Just when you thought the economy is safe again, the ghost of subprime loans is back. This time it’s haunting the auto industry and doesn’t bode well for automotive stocks. In fact, the problem is beginning to hurt car companies in myriad ways, including fewer sales.
Subprime refers to riskier loans made to borrowers with a less-than-pristine credit history. The loans, you may recall, had a hand in the global financial crisis. In the years leading up to 2008, banks made many subprime loans to home buyers. The result was the banking industry’s overexposure to risky loans and the painful paying of the piper that followed. When the housing market bubble popped and borrowers defaulted, banks — and ultimately taxpayers — were on the hook for the money, and the world economy became mired in a credit crisis.
[See: 11 Ways to Buy Bank Stocks.]
Given recent history, you would think lenders had no interest in repeating it, but over time the percentage of car loans made to borrowers with the lowest credit scores surged. In the third quarter of 2010, subprime auto loans were at a post-financial crisis low of 17.1 percent, according to data from the New York Federal Reserve Consumer Credit Panel and credit rating agency Equifax. By the second quarter of 2015 that number had peaked at 25.4 percent.
Although subprime loans helped boost car sales in recent years, the problem is now coming home to roost. The number of delinquencies jumped to 7.5 percent of all auto loans in the last quarter of 2016, a post-financial crisis high and up from a post-crisis low of 6.4 percent in the second half of 2012, according to New York Federal Reserve and Equifax data. Bad loans in the fourth quarter of last year totaled $23 billion.
The effect on automakers. The soaring delinquency rate is prompting lenders to make fewer subprime auto loans. Recent data show subprime loans now account for less than 20 percent of all car loans.
Already, sales of cars and light trucks are declining as lenders tighten their standards. In May, sales totaled a seasonally adjusted 17 million units, down from a post-crisis peak of 18.7 million in December, according to U.S. Commerce Department data.
“Slowing demand is linked to reduced reliance on subprime,” says Joe Brusuelas, chief economist at professional services firm RSM in New York.
As the number of loans shrank, the total value of all auto loans also dropped, from $150 billion in the third quarter of 2016 to $132 billion in the first quarter of this year. An RSM report indicates that weak topline sales and tighter credit implies signs of stress and narrower profit margins.
A vicious cycle. Falling prices for used cars are likely to make matters worse. The RSM report shows that used vehicle prices have become a bigger issue after falling 4.7 percent in the last year. Their falling prices will make it harder for car companies to sell new vehicles.
Meanwhile, the growing number of defaulting borrowers is prompting repossessions. “It’s starting to happen,” says Richard Suttmeier, founder and CEO of Global Market Consultants in Land O’Lakes, Florida. “I live right at the front of the neighborhood where I see cars get towed out of here every so often.”
Repossessions only make the car companies’ headaches worse by feeding the supply of used cars and exacerbating depressed prices as the vehicles get auctioned off.
That vicious cycle hurts car companies in another way. Like banks, many car companies have financing divisions that make loans to car buyers through dealerships. As a result, the auto companies also stand to lose from the rising number of bad loans from their financing arms.
There seems to be more stress with the auto finance guys than in the bank-originated loans, says Steve Chiavarone, portfolio manager at Federated Investors in New York.
All of this presents auto manufacturers with a problem. “They may have to accept lower volume or cut the prices,” Chiavarone says.
Either way, industry profits could plummet.
[See: Car Companies and the Race to Profits.]
The road for investors. So what should an investor do?
The automotive sector is a cyclical business. If you’re a long-term investor who owns stock in a car company, ride out the cycle and wait for the eventual upswing. That’s especially true if the stock pays a healthy dividend.
For instance, Ford Motor Co. (ticker: F) survived the financial crisis without a government bailout or having to declare bankruptcy. Although Ford eliminated its dividend for a time, the company reintroduced it in 2012.
“They’ve increased it successively for several years,” says Efraim Levy, an equity analyst for CFRA in New York. The stock has a dividend yield of more than 5 percent, so investors get paid handsomely to wait for the stock to rebound.
“Ford is actually in a pretty good position; I expect them to remain profitable throughout the cycle,” Levy says.
By comparison, General Motors Co. ( GM), which went through bankruptcy and only started paying a dividend again in 2014, yields more than 4 percent.
Still, the yield for both stocks is far better than that for government bonds, which yield less than 3 percent.
Investors could also use the recent poor performance of the auto industry to accumulate a position at better prices than just a few months ago. The Fidelity Select Automotive Portfolio ( FSAVX) mutual fund holds a portfolio of stocks in the industry’s manufacturers, marketing firms and suppliers. Annual expenses are 0.96 percent, or $96 per $10,000 invested, and the fund requires a minimum investment of $2,500.
The smart way to accumulate a position in the fund is to buy shares steadily over a set period, a process known as dollar-cost averaging that reduces the risk of timing the market badly, such as buying shares right before prices tank. For example, for a $5,000 stake in a company, you could invest $1,000 over each of the next five months.
Short-term investors may want to sell their shares until this storm passes, while more daring investors might consider short-selling shares of the First Trust Nasdaq Global Auto exchange-traded fund ( CARZ). It holds a basket of 34 automakers and has annual expenses of 0.7 percent, or $70 per $10,000 invested. The fund is a good way to get global exposure in auto stocks, as it holds companies in the U.S., Germany, Japan, South Korea, France and China.
[Read: How to Bet Against Stocks.]
Shorting involves selling borrowed stock with the hope of repurchasing it later for a profit at a lower price. The strategy is risky because the losses can be far greater than the amount originally invested, so it should only be considered by the most experienced of investors.
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Subprime Loans Are Haunting Investors and Auto Stocks originally appeared on usnews.com
