A subprime loan crisis is looming

We all know what triggered the 2008 financial crisis that cut over half of the stock market values. The culprit was the large scale delinquencies of subprime housing mortgage loans that almost brought down the whole banking industry. You probably would think that everyone should have learnt the lesion and won’t repeat the disastrous mistake again. Actually not at all and another subprime loan crisis is already brewing and quickly worsening. This time it is not the mortgage loans but the subprime auto loans!

 

Subprime auto loans, defined by those with a credit score below 620 at origination, have become extremely popular and quickly catching up with the prime loans. As you can see below, the total amount of outstanding subprime auto loans has already surpassed the peak in 2008, worth $300 billion by end of 2016.

 

The concerning trend ongoing is the increasing rate of delinquencies of the subprime auto loans that is worsening each passing day. Back in Feb 2016, Experian, one of the big three credit bureaus, already reported auto loan delinquencies had hit a six-month high. Of those loans, nearly 5% of subprime loans were delinquent by 60 days or more – the highest level since 2008 at that time (see below). One year later, Experian just reported again that the delinquencies of such loan are even higher than they were before the financial crisis in 2008.

You have to understand, this is just the beginning. One major factor that causes sharp increases of auto loan delinquencies is the increasing loan costs due to the Fed interest rate hike. People holding subprime auto loans are those with very little budgetary buffer pay their loan interest. Any inch higher of the interest will be a hit to their capability to serve the outstanding loans on time. Now more interest rate hikes have increasingly become the certainty in the years ahead and late payments from such subprime auto loan are spiraling and become really dangerous to those institutions that lend out such loans. The bank industry is certainly one of them but I think the entire auto industry may face the risk of collapsing if the worsening situation truly gets out of control in the next couple of years. Three major forces will hit the auto industry particularly hard: many auto companies are lending out subprime loans by themselves in order to boost their car sales. They will obviously lose big when such loans become delinquent and at the same time their car sales will also get hit due to decreasing demand from such buyers. Then the used cars taken back from such bankrupted car owners will increasingly become a financial burden as well due to fast depreciated values of such cars. I think one auto company is again in the center of this looming crisis.

 

It is General Motor (GM), once the American glory icon that collapsed and bankrupted in the 2008 financial crisis. With the government help, GM got back, seemingly strong but only on the surface. Fundamentally GM is still under the enormous financial burden due to the super large pension obligations that they cannot get rid of, thanks to the OB government. Basically GM is still hijacked by the strong union that virtually controls the company at the current state. To meet their pension obligations, GM has to boost their car sales aggressively by any means they can find. Selling cars to people with poor credit scores is one of a major source of revenues for GM. It is one of the largest owners of subprime auto loans, believe or not. GM Financial, the integral part of GM for auto loans, is holding $54.3 billion in debt related to financing, of which 64.7%  are categorized as subprime at present. In the near zero interest environment, GM may survive well by holding such junk loans to boost their car sales. But the alarming uptrend of subprime loan delinquencies is not their friend at all and the situation will only become critically worsening in years ahead. I obviously don’t know when the 2008 type of crisis will hit GM but I think the risk can only go up, not down as long as the Fed is keeping their rate hikes. If you hold GM shares allured by its high dividend yield (4.4% as of now), be careful. I’m not sure you will be happy to still hold them in a few years from now. If the subprime auto loan crisis follows the same path as the subprime home mortgage crisis 8 years ago, it is not unthinkable that GM may go belly up again. I personally even start to buy long term deep out of money GM puts that cost very little but could be hugely profitable if the worst do come for GM down the road.

 

At least you should not be complacent if you are holding or considering to buy GM now. Considered you are warned!!