The Auto Finance Outlook for 2019

From January 2016 to October 2018, the Dow Jones Industrial Average increased from 16,000 to over 26,000, representing a period of unprecedented growth in terms of level and pace. U.S. Gross Domestic Product (GDP) during the same period grew from .4 percent to 4.2 percent, after economists had predicted we would never again see growth above 3 percent. In the last few months of 2018, however, the Dow dropped down to just under 22,000 and GDP dropped down to 3.4 percent. Analysts attribute this to volatility in the tech sector, the risk of rising fuel prices, fears of a trade war and the impact of political gridlock.

The cloud of economic uncertainty has sparked a number of market watchers to predict an impending recession, leaving many lenders wondering what 2019 will mean for the auto finance industry. The answer to what lies ahead for lenders requires a review of the demand for auto loans, as well as the availability of capital to finance them. The latter is driven by both the performance of existing loans and data-driven expectations regarding economic risk.

Auto loan demand
The seasonally adjusted annual rate (SAAR) for new auto sales increased from 15.6 million units in 2013 to 18.4 million units at the end of 2015, at which time it appeared that demand had leveled off. New auto sales fluctuated between 17.5 and 18 million units throughout 2016, but sharply dropped off to a pace of 16.8 million units by the third quarter of 2017. During that period (June 2016 to June 2017) dealer inventories increased substantially, as measured by the inventory to sales ratio (refer to the graph titled ‘Total Auto Sales’). In response to dealership pressure, manufacturers cut production of select models and corrected output to more closely match demand, which has remained steady around the 18 million seasonally adjusted rate. (Figure 1)

Due to strong growth in the auto sector over the last five years, a levelling off of demand felt like a contraction. The fact of the matter is that both new and used vehicle sales remain relatively high, and the economic fundamentals going into 2019 suggest that they will remain so. Factors supporting this include:

• Strong GDP – While the growth rate for GDP did drop off in the third quarter, it remains at a high level when compared to the annual increases over the last 10 years.
• Strength in manufacturing – The Purchasing Manager’s Index, produced by the Institute for Supply Chain Management, is presently at 59.3 percent. While it is slightly down from prior months, it has consistently been above 50 percent which indicates economic growth.
• Unemployment and wages – Unemployment, at 3.7 percent for November, is at the lowest level since 1968, and data from the Bureau of Labor Statistics show that wage growth is at 3.9 percent, which is the highest point in over 10 years.
• Consumer sentiment – The Conference Board reports that while Consumer Sentiment dipped in the past month, it remains near the highest levels observed in the past 11 years.
The latest Experian State of the Auto Finance Market Report (Q3 2018) shows that the percentage of new car loans with financing is 86 percent, whereas the percentage of used car loans with financing is 53 percent. These figures are slightly up from last year and remain consistent with figures from the last three years. Both Experian and the Federal Reserve (G-19) report that auto loans continued to increase throughout 2018 to a level of nearly $1.2 trillion outstanding (refer to the graph titled ‘Auto Loans Outstanding’).

The combined factors of robust economic growth, increasing production, low unemployment and higher wages are driving optimism among consumers, which historically leads to increased consumption. Barring an unforeseen economic shock, the data suggests that consumer demand will remain elevated throughout 2019. Furthermore, the year over year increase in auto loans in the third and fourth quarters of 2018 suggest that the level of auto loans is likely to continue to increase in 2019. For those who are more comfortable with a pessimistic view, a contraction next year of 5 to 10 percent (highly unlikely) still puts auto loan volume above where it was in 2015-2016 when many thought the market had peaked. (Figure 2)

An interesting fact concerning this growth is that most of it has come in the prime sector, from captive finance companies and credit unions. There has actually been a contraction since late 2016 in subprime lending, which is interesting given the constant drumbeat among the media and self-appointed experts suggesting the next subprime bubble is upon us. As historian James Buchan put it, “economists, like royal children, are not punished for their errors.”

Experian recently reported that subprime auto lending is at record low levels, which is presently around 21 percent of auto loans. That level has historically been between 30 and 33 percent, depending on how the sector is defined. There are two factors driving this trend. First, in spite of the media reports over the last 10 years, subprime customers are actually paying their bills. This has the strange effect of causing credit scores to increase, thus reducing the subprime population.

The second reason for this is that many lenders over-reached in 2015 and 2016. Some let delinquency get out of hand, which changed their capital structure and forced them to pull back. Others found that the pricing required to maintain volume levels was insufficient to cover operating expense and credit losses. Large banks that hold subprime paper also tightened up due to regulator and investor scrutiny.

This resulted in a contraction of approximately $20 billion annually in subprime lending. The good news is that many of these lenders are now showing positive credit results from more restrictive underwriting standards, which should lead to growth opportunities in the subprime space for those who have properly managed their credit facilities.

Supply of capital
The majority of the auto loans originated in the United States sit either on the balance sheets of the largest banks, or in credit facilities provided by those same banks to non-bank lenders. Several large banks, captives and independent finance companies also use the asset-backed securities (ABS) market as a source of long-term debt, which accounts for over $100 billion in new issuance annually. The primary determinant as to whether this capital will be available tomorrow is where we stand today with respect to (I.) auto credit performance and (II.) economic risk.

I. Credit performance
There is a common misperception that the credit cycle is a perfectly symmetrical sine wave, where credit ramps up, blows up, and resets for growth. This leads to two assumptions that are accepted as gospel truth but are also false. That is, that growth (particularly in non-prime) only comes when lenders universally collude to throw underwriting standards out the window, and that once we hit the top of the cycle that there must be a catastrophic event.

The data does not support this at all, as none of the downturns in the last 20 years were caused by a meltdown in auto, and auto loans (including nonprime) performed reasonably well through these periods. What we see historically is that there is a natural market clearing level for available cars, people who want buy the cars and the capital available for financing that is occasionally interrupted by a liquidity crisis on Wall Street. The top of the cycle is simply this natural clearing level which can go on indefinitely, although less efficient players will either go away or get absorbed into other lenders.

To illustrate this, consider 2015 to 2016. The market was extremely competitive, and some lenders did overreach in order to continue a growth story. Many recognized the top of the credit cycle and were predicting that the bubble was about to burst. What happened instead was that lenders in the riskier segments tightened up credit to reduce originations – otherwise known as rational lending.

Today, the fruits of those efforts are evident. Rather than a crisis, we see credit performance improving and subprime volume at its lowest levels in many years. Total market 30+ and 60+ delinquency has been incredibly stable, and non-prime delinquency has been improving (Figure 3). It is important to remember that most of the negative delinquency headlines are based on the $23-$25 billion in subprime bonds, which represent only 10 to 15 percent of subprime paper, nearly two thirds of which come from only three lenders. Other positive trends include:

– Experian’s Auto Default Index has shown improvement throughout 2018
– Standard & Poor’s has reduced their loss expectations on six lenders, including some of the larger subprime lenders (which only happens when there is overwhelming evidence that losses will come in below the original estimate)
– Standard & Poor’s reports that vehicle recovery rates are improving for subprime bonds

The preceding bullet is one to take note of, as auto lenders may have very stable performance in terms of default rate but show increasing net losses if vehicle values plummet. In May 2017, Ally warned that slumping used vehicle prices could impact earnings. This came at a time the Inventory to Sales Ratio was at its highest. (Figure 4)

Presently, that ratio is at its lowest level in more than five years, indicating there is a healthy match between sales and inventory. There has been concern for years over the large volume of off-lease vehicles and how that could impact prices, but to date it has not. In fact, the major vehicle value indices show that used car prices have been on the rise since July 2018. This trend coincides with the improvement lenders have seen in vehicle recovery values.

II. Economic risk
The first American winner of the Nobel Prize in economics was Paul Samuelson, who once said, “the stock market has predicted 9 out of the last 5 recessions.” There is no question that the stocks have shown volatility in the last two months of 2018, but it is important to look at the whole picture in order to assess economic risk. None of the major economic indicators, such as unemployment, GDP, production levels, new orders or consumer confidence are in the danger zone.

The turmoil in the market began with a string of negative news items related to the big tech stocks and how they have handled privacy. The concerns are rooted in the fear that the federal government could break these companies up or otherwise hamper them by piling on significant regulation. This was followed by news that OPEC is cutting production to keep prices high while U.S. oil reserves are increasing. Finally, trade tensions related to the renegotiation of tariffs has driven the analysts to predict a recession in 2019. The data they point to in support of this is the compression of the yield curve. (Figure 5)

Economists look to an inverted yield curve as a primary predictor of recessions. The inversion occurs when short term treasury bond yields are higher than longer term bonds. This occurred just prior to the last three recessions (refer to the graph titled ‘Treasury Yields’). The important thing to note is that yields are not presently inverted, but merely compressed. Treasury yields were actually far more compressed throughout most of the 1990’s, which represents one the greatest peacetime expansions of the U.S. economy.

There are generally two kinds of predictions economists make. First, if current news is good, they will predict that at best things will remain as they are. Second, if current news is bad, they will predict catastrophic results with an outside chance that things may only get slightly worse. As far as a recession in the coming year, none of the fundamentals support this conclusion and the major risk items (e.g., tech breakup, trade war) are completely in the government’s control heading into a new election cycle. This was not the case with the last two recessions, which were caused by a housing and technology bubble.

The outlook for 2019
When I was attending ABS conferences as an auto lender, we would speak to dozens of bond investors as well as the rating agencies about the negative headlines and their potential impact on our credit performance. The running joke was that it only takes one negative data point to establish a trend, but it takes at least ten positive ones to do the same. This is often true when it comes to conventional wisdom on the broader market outlook; however, every competent forecaster knows they must separate noise from meaningful trends in order to understand what is really going on.

For auto lenders, the news appears to be very good. Demand for autos is robust, as is the pace of new financing activity. Used vehicle prices are improving due to adjusted inventory levels, which should lead to continued improvement in vehicle recovery rates. Lenders are behaving rationally, and non-prime credit is improving. Positive loan performance combined with strong economic trends spell good news for those providing capital to auto lenders.
Prior to the last recession banks were severely over-leveraged, which is not the case today. Presently, there are over $1.6 trillion in excess reserves in the U.S. banking system. In October of 2018, the Federal Reserve proposed loosening capital and liquidity requirements for large banks, which will allow them to put that money to work. Given that vehicle finance is the second largest consumer loan segment, 2019 could turn out to be one best auto lenders have seen in many years.

Daniel Parry is co-founder and CEO of TruDecision Inc., a fintech company focused on bringing competitive advantages to lenders through analytic technology. He was previously co-founder and CEO of Praxis Finance, a portfolio acquisition company, and co-founder and former chief credit oficer for Exeter Finance. Prior to this, he was senior vice-president of Credit Risk Management for AmeriCredit Corp (GM Financial). If you have questions, you may reach Daniel at [email protected].