Call me crazy, but I thought the world had learned its lesson when it comes to making subprime loans.
In fact, I seem to remember a time not too long ago when the glut of subprime loan defaults became the catalyst for a near-collapse of the global financial system. Of course, these were much larger dollar amount home loans, and not auto loans. Still, the concept of lending money to those who are at greater risk for default than prime borrowers fills me with a sense of anxiety.
So, you can imagine my sense of angst when I discovered that General Motors (NYSE:GM) — the company all Americans have an ownership stake in — is expanding its efforts to boost sales by releasing another loan program for subprime buyers with low credit scores.
The first program, which began in 2010, was aimed at subprime buyers with credit scores below 650. Financially speaking, these riskier loans came with a very high annual percentage rate of 12%; the high APR is designed to make up for the loss of revenue from the greater number of loan defaults inherent in these instruments. In 2010, GM actually spent $3.5 billion to buy finance firm AmeriCredit Corporation, precisely because it wanted to have a way to make more subprime loans.
Now, to be fair, GM did this to keep up with Japanese auto giants Honda Motor Corp. (NYSE:HMC) and Toyota Motor Corp (NYSE:TM). Both companies have financing arms in place for subprime buyers, and by some estimates, Honda saw about 20% of sales from such customers. For GM, sales to customers at greater risk of default definitely is on the rise, and since the addition of AmeriCredit, subprime new-car sales have climbed to more than 8%.
GM’s subprime push is, in my opinion, part of a disturbing trend that could backfire on the automaker, and on the entire industry.
According to credit firm Experian Automotive, during the first quarter of 2012, subprime vehicle loans (in this case, loans made to consumers with credit scores below 680) jumped more than 18% over the same quarter a year ago. Overall, loans to this segment of the auto-buying public during Q1 came in at slightly more than 23% vs. the 20.8% in Q1 2011.
The question now becomes: Are automakers setting themselves up for a whole lot of defaults? The answer, of course, is that we won’t know until after the fact. Just like in the housing crisis that brought us to the brink of collapse, we didn’t know until retrospect that all of that subprime paper was destined to implode.
After what happened in the housing space, I think companies should know better than to rely heavily on subprime. However, the metrics in the auto space are such that carmakers are going to risk losing money from defaults to juice up what was a lag in U.S. sales last month.
In July, the three leading U.S. carmakers reported sales for the month that missed analysts’ estimates. GM sold 201,237 vehicles in the U.S. in July, a number that was 6% below last July’s measure. Ford (NYSE:F) said it sold 173,966 cars and trucks last month, a 4% slump vs. last year. Chrysler, now majority-owned by Italy’s Fiat (PINK:FIATY), reported sales of 126,089 vehicles. That metric was up an impressive 13% over July 2011, yet it still fell short of expectations.
The silver lining here for investors is that there are companies that stand to benefit from the trend toward more subprime auto buying. AutoNation (NYSE:AN) is a national dealership chain that offers its own subprime financing, and that caters in part to subprime buyers. In July, the company saw a 14% increase in sales.
Group 1 Automotive (NYSE:GPI) is an auto retailer benefitting from the subprime customer. The company, which also operates a financing arm with subprime loans, reported a 37% increase in new car sales for quarter ended June 30. That helped the Group 1’s net income rise 15.8% in the quarter vs. a year ago.
Yet another auto retailer in this category is Lithia Motors (NYSE:LAD). The company gets a lot of its sales from Chrysler dealerships, but it also gets a lot of revenue from subprime customers. Sales to the latter rose 31% in the second quarter.
For everyone’s sake — automakers, investors, car buyers and every American who owns a piece of GM — let’s hope that this current subprime loan push doesn’t end up the way that other one did a few years ago.
As of this writing, Jim Woods did not hold a position in any of the aforementioned securities.