The Next Financial Danger Point?

Are subprime auto loans the next shoe to drop in the economy?

Auto loans have been getting a lot of attention. In a recent issue of Barron’s, two unrelated articles discussed auto loans as a potential source of worry for the economy and regulators.

Since the financial crisis, auto loans have been one of the major sources of credit. The volume of auto loans grew steadily, until recently.

The standards used to make the loans also were gradually relaxed. The practices helped cause consistently strong auto sales since the financial crisis ended.

CarMax, the used car seller, was the subject of one of the Barron’s pieces. The article reported that the company’s imminent quarterly earnings report was likely to have bad news about loans on its books. It pointed out that defaults and delinquencies on auto loans have been rising across the nation. Also, the residual values of cars are declining (as we anticipated in Retirement Watch about a year ago), and that means less collateral backing the loans.

Sure enough, when CarMax issued its earnings report, it included a higher loan loss provision. Even so, some analysts said the increased loan loss provision wasn’t high enough. The company’s stock price peaked in late January and has been steadily declining lately.

Another article reviewed the general changes in the auto loan market summarized above and cited several analysts. One, Stephanie Pomboy of MacroMavens, a consulting firm, said that the auto loan bubble has gone bust. A major problem is that during the boom, automakers kept raising prices. To make the vehicles affordable, lenders extended auto loans from the traditional three years to five years and then seven years. Combined with lower lending standards, that put vehicles in the hands of a lot of people who can’t afford them.

With the glut of used cars on the market, many vehicles aren’t worth enough to cover the loan balances and repossession costs after borrowers default.

One of the investors featured in The Big Short who saw the housing crisis coming and sold short mortgage securities recently has said that subprime auto loans are the next crisis he sees.

There are going to be some problems in the next year or so for owners of auto loans as defaults increase and the large supply of inventory decreases used car prices. But this isn’t likely to be anything like the mortgage default crisis.

Banks and other major financial institutions don’t have nearly as many auto loans on their books as they did mortgages before the financial crisis. Most of the damage will be concentrated in specialized auto loan lenders that are mostly captives of the auto manufacturers and firms such as CarMax. Some investors, such as money market funds, also buy packages of syndicated auto loans and might suffer some losses.

Problems from increased defaults on subprime auto loans should be widespread. We aren’t facing the kind of systemic problem that was the case with housing. Bad mortgages caused problems throughout the financial system. Banks and other institutions that were key to the financial system had severely impaired balance sheets because of mortgage losses. That isn’t likely to be the case with auto loans.

The Data

Inflation seems to be falling, but the details aren’t as dramatic as the headlines. The Consumer Price Index (CPI) declined 0.3% last month and 0.1% after excluding food and energy. The index increased 2.4% over 12 months, and 2% after excluding food and energy.

Energy price declines were a major part of the headline CPI numbers. But telecommunications prices dropped sharply based on changes in cell phone plans. That shouldn’t be a continuing issue. Apparel also took a sharp one month drop. Transportation also fell sharply because of declining auto sales. Also, segments with traditionally steady price increases, housing and medical, had only 0.1% gains for the month. Overall, it appears the price decline was a culmination of short-term or one-time changes. It shows that while we’re in for higher inflation going forward, it won’t be a steep or steady rise.

The week’s housing data present a mixed picture.

Housing starts declined 6.8% from February to March. But over 12 months, starts are up 9.2%. But building permits increased 3.6%, which indicates higher housing starts in about six months or so. These numbers are volatile from month to month, so trends over several months or the 12-month number are more valuable than the one-month number.

But home builders remain optimistic. The Housing Market Index from NAHB was 68. That’s down from last month’s 71, but it still is a strong number and among the highest of the economic recovery. Also, traffic to sales centers and models continues to increase. That’s been one of the weak points the last few years.

There also was mixed data on manufacturing.

The Empire State Manufacturing Survey fell to 5.2 from 16.4. That’s not terrible news. While it is a steep decline, the high numbers of the past few months were unexpected and likely unsustainable. Most of the components of the survey indicate that manufacturing in the region still is doing well.

The Philadelphia Fed Business Outlook Survey also had another strong month. It fell to 22.0 from 32.8, but it’s still a very strong number. An important component of both reports is that delivery times have been slowing, indicating businesses are receiving orders faster than they can produce goods.

Industrial Production wasn’t as positive. The headline number was a strong 0.5% increase. But that largely was due to higher utility output caused by stormy weather. The manufacturing component of the report was down 0.4%, and last month’s number was revised down from 0.5% to 0.3%. Some analysts attributed the decline to weather, especially Category 3 storm Stella, which disrupted the northeast.

Remember that the regional surveys are anecdotal, while reports such as Industrial Production are hard economic data. Since the election, we’ve seen strong surveys of consumers and businesses, but they haven’t yet resulted in changes in economic behavior.

New unemployment claims increased by 10,000 from the previous week. But the four-week average declined by 4,250 to 243,000. Also, continuing unemployment claims on both the weekly and four-week basis are at 17-year lows.

The Leading Economic Indicators from The Conference Board had another sharp increase, this time of 0.4%. That beat expectations by a wide margin and is the fourth consecutive strong report.

The Markets

The S&P 500 declined 0.27% for the week ended with Wednesday’s close. The Dow Jones Industrial Average fell 0.89%. The Russell 2000 gained 0.59%. The All-Country World Index lost 0.46%. Emerging market equities lost 0.54%.

Long-term treasuries rose 1.29%. Investment-grade bonds added 0.58%. Treasury Inflation-Protected Securities (TIPS) appreciated 0.11%, while high-yield bonds dipped 0.02%.

Meanwhile, the U.S. dollar lost 1.07%.

Energy-based commodities slid 2.84%, while broader-based commodities dropped 1.66%. Gold returned 0.41%.

Bob’s News & Updates

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