Auto Bubble? Easy Credit Might Be Bad Credit (politically low interest rates at work)

“While many analysts and investors were very happy with the August sales figures, some commented that they were growing concerned that the automakers were beginning to repeat the mistakes of the pre-financial crisis years that contributed to the companies’ financial collapse. Those mistakes included utilizing aggressive financial incentives to spur sales and relying on loans to lower credit-worthy borrowers in order to enable buyers to stretch their monthly payments to afford new car purchases.”

August 2014 sales by U.S. automakers increased 6% from the same month last year, equating to a seasonally adjusted annualized rate (SAAR) of 17.5 million, according to an analysis by Automotive News. For the eight months through August, auto/light vehicle sales are 5% higher than for the same period in 2013.

August’s red-hot pace is a reversal of 2009’s crisis low of 10.4 million, after which the rebound has been a million units annually. Last year’s sales were 15.6 million.

One analyst commented that he remembered when one of the auto executives who was testifying before Congress during the debate over bailing out General Motors (GM-NYSE) and Chrysler during the 2008 financial crisis said he would love for the industry to ever return to a 13 million unit sales year. Of course, he was in the midst of what turned out to be a nine million unit sales year, so any year with a double-digit unit sales growth would certainly portend a much better financial outcome than what was driving his company into bankruptcy.

Exhibit 5.  U.S. Auto Sales Soaring

Source:  Automotive News

While many analysts and investors were very happy with the August sales figures, some commented that they were growing concerned that the automakers were beginning to repeat the mistakes of the pre-financial crisis years that contributed to the companies’ financial collapse. Those mistakes included utilizing aggressive financial incentives to spur sales and relying on loans to lower credit-worthy borrowers in order to enable buyers to stretch their monthly payments to afford new car purchases.

Those analysts concerned with the industry possibly repeating past mistakes point to the volume of new manufacturing capacity being added to the industry, employing

* Zero-interest car loans with terms lengthened to six or seven years,

* Higher loan-to-value ratios suggesting that expensive add-ons such as extended warranties or high-end sound systems were being included in the loans,

* Rapid growth in the share of auto loans made to borrowers with FICO scores of 660 or lower–considered poor credits; and

* Weakening of used car prices suggesting a growing glut of used cars and a shrinking pool of prospective auto buyers.

As Automotive News points out, “Analysts say much of the pent-up consumer demand that has driven industry volumes in recent years has been tapped, prompting automakers to sweeten some deals in search of incremental sales.”

Industry Response

The auto industry’s response to these concerns is typical and largely reasonable.

The companies are suggesting that they have not forgotten what got them into financial problems in the past and are not on the road to repeating those mistakes. Adding new manufacturing capacity is normal in an industry upturn, but the plants are new and mostly located in more favorable labor markets helping the companies with respect to their manufacturing costs.

Still, automakers should realize that the current credit environment is fueled by easy money policies from the Federal Reserve Bank, a source of micro (sectoral) business cycles, not only macro boom/bust.

Analysis

Embracing zero-interest loans is a reflection of the “end of season” time period when dealers try aggressively to empty their lots providing room for the newly arriving models. That probably means the 17.5 million sales’ rate will prove unsustainable. However, the sales success so far this year – five straight months with SAAR sales above 16 million units – supports analysts’ estimates of a 16.3 million unit rate for 2014, the best sales rate since the 16.6 million sales’ rate of 2006.

The concerns over whether a bubble is growing for subprime loans reflects the recovery of the higher risk loan sector that was nearly eliminated during the financial crisis years. Average credit scores of subprime borrowers for used cars peaked in 2010 at around 653, but fell to 646 in the fourth quarter of 2013. These scores, according to a report from the credit rating agency Moody’s, have edged up over the past two quarters.

Total loan volume attributed to riskier borrowers has increased but the amount has remained fairly level for the past year and still well below the level reached in the financial crisis era. A possible concern is that according to auto statistics firm Edmunds, 13% of dealers’ loans were issued at 0% interest in July and August, up from 11% last summer and the highest percentage since December.

With respect to falling used car prices, it is not a complete surprise as more young used cars have entered the market given the recent string of strong new car sales years.  As this pool of modern used cars grows, one would expect their prices to weaken. This doesn’t mean that used car prices are unusually low or that they are creating a problem for the auto market. Rather, this is a typical pattern experienced following every recession in which auto sales contract.

This contraction contributes to the average age of vehicles in the fleet to rise, which is ultimately what drives people to purchase new cars or modern used cars when economic conditions and their own financial situations improve.

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G. Allen Brooks, a leading consultant to industry on energy economics and politics, blogs at Energy Musings. His previous points at MasterResource are  Natural Gas Vehicles 2014: Caution, not Government Subsidies and The Struggle to Mainstream Electric Vehicles.