What’s Behind Slowing Car Sales and Stalled (Auto) Stock Prices

While stock market averages close to all time highs that isn’t the case for the shares of car companies and car dealers, which have gone in reverse (mostly) for over a year now. Since stocks reflect future expectations, the lackluster performance is traceable to the simple fact that after the last two years of 17+ million sales, vehicle demand will decline this year and take profit margins in the same direction 

The signs of a negative turn in the market are readily apparent. Despite high consumer confidence and low unemployment, dealer inventories ballooned in the past six months, incentives crept up and US automakers have slowed production. Automakers are warning of lower profits in their finance operations and independent lenders are more carefully evaluating their participation in the sub prime market.

What’s happening is simply a reversal of the era of “easy credit” on auto finance that enabled peak auto of 17.5 million units along with equally strong demand for used cars. Unlike previous economic expansions, the last eight years or so saw very low interest rates (in part due to Federal Reserve ZIRP) and ample liquidity within the financial system.

But the last five or six years or so were not typical of past expansions where interest rates tend to rise along with economic growth. As the credit crisis eased, lenders saw the profit potential of making auto loans to less credit worthy customers which accounted for an increasing share of the auto loan market. Then favorable default and loan loss data (coupled with the mindset that borrowers pay their car loans before their mortgages) encouraged competition among lenders and brought new players into the subprime business. And for some years, loan losses on lower credit tiers were within acceptable parameters. 

A key factor that protected all lenders were the sky-high used car values associated with the shortage of late model used cars. For example, In 2011 and 2012 demand for used cars was rising while the supply of late model vehicles was at a cyclical low due to low new cars sales from 2008 through 2010. During this period, a three-year-old car in good condition might command nearly the same price as a brand new same model car. Owners of these late model cars were pleased because they essentially suffered no depreciation over two or three years and often had equity to apply toward the purchase of a new car.

Most consumers measure vehicle affordability not in terms of the total costs for the vehicle, sales tax and any other products and services but rather whether the monthly payment is affordable. Lenders supported the auto boom not only with record low interest rates (often 0% or 1% from auto company captive finance operations), but also much longer maturities and very high advance rates. (The amount of the retail price the lender is willing to fund relative to value.) These generous terms were often extended to non-prime and even subprime customers. Low interest rates and “generous” underwriting and funding advances allowed customers to purchase more expensive cars than they might otherwise have.

With loan defaults rising along with much greater loss severity, lenders are now raising rates especially on loans over 60 months in duration, reducing advance rates, and rejecting a higher percentage of sub prime shoppers. The loss severity on defaulted loans is associated with the negative equity in those loans attributable to excessive initial funding advances, longer maturities and falling used car values. 

Simply put, loans amortize at a slower rate initially (except zero percent loans) while vehicles depreciate at an accelerated rate. Long maturities – with the average loan of 66 months – but many borrowers with 72 to 84 month or longer loan terms means that the principal balance falls slowly (especially in the first two thirds or so of the loan term) while vehicle depreciation is fastest early on and slows as the vehicle ages. 

That party is now ending. In fact, we are already past the tipping point. The Fed has said it would increase rates (albeit short term rates through the Discount Rate) but also has curtailed its asset purchases thus taking a large buyer of financial securities out of the market. Simultaneously, used vehicle values are falling and vehicle manufacturers – almost across the board – have sought to boost slowing new car sales with a raft of new and more costly incentives that also have a negative impact on used car values.

There are elements of a perfect storm brewing in the vehicle market. No one should be surprised by the recent decline in the seasonally adjusted selling rate as lenders make prudent decisions with respect to whom and on what terms they will extend automotive credit.  

The combination of tighter financing and falling used car values will put a damper on new car sales…and especially for borrowers with large negative equity positions in late model vehicles and those in lower credit tiers. The effects will likely include lower total new vehicle sales, a shift by consumers to less expensive models, and pressure on the profits of automobile manufacturers, dealers and lenders especially the captive finance subsidiaries. 

Written by Maryann Keller, Principal at Maryann Keller & Associates.