Ill-Advised Mortgages? Student Loans? Now Auto-Makers Ride the Wave

Free money begets free lending. Free lending begets over-leverage. Over-leverage begets defaults. The length of time free money is available, and any incremental money put into supply (e.g. the stuff that came rolling off the Greenspan / Bernanke printing press), determines the amount of free lending and over-borrowing. The degree of over-borrowing relative to income begets the magnitude of defaults, and the magnitude of defaults begets the losses to a credit implosion.

It all started with ill-advised mortgage lending ...  shortly thereafter with student loans ... 

"Educating those in need, fostering the world's creative potential, and even doing God's work may feed the soul, but they don't pay." (Emily Jane Fox, CNN Money)

Outstanding U.S. student loan debt surpassed the $1 trillion mark in 2013. Shocking as it is, those Creative Arts and Religious Studies degrees don't quite pay off. Now, private lenders and taxpayers alike suffer the consequences. Ill-advised mortgage lending was the first to trigger a massive wake-up call (when the subprime mortgage crisis took center stage), but it wasn't long before we moved on to a new, less-regulated arena: student loans. We have to educate our youth, no matter the cost, right? Even if we can't afford it? My theory, and it's pretty simple, is that if you can't afford it, you can't have it (nor can you provide it). Only governments that cut entitlements and eliminate unnecessary spend, those things that come with the art (or science) of balancing a budget (an extremely difficult task, for politicians that is) can offer such luxuries. But, our politicians don't understand this whole "budget" phenomena. Crazy budgets...The thought of the U.S. running a fiscal stimulus? Insane. Out of this world. That's why U.S. taxpayers foot the bill for debt-laden college graduates via loan forgiveness programs offered by the federal government. Private lenders get screwed though - they should've done their homework. 

According to data released yesterday by the Federal Reserve Bank of New York, total outstanding U.S. auto-loans has now surpassed the $1 trillion mark, like student loans did just two years ago. In the second quarter of 2015, we broke an historic record: in the U.S., we originated a record $119 billion in auto-loans, a good share of which were likely ill-advised ... think of all the well-performing student loan portfolios (anybody know of one?).

Irresponsible lending in the case of student loans is, however, different from auto- or mortgage-loans. Auto-loans and mortgages are backed by actual, tangible collateral. Which leads me to the other problem when money is free, for years, and years. Collateral is used to determine the amount by which a lender is willing to lend. When money is free, much more liquidity is available for people to go out and buy stuff. When lots of people are trying to buy the same stuff at the same time, well ... prices go up, the simple rule of supply and demand. Ravenous borrowers and lenders alike seek to take advantage of the free money opportunity, leading asset prices to unsustainable levels. In the end though (when one actually has to pay this unusual thing called interest), the collateral behind  interest-free (or nearly free) loans remains unchanged; rather, it generally depreciates in value with natural wear and tear, product upgrade cycles, etc. The only difference is its value now versus its price when measured by the lender. The cars are still the same. The production levels (GDP) and income levels are roughly the same. But the debt burden is much higher, and the collateral may not be worth so much, when interest rates are higher and the supply of money lower. 

U.S. and foreign automakers are certainly riding the free money wave. With the Great Financial Crisis (GFC) now six years' past, auto-lending has sharply accelerated, to a 10-year high at $119 trillion (data released today by the Federal Reserve Bank of NY). May annual purchases were at an annualized rate of 17.6 million, the highest since 2005.

Auto-loans and U.S. mortgages offer a useful study in contrast over the last 5 years. Both types of debt fell in in the wake of the GFC: from 2008-2010, the total stock of auto-loans dropped by over $100 billion. Mortgage balances fell by over $800 billion. But after the crisis, major tightening of mortgage lending regulation has prevented another debt boom. There was some tightening in auto-lending regulation, but by and large it's returned to where it was pre-GFC. That's in sharp contrast to mortgage regulation. In 2006, nearly $650 billion was lent to consumers in the mortgage market with credit scores below 660. Since 2010, this number has fallen below $150 billion (source: the New York Federal Reserve). During the crisis, sub-prime borrowers were initially taking fewer auto-loans as well. But in 2010, dynamics reversed and sub-prime borrowing in the auto market began to accelerate, for people of all credit scores. Subprime borrowing has now climbed higher such that the mix of all credit scores in the auto-loan pool is similar to pre-recession levels, underpinning a potential implosion.

So how does this translate to investing? On a quarterly call, I'd be long the equity of auto-makers ahead of 3rd quarter earnings but ready to dump thereafter. I'd also avoid any manufacturers whose growth expectations were or are heavily dependent on China or other emerging markets (who suffer the most when China devalues), and would certainly want to evaluate each manufacturers' relationship with its financing arm before making any investment (e.g. Mercedes Benz Financial in the case of Daimler AG, GM Financial for General Motors). If they're part of the same entity, I'd be cautious on a long-term view. Investment in any one of the auto-makers with financing arms as subsidiaries would require extensive evaluation of these companies' underwriting standards.