With real estate prices soaring faster than average wages can keep up, many contrarians are again keeping a wary eye on the housing market. But this time around, it’s the automotive sector that finds itself on the wrong side of the ledger. Thanks to a toxic combination of pressure, greed, and outright fraud, automotive subprime loans are now a legitimate concern.
To understand the present controversy, it helps to rewind back to the last subprime loan crisis. To make a quick buck, mortgage providers issued subprime loans, or credit extended to low-income earners. Several of these loans were packaged into high-yielding securities.
Of course, the problem was that low-income workers had no business “owning” the homes that they did. Defaults came fast. Because so many people invested in securities levered toward subprime loans, the defaulting poor took down the arrogant rich. It was poetic justice in a way, but it almost destroyed us.
The automotive subprime loan crisis is taking an almost identical path: declining car sales, demographic shifts, the pressure of turning over inventory quickly. While no one suggests that subprime loans for cars will upend the American economy, it’s still a worrying dilemma. Much of the fraud is from lack of oversight. For example, “stated-income loans” without outside verification are completely legal in the auto industry, but not in mortgages.
This creates a genuine fear that the four-wheeled subprime loan crisis is more corrosive than initially realized. It also directly contradicts government assertions that the consumer economy is recovering just fine. If things get even uglier, watch out for these three stocks levered toward subprime loans.
Subprime Loans: Banco Santander, S.A. (ADR) (SAN)
No other financial institution defines the car industry’s subprime loan crisis quite like Banco Santander, S.A. (ADR) (NYSE:SAN). Going back to 2013, SAN inked a lucrative partnership with Fiat Chrysler Automobiles NV (NYSE:FCAU). As a result, “the two have built one of the industry’s most powerful subprime machines,” according to Bloomberg. Unfortunately, the deal was something less than kosher.
Official legal documents and proceedings, as well as insider interviews, exposed the murky world of automotive subprime loans. Practices that wouldn’t be acceptable in most other industries were given a pass in the auto sector. According to Moody’s Investors Service, SAN only vetted 10% of subprime loans that were recently packaged into investable bonds. The value of those bonds totaled $1 billion, which may not threaten global fiscal stability, but is still a staggering amount of potentially fraudulent products.
To be fair, it’s not just SAN that’s involved in this growing subprime loan crisis. Car dealerships are playing fast and loose with the loan application process. Just like in the previous housing bubble, dealers are knowingly sending off unqualified consumers in cars they can’t really afford. SAN reported that it no longer works with dealerships that resort to ethically improper lending practices. Still, the company settled similar disputes, so the problem may be worse than imagined.
Whatever the case, the optics don’t look good at all. Given Americans’ recent tango with a subprime loan crisis, SAN stock is a name to avoid.
Subprime Loans: Ally Financial Inc (ALLY)
You don’t necessarily have to be in on the fix to still be affected by the subprime loan crisis. This is a sad and tough lesson that Ally Financial Inc (NYSE:ALLY) may learn if the problem gets out of hand. According to Experian, ALLY was the top auto lender in the nation in the fourth quarter of 2015. That status makes it especially vulnerable to negative industry trends.
Unfortunately, the signs don’t look too hot. In another Bloomberg report, the “total amount of the debt outstanding has risen more than 50 percent since the end of 2010, a rapid increase.” Within this broadly concerning picture, delinquencies on subprime loans are skyrocketing. In the final quarter of last year, lenders were unable to collect over $1.1 billion in delinquent accounts. Because of this epidemic, institutions like ALLY were forced to implement tighter controls on their lending practices.
However, that only solves one end of the equation for ALLY. The other is dealership fraud, and it’s a huge dilemma. Dealers are obviously incentivized to push rising inventory in a “peak auto” cycle. Such pressure inevitably leads to crooked sales somewhere. Also, the dealers have expert knowledge of the industry, and may know how to tweak numbers “effectively.”
Such shenanigans must surely keep ALLY executives awake at night. Investors should also be leery of subprime loans. The crisis may not affect everyone, but it will certainly hit the embattled auto industry hard.
Subprime Loans: AutoNation, Inc. (AN)
Sometimes, you just have to face the ugly truth — this is not a great time for the auto industry. Most major automakers are hurting badly this year, with a notably ironic exception of Fiat Chrysler. The ones that aren’t sinking are like General Motors Company (NYSE:GM) — not bad, but not great. So to be the biggest U.S. car retailer isn’t exactly a strong marketing point for AutoNation, Inc. (NYSE:AN).
Since the start of 2016, AN stock has suffered prolonged periods of volatility. Given the surge in subprime loans and associated delinquencies, I don’t believe that AN will recover anytime soon. Since 2010, the auto retailer’s days inventory has increased 23.5%. Presently, this metric is worse than it was during the lows of the Great Recession. It goes without saying that AutoNation has been challenged to turnover its vast supply of vehicles.
Although it’s a cynical argument, AN dealers are likely to push subprime loans in an effort to keep their job. Even if such shoddy practices aren’t occurring, the optics against the industry is very unfavorable. Furthermore, it’s patently obvious that the consumer economy has yet to recovery significantly. Otherwise, we wouldn’t see junk loans being proliferated, and investors competing over these high-yield junk bonds.
Sadly, AN stock is a situation of an investment levered toward a sector that has gone well ahead of itself.
As of this writing, Josh Enomoto did not hold a position in any of the aforementioned securities.