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February 2017 | Cheap credit and relaxed credit standards during this business cycle have already brought future auto sales forward. The industry is unprepared to deal with any increase in interest rates.


During this business cycle vehicle production doubled from the low point in 2009. From a historical perspective, the absolute level of production does not seem out of line.

However, behind this jump in sales is a mountain of credit.

What is ominous for the auto industry is that the buyers are hocked up to their eyeballs and will not be returning as customers any time soon. This is best expressed by the number of months that an auto loan is upside down, meaning that the value of the collateral is less than the amount due on the loan. It’s what led to jingle mail in the housing market (when the keys to the house got mailed back to the lender).

This is the auto equivalent of the no money down house purchase. Apparently the lenders have decided that
making loans where the value of the collateral is less than the loan is an acceptable practice. We have seen this
movie before.

Some recent developments highlight this:

  • The percentage of used cars being purchased with a trade-in with negative equity is an all-time high of 31%.
    The average balance of negative equity on these trade-ins is $3,635. ( Q3 2015 Used Vehicle Market Report)
  • also reported comparable figures for new car purchases that are even higher. 32% of the
    trade-ins had negative equity with the average negative balance being $4,832. (Auto Loans Get Even Dicier,
    Aaron Black, Wall Street Journal 11/29/2016)

This is pretty ugly. One has to think about what would happen to these negative equity trade-ins if interest rates
moved up. There would likely be a simultaneous tightening of credit standards. This is pretty significant when
close to 87% of new autos are financed.

Competition for credit

The rise in the use of auto credit has to be viewed in the context of overall credit usage in our economy. The
following table contains some interesting information

  • Total consumer credit was 19.6% of Gross Domestic Product in 2015, up from 13.5% in 1990.

  • Household mortgage debt was 52.6% of GDP in 2015, up from 41.6% in 1990. This is down from the
    peak of 66.9% in 2010, result of tighter lending standards. (It doesn’t take much to tighten the eligibility
    standards for no doc loans.)
  • Total government debt is still on an upward trajectory, 84.1% of GDP in 2015, up from 47.3% in 1990 and
    70.4% in 2010. The amount of federal debt increased from $10.5 trillion at the end of 2010 to $15.1 trillion
    at the end of 2015. This kind of growth is clearly not sustainable.
  • The federal government has become the engine of credit creation, with federal government debt up 172%
    in the past 10 years, far outpacing the 38% increase in GDP. Growth in government debt was 78% of the
    increase in total debt.

Consumer credit is not the best borrowing

The increase in consumer credit is likely the result of households gravitating to the place where credit is
available. (Auto loans and credit cards are looking like the borrowing of last resort.) However, for most
households consumer credit is not a good choice.

  • The interest on consumer loans is not tax deductible unless the proceeds of the loan are used for a business
  • The interest rate on unsecured consumer debt is much higher than on mortgage debt.
  • Secured consumer debt (mainly auto loans) has a term that is much shorter than mortgage debt.

Perhaps this was not a good idea

  • Increased use of auto loan debt has brought demand forward. However, leveraging up is a one trick pony.
    We seem to have reached the outer limits of auto financing, setting up the industry to land with a dull thud
    with either a recession or an uptick in interest rates.
  • The effect of leverage makes investing riskier.

From the perspective of investing in auto stocks, the jump in auto sales resulting from an increase in the use of
credit has already occurred. Consumers are tapped out. Do you want to invest in companies whose customers
are tapped out?

Another concern is the indirect leverage supporting the consumer society. How much spending has been
supported by government borrowing?

Consumers are exposed to even modest increases in interest rates. Higher rates would stop the process of rolling
negative equity into purchases of new and used cars.

  • What’s in your Portfolio?

These auto loans are securitized. For every auto loan that’s created, someone is holding the paper. The usual
suspects are bond mutual funds and annuity sponsors. Payment performance will suffer during any downturn in

You might want to make sure that you’re not an unconscious investor in securitized auto loans.

  • From the perspective of the borrower, it is probably best to stick with mortgage debt. The interest rate is
    lower, and for up to $100,000 of borrowing, the interest on home equity loans is deductible, even if used to
    purchase an auto.


Over the past 15 years we have witnessed two episodes of credit abuse, the housing bubble during 2000-2008,
and auto financing from 2009 to present. If the incoming president is going to make the economy grow, it won’t
be on the back of credit expansion in the housing and auto industries.