Debt Downgrade Threat: Trouble for the Surging Auto Sector

Last Updated Jul 25, 2011 5:54 PM EDT

Do not downgrade us!
I've written about it a few times already, but it's worth repeating: the auto industry is just about the only bright spot in the U.S. economy right now. Sales. Profits. Hiring! What's not to love? Unfortunately, if Standard & Poor's and/or Moody's downgrade our debt, one of the ripple effects could be damage to the car business -- just as it's getting back on its feet.

The debt of debts
Debt is all about managing risk -- which has made U.S. debt the closest thing to a risk-free option, for a very long time. You don't by AAA-rated Treasuries because you want to make money; you do it because there's absolutely no change that you'll lose it.

Nice low rates on ultra-safe Treasuries means that other type of credit, including auto loans, can bear more attractive rates. At the simplest level, this is good because it keeps money moving. This has been critical for the auto industry, as demand has recovered from 2009-10 lows, because the finance arms of carmakers and banks that deal in auto loans have been able to provide the dough that people need to buy new cars and trucks.

It's created a virtuous cycle, with the steady profitability of Ford (F), General Motors (GM), and now even Chrysler leading a U.S. manufacturing rebound -- on that, at least in the Midwest, is putting a dent in unemployment, as carmakers anticipate growing demand in the future.

The importance of subprime
But a debt downgrade will throw a proverbial wrench into the works. Rates would rise on all manner of loans pegged to Treasuries, including auto loans. This is from Forbes:

A ratings downgrade would have negative implications for debt issuers whose credit strength is directly linked to the federal government. This includes debt guaranteed by the federal government, like money market funds and bank CDs, and the obligations of government agencies like Ginnie Mae, Freddie Mac and Fannie Mae mortgage debt. A downgrade could limit investor demand for US Treasuries as fund managers rush to buy other triple A rated debt, or hard assets and commodities, mainly gold.
Or, to quote Reuter's Felix Salmon in a moment of Anglo-American cleverness:
Taking the triple-A out of the ratings universe would, at one level, be purely cosmetic. It would be like removing the pinstripes from the Yankees' uniform, or changing the markings on Nigel Tufnel's guitar amp so that they only go to 10 rather than 11.
If the U.S. sees itself downgraded, customers with good credit, in the market for a new car, will feel pain. But customers with poor credit -- and there are plenty of them out there, after such a horrific recession -- may be frozen out completely, as the subprime lending strategies of the automakers are upended.

Adding risk to risk
Bring subprime borrowers back in to the auto marketplace will enable automakers to build more cars and hire more workers, not to mention make more money, all without enduring unsustainable levels of risk. An inexpensive car can be purchased with very little money down and a loan that's structured in such a way that the lender notches a major return and the customer isn't saddled with an onerous payment (remember: cars aren't houses).

Given the subprime auto loan candidates are probably not in terrific financial shape, a few extra percentage points could mean the difference between buying and not buying. And that could prevent the U.S. auto maker from stabilizing at around 15 million vehicles per year by 2013-14.

You could say that that's the least of our worries, and you'd be partly right. Still, we don't want car sales to retreat, or even stall, at this point. The recovery continues to be as much as 5 million vehicles short of the pre-Great Recession peak of 17 million.

In the end, we don't want it to be a massive risk for anyone to buy a new car over the next five years. But if we're downgraded, that's where we're headed. People will still buy cars. But the people we truly need to buy them will have a much more difficult time.


Photo: GM Media