the lead up to the housing crash is because the mortgages could be repackaged as mortgage backed securities and sold to investors who desperately wanted high returns. High returns usually come with high risk, unless you’re a savvy investor. Clearly the investors in subprime debt weren’t savvy as they were burned by the housing collapse.

The chart below breaks down the non-housing debt balance. 

The student loans and auto loans have risen above their previous peak. The auto loan debt has risen about 43% from its Q3 2007 peak. From 2008 to 2016, median household incomes have risen about 15%. It’s important to look at the debt balance in relation to incomes because nominal debt will naturally increase because of inflation. The fact that auto loan debt has almost tripled compared to the rate of income growth shows the speed of the bubble being inflated. One of the key defining measures of a debt bubble is the quickness of the rise. The $1.17 trillion auto loan market is a debt bomb which will go off when default rates rise.

While the $1.17 trillion auto loan debt is much less than the peak of the housing debt bubble which was $9.99 trillion in Q3 2008, it’s important to recognize that mortgages are backed by houses, which is an asset that generally has appreciated for decades as the population in the United States has increased. However, cars and trucks immediately lose value when they leave the lot and continue to depreciate in value as they are utilized. Defaults can be ugly for the lenders if not much of the principle on the loan has been payed off.

One of the keys to determining when the bubble will burst is looking at the incentive spending by car manufacturers. July was the fifth straight month that the seasonally adjusted annual sales rate (SAAR) has been below 17.0 million units, even while incentives soared. To give context, at the height of the market, sales are easy to come by without incentives. When sales start to weaken, automakers give out incentives to increase demand and to avoid negative year over year comparisons. At first the incentives work, but when the market is saturated with newly purchased vehicles, or excess consumer debt, the incentives stop working, which has resulted in record breaking incentives not being able to stop sales from declining. Automotive News reports U.S. light vehicle sales are on pace to decline in 2017 after seven straight annual gains. Incentives are over 10% of the price of the vehicle which is above the normal range of 7.5% to 9.5%.

The chart below breaks down the causes of the auto bubble. The numbers listed shown the percentage of sales. 

The percentage of sales which were leases was close to zero in the early 1990s. In 2016, it was at 22.5%. This is a part of how the economy has been financialized. During the housing bubble, the innovation was home equity lines of credit. It went terribly wrong when the market prices of the homes went underwater, which means equity became negative because the house declined in value since the purchase. Leases are a cheaper way to buy a car as the monthly payments are lower than when paying a loan on a purchased vehicle. However, when the lease expires, the used car needs to be sold or leased again. All those leases expiring at once from the leases started in 2014 will cause an influx of supply in the used car market, filling the market with excess inventory while demand is already declining, lowering prices even further. To counteract the decline in used car prices, firms will have to increase the price of leases which will be problematic as new car sales are already slowing.

As you can see from the right of the chart, the percentage of subprime auto loans has skyrocketed just like subprime housing loans spiked in the early 2000s. The peak in 2006 was 33.9%; the rate in 2016 reached 41.0%. Giving out this percentage of loans to subprime borrowers is like playing with fire because these borrowers have the lowest credit ratings. The reason these loans are given out is to increase sales growth. In the next recession, the percentage of subprime loans will crash which will amplify the sales decline.

The first column of the chart shows the growth of floor planned cars sold. Floor planning is when a car dealership takes out a loan to acquire new inventory. Usually the interest paid on the loans taken out to finance a dealership’s new-vehicle inventory represents a cost for the dealership. Since the 2010s, floor planning has switched from a cost to a source of profits because interest rates are so lows. If the cars can be sold quickly, the costs are lowered. An innovative financial tool to make it less cost intensive to acquire inventory has turned into a profit center since the auto market has been strong. Until recently, this has worked out well for dealerships. Lately, with inventory turnover slowing this has become a greater problem for dealerships, forcing them to apply incredible discounts and offers. The dealerships are like the mortgage brokers during the housing bubble. This party will end if interest rates rise or if sales slow, incidentally both of which are occurring right now, which will lead to a cycle of deleveraging similar to that of the housing bust in 2007.

If you’re in the market to purchase a car, 2018 may be a great year for you as more inventory floods the market. 

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