Delinquencies on consumer loans are getting increasing attention, and for good reason. While delinquency rates on home mortgages are at rock-bottom levels, an increasing number of people are falling behind on credit-card and auto loans.
Particularly troubling is that this shouldn't be happening at this point in the economic cycle. Unemployment is at 20-year lows, interest rates are still low, etc.
Understanding what's going on and its implications requires some nuanced reading of the data. Here's my take on where we stand and its implications.
The Iron Rule of Lending
If you take nothing else away from this column, remember this: the only way to get meaningful market share in lending is to lower your standards. All of the good borrowers who want loans (of whatever type) already have them. The only way to find new borrowers is to be willing to lend to those that can't get a loan from existing players.
Traditional ways other business types get share, such as lower prices or superior service, turn out to be very minor elements in lending generally and consumer lending especially. Lending rates are mostly a function of cost of capital, so it's difficult for one lender to offer meaningfully lower rates than another. Plus, once someone does, everyone follows since they mostly face the same cost of capital.
Anyway, this iron rule of lending tells you that when you see a certain type of loan growing in total issuance, the lending standards are almost certainly easing.
What's Going on in the Auto Space?
Total auto loans outstanding are up 57% since 2012 vs. just 11% for home mortgages and 21% for credit cards. For context, total GDP (unadjusted for inflation) grew 22% during the same time period, so the home-loan and credit-card rates make perfect sense.
There's no way to justify the 57% growth in auto loans. Auto lenders, as a group, are definitely lending to people today they wouldn't have lent to in 2012.
Now the rising delinquencies in auto loans are making more sense. It isn't that consumers are so strapped, despite a very strong labor market, that they can't make their car payments. It is that weaker borrowers are entering into the pool. Those weaker borrowers are more likely to go delinquent, even in a good economic environment. Hence the better way of thinking about this rise in delinquency is not that the consumer is weak, but rather that underwriting is poor.
Not All Lenders Are Made Equal
There are three major types of lender in autos:
There are captive finance arms, which are owned by a manufacturer or a dealer. These mostly lend to prime borrowers, although CarMax (KMX) or Westlake Financial are more mixed.
There are bank-based lenders, which lend across the spectrum, with groups like Santander (SAN) among the larger sub-prime lenders. Most of these are small parts of a big bank, and have been in the auto business for many years.
Then you have specialty lenders, mostly backed by private equity. This category is full of new entrants into the lending business that were trying to take advantage of cheap short-term capital and relatively high interest rates on sub-prime auto loans.
We can see this phenomenon in action by looking at larger and smaller sub-prime issuers in the asset-backed securities market. According to a recent report by Wells Fargo (WFC) , the two largest sub-prime issuers (Americredit and Santander) have an average delinquency rate of 9.4% as of March 2018. That level has been fairly consistent since 2014, consistently in the low 9%s.
The universe of smaller sub-prime issuers currently has a delinquency rate of 14.3%. Most (though not all) of these issuers are of the recent entry, private-equity backed type. That rate is a bit higher now than in recent years, having averaged 12.6% since 2014.
What has really resulted in the overall delinquency rate rising is the mix between the big lenders and the smaller ones. In 2012, Americredit and Santander accounted for 86% of all issuance. In 2014 they were 76%. As of 2018, they are just 51%.
This gets precisely to my first point. The new entrants have only been able to gain customers by lowering standards. Overall delinquencies are mainly rising because these new entrants are bringing new borrowers into the total pool.
If This Feels Like 2007...
You aren't crazy. There are important parallels. In the housing bubble, many specialty lenders popped up, often tied to either private equity or mortgage bond dealers. Not only did competition from these lenders help encourage weaker lending standards overall, it also fueled the rapid price increases in housing. In effect, more lending resulted in higher demand for houses, pushing prices higher, which encouraged speculation. There's your bubble.
I think the parallel on the lending side is there, but not on the asset side. That is, I don't think there is a bubble in used-car prices.
It is also the case that the asset value in autos isn't a key part of the lending equation. In home mortgages, the lender views the value of the home an important part of the lending consideration, since seizing the house can often make the lender whole even when the borrower defaults. However, autos are rapidly depreciating assets, especially used cars that are typically a big part of sub-prime lending.
Hence you aren't going to get the feedback loop of increasing defaults leading to declining asset prices leading to even higher defaults and even larger asset price declines. That is exactly what led to the housing crash turning into the Great Recession. Autos just doesn't have that kind of potential.
There's Still Plenty to Worry About
Already many of these PE-backed auto lenders are shutting down. Not only are losses rising, but the higher short-term rates plus a flatter yield curve are making the business less profitable. If losses keep rising, especially if we were to get into a generalized slowdown, we could see these marginal lenders exit the business more quickly. This in turn would have major implications for auto demand, specifically used car demand.
Take a look at the chart on stocks like CarMax, which is near five-year highs and has surged this year. That stock would be very vulnerable to any pullback in lending. Manufacturers, such as General Motors (GM) , Ford (F) , etc., are also vulnerable, although probably not as much as auto dealers.
Lastly, there are macro implications. Above I argued that most of the increase in delinquencies in auto loans is related to weaker new borrowers, not consumers being strapped overall. However, the rise in consumer borrowing overall suggests there is limited room for consumer spending to grow. I think the overall statistics indicate that any tailwind from normalizing lending standards is now gone. This is yet another reason why I don't see growth accelerating, and don't see long-term interest rates rising.
This column originally appeared June 6 on Real Money Pro, our premium site for active traders and Wall Street professionals. Click here to get great columns like this even earlier in the trading day.
