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Subprime loans drive US auto sales growth

Consumer demand
By Paul Hodges on 08-Oct-2014

US autos Oct14Major problems are developing in the US auto market.   The critical issue is that companies have been adding capacity since 2009 on the basis that demand would return to SuperCycle levels.  But it hasn’t.

The result is that the mass market has become more and more competitive.  Only sales into the high margin luxury/pickup segments are actually making a respectable profit, as Bloomberg has noted:

There is no vehicle type more important to the Detroit Three than pickups. They generate $8,000 to $10,000 in gross profits per vehicle and still produce most of their automotive income, according to Morgan Stanley.”

In turn, this means that financing deals have become critical to maintaining sales.  Today, an astonishing 85% of new car sales and 54% of used car sales are being either financed or leased.  As analysts Edmunds.com note:

Buyers have been able to secure low financing deals and have responded to lease offers in record numbers.”

Yet despite these offers, as the chart shows, total sales in the year to September are only up 5% this year versus 2013.  And as Ford’s chief economist warned:

We are reaching a point where the rate of growth is beginning to moderate. We are getting closer to a likely plateau.”

The reason is that companies have already pushed the boundaries as far as possible.  Loans to ‘deep subprime buyers’ (those with credit scores below 550), have been the main driver for recent sales growth, along with the increase in lending term.  Deep subprime loans jumped 13% in Q2, up 770k, compared to 5% overall loan growth.

The detail of the incentive programmes highlights the intensely competitive state of the market.  Honda have increased their incentives by 41% since September 2013, Nissan by 26%, Toyota by 23%, Fiat-Chrysler by 16%.  Only Hyundai has actually reduced spending.

At the same time, they have increasingly had to offer long-term loans to those buying the higher-priced cars on which they still make money.  Otherwise, buyers couldn’t afford the monthly payment:

  • One in 4 auto loans now has a payment term of between 6 to 7 years – the highest ever recorded
  • The average monthly payment on these loans is a record $474/month
  • The average length of all auto loans is also at a new record of 5 1/2 years

Of course these strategies are self-defeating.  By tying buyers in for 6 years, the companies essentially miss the chance to sell them a new car before then, as the existing loan is still being paid off.

Even worse, however, is the growing reliance on subprime loans.  The New York Times reports shows these were 27% of all auto loans in 2013, with interest rates often at 23% or more.  And total subprime lending in Q1 reached $145bn.

Of course, the automakers know that these borrowers are highly likely to default. So they are increasingly forcing these buyers to install ‘starter-interrupt devices’.  These are now installed in around a quarter of cars bought with subprime loans.  They allow lenders to disable the car remotely, leaving the driver unable to operate their car.

As one would expect, these are increasingly leading to horror stories of car engines being turned off when payment is late by a day or two.  And even worse, the NYT reports claims that engines have been turned off whilst cars are being driven on the freeway.  None of this sounds like an industry which is likely to see robust growth for the next few years.

Instead it gives the impression that companies are ‘scraping the barrel’, trying to achieve sales by any legal mechanism in order to boost today’s revenue.  As Business Week reported last year:

Perhaps more than any other factor, easing credit has been the key to the U.S. auto recovery,” Adam Jonas, a New York-based analyst with Morgan Stanley, wrote in a note to investors last month. The rise of subprime lending back to record levels, the lengthening of loan terms and increasing credit losses are some of factors that lead Jonas to say there are “serious warning signs” for automaker’s ability to maintain pricing discipline.”

A year later, we are clearly much nearer the end of this second subprime boom.   As we learnt in 2008,  companies cannot create a sustainable business model by lending at sky-high rates to people who cannot afford to repay the loan.