General Motors Goes All in on Subprime Auto Loans
General Motors (GM) has essentially just divested itself of all remnants of it former captive-finance arm, once known as GMAC but now called Ally Financial. By selling $1 billion in Ally shares, and notching a profit of $300 million, GM has decisively signaled its commitment to its own financing unit, the erstwhile Americredit, now GM Financial. And the first order of business? Fire up some subprime car loans!
Yikes! Isn't subprime lending supposed to the be the third rail of the revived U.S. financial system? What company in its right mind would go near borrowers with FICO scores below 680? Well, in the auto industry, lots of companies, given that people need cars but have also seen their credit ratings hammered over the past two years.
It's not like these people are trying to buy a house!
Subprime lending doesn't really operate quite the same in the auto industry as it does in the real estate realm. While in both markets people often bringing down-payments to the table, when financing a house the outlay is generally huge when compared to income. For a car, however, it's not that bad, and can often be partially offset by trading in an older model vehicle.
Additionally, the monthly payments on car loans are relatively modest when compared to mortgage payments. For lenders, the spreads on interest rates are attractive -- especially now. Banks have access to capital effectively for free, because the Fed is keeping rates at near-zero levels. A subprime auto loan customers obviously doesn't get to borrow his money at 4%. Americredit's portfolio averages 17% when GM acquired it. As the Atlantic's Daniel Indiviglio points out here, with rates like that, you can play in the minefields of higher risk and walk out not just alive but rich.
Indiviglio also notes, crucially, that auto lenders don't expect the underlying asset to appreciate in value. Depreciation limits their loss. As I like to say, the automakers don't really sell auto -- they sell auto loans. A default on a home loan has conventionally been thought of the borrower bailing out of an asset that's ascending in value. Reverse that and you get the financial crisis. In the auto loan business, the model was already reversed.
The battle for the bulge
My belief is that GM and its new CFO, Dan Ammann, are anticipating a bulge in the auto market over the next few years, but are not stupid when it comes to their overall assessment of the economy. Let's say the unemployment rate drops a few points, assuming that the GDP appreciates at 3-4% (less than that it won't really move down much). This means that plenty of people with compromised credit will be returning to the workforce and will need to replace an aging vehicle. These folks are unlike to have 750-plus FICO scores.
Combines with some aggressive incentives, being able to originate loans for this bulge group means that GM will be able to both sell cars -- ideally a lot of lower-priced Chevys, the workhorse brand of the new company -- and book profits on rate spread for the loans GM Financial originates. Sewing is all up is the expectation that GM Financial will also provide "floor plan" financing to dealers, loaning them money to buy GM vehicles. Not as profitable a business as consumer loans, but it does get the sheet metal onto the lots.
Kinda sort brilliant, and not as risky as it sounds
You could be excused for thinking that this sounds like a crazy and irresponsible scheme. Loans to borrowers with bad credit? Horrors! Throw in the fact that the loans can be rolled into securitized investment products (theoretically mitigating the risk on risky lending) and some conservative observers will yank their hair out. However, if you study what GM is up to dispassionately, you can see that this is one of the only ways for it to start raking in some dough. After all, it's access to the debt markets is sorely limited, due to it's bad bond ratings. There's money in the subprime hills -- and GM aims to get some of it.
Update: GM's Jim Cain kindly contacted me to clarify that GM sold its preferred equity in Ally, but retained 9.9% common equity. Press reports have valued this at around $7 billion, but GM could have converted the preferred shares it sold into common equity, and made the decision not to up that stake in advance of an expected Ally IPO later this year.
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