Ready to start your engines for the summer driving season? Will our cars lead us into the next recession? Although auto sales declined substantially this year, the real story is that the subprime bubble in auto lending is now showing cracks. How will this impact real estate and the general economy?
I was recently looking at a real estate loan on a condo in Denver valued around $250k. As I drove through the parking lot I saw numerous Mercedes, Lexus, BMW vehicles many with values well over $75. I began thinking how could the numbers add up for someone to afford this pricey of a vehicle? There is no way this is sustainable!
In the United States, it seems that there are two major indicators of the economy. The two traditionally largest purchases a consumer makes are for their car and their house. When one (or both) of the indicators make large movements this can foretell a change in the broader economy. For example, as auto sales began cooling consumers spending pulled back sharply in Q1 of this year (see NY times article). Real estate looks tame compared to what is occurring and will likely transpire in the auto sector.
There are two major trends occurring with autos that are closely intertwined. First, sales are cooling. In April both Ford and Chrysler saw their auto sales decline 7% (NY times) While sales are declining, at the same time delinquencies are up on auto loans. Both items are working to slow the auto sector significantly with all the major automakers announcing furloughs or job reductions. For example, GM recently announced they are cutting production in half at one of their transmission plants which will significantly reduce staffing (autonews)
Along with demand softening. Auto lending looks like the last mortgage crisis. Over the last 7 years auto sales increased to historic levels. One of the drivers of the large increase was loosened auto lending. Like the housing boom, lenders packaged loans and sold various tranches to investors.
As more auto loans were originated, standards were loosened. According to a recent Bloomberg article a major subprime auto lender checked income on just 8 percent of the loans originated. Furthermore, 20 percent of borrowers admitted that their applications for debt contained inaccuracies. Sound familiar? There are still lawsuits today against banks for this same practice during the mortgage mess.
According to the office of the comptroller: “Auto lending risk has been increasing for several quarters because of notable and unprecedented growth across all types of lenders. In the last two quarters, delinquencies on auto loans have begun to increase and net losses have also reflected non-seasonal increases. As banks competed for market share, some banks responded with less stringent underwriting standards for direct and indirect auto loans” (OCC.gov)
Who cares about auto lending?
The loosened standards are leading to higher charge offs on auto loans both at banks and within securitized pools. Auto delinquencies have hit their highest level in seven years. Furthermore, 32 percent of all trade ins during the first 9 months of 2016 were “underwater” meaning the car was worth less than they owed which could lead to further delinquencies.
According a recent Morgan Stanley report previously owned cars are predicted to decline by 20% over the next 4 years (and they might plunge as much as 50%). Even on the low side of the 20% decline auto loan losses are set to explode.
Who will be left holding the bag when it explodes? It is going to be a large bag ! The total balance of auto loans outstanding just reached 1 trillion dollars, the highest amount ever recorded. The million-dollar question is who will take the hit?
The easiest suspects to identify are the automakers. For example, in recent SEC filings Ford increased its loan loss reserves to 449 million a 34 percent increase and GM set aside 864 million, a 16% increase. Between these two auto makers the anticipated loan loss reserves is almost 1.3 billion dollars!
Banks will also be hurt. Many banks have built substantial auto lending portfolios in an effort to increase their yields. As defaults increase, banks will no doubt be impacted.
The increased losses will trickle through the economy in unique ways. In the last mortgage crisis, finding out who actually was holding the bag when the **** hit the fan was an interesting question. As mortgages were “stripped” meaning different buyers bought different pieces (tranches) of a mortgage nobody really knew what they had until the music stopped. Yields are extremely low by historic standards and therefore there is a huge desire of investors to increase their returns. Many pension funds, hedge funds, retirement accounts, etc.. have invested in auto loans and I would suspect that many individual investors also have exposure in their portfolio
What about real estate and mortgages?
Auto loans appear to be a leading indicator for the general economy. The market “euphoria” we currently have in many markets will come to an end. The looming auto crisis is a good reminder of the risks within the economy. As lenders take losses on autos, this will undoubtedly influence their underwriting decisions on other asset classes. Lending has already begun to tighten ( What does your bank know that you don’t). Autos will be one more drop of water on the real estate party to “cool” the market.
What does this mean for the general economy?
Make sure you are wearing your seatbelt! We likely will be driving into the next recession. Two major impacts will occur. Losses will undoubtedly happen with various players in the economy. As losses mount risk appetite decreases so lending in turn tightens not just on autos, but mortgages, credit cards, business lending, etc…. As we saw in the last mortgage bust it took almost 8 years for lending to normalize for mortgages which crimped demand for multiple years. The second major impact is consumer confidence will get bruised. As consumers pull back the rest of the economy will suffer with less spending, etc…
The “contagion effect” begins to occur as a result of decreased lending and lower consumer confidence where implications multiply through the economy. It is certain that there will be fallout from the looming auto crisis that will impact not only the auto sector, but other industries and consumers throughout the economy. How deep and widespread the “auto flu” travels is the million dollar question.
Written by Glen Weinberg, COO/ VP Fairview Commercial Lending. Glen has been published as an expert in hard money lending, real estate valuation, financing, and various other real estate topics in the Colorado Real Estate Journal, the CO Biz Magazine, The Denver Post, The Scotsman mortgage broker guide, Mortgage Professional America and various other national publications.
Fairview is a hard money lender specializing in private money loans / non-bank real estate loans in Georgia, Colorado, Illinois, and Florida. They are recognized in the industry as the leader in hard money lending with no upfront fees or any other games. Learn more about Hard Money Lending through our free Hard Money Guide. To get started on a loan all they need is their simple one page application (no upfront fees or other games).