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November 11, 2019 | Auto Debt Helping to Drive Tipping Point in Transportation Sector

Danielle Park

Portfolio Manager and President of Venable Park Investment Counsel ( Ms Park is a financial analyst, attorney, finance author and regular guest on North American media. She is also the author of the best-selling myth-busting book "Juggling Dynamite: An insider's wisdom on money management, markets and wealth that lasts," and a popular daily financial blog:

A third of Americans who traded in cars to buy new ones in the first nine months of 2019 had negative equity, compared with 19% a decade ago, according to car-shopping site Edmunds (chart on right).  Similar trends are evident in Canada.  See A $45,000 loan, for a $27,000 ride:  More borrowers are going underwater on car loans.

On average, the balance owing was $5,000 above trade-in value and added to the debtor’s next auto loan–the opposite of a downpayment.

From 2009 to 2015, zero-down and then negative equity loans helped drive the purchase of new vehicles where dealer incentives are most rich, rather than used vehicles, which tend to be the smartest value for the buyer.  But as people have become more indebted, and transportation on-demand services more widespread, personal use auto sales in North America (shown below) have stagnated over the past five years despite population growth.

Those with negative equity trade-ins, end up with longer loan terms (i.e., seven years) on depreciating assets with higher interest rates and higher monthly payments.  This increases repayment risk and reduces the owner’s spending and saving ability for years after that.  In nearly all cases, used vehicles are smarter than new, while ride-sharing in one form or another and taking public transit where possible, are smarter still.

To date, lenders have been willing to make underwater loans because they could be ‘securitized’–bundled into bonds–and sold to investors.  But we’ve seen this story before in the subprime housing debacle, and investor appetite tends to evaporate once loan defaults mount, and security prices fall.  That’s starting to happen now.

Loan defaults have been rising for the last two years.  Some 5.2% of the subprime auto-loan balances were at least 60 days past due on a rolling 12-month at the end of the second quarter of 2019, up from 4.8% the year before (Fitch).  Another 4.64% of US auto loans and leases in the second quarter were 90 days or more behind (New York Fed data).  As pointed out by Wolf Richter and charted below, this is a similar delinquency rate as the third quarter of 2009, coming out of the Great Recession.

Poor vehicle quality has been a keystone of the North American auto manufacturing model for the last few decades, with profits increasingly dependent on finance fees, repairs, parts, service and frequent replacement.  And after the last recession, vehicle prices rose faster than wages because lower interest rates meant buyers could carry higher loan amounts than when rates were lower.  But they’re financially more fragile in the process.

Sure enough, a common reason cited for trading in vehicles today is off-warranty mechanical problems that owners don’t have the cash to fix, so they seek to roll the loan balance of the old vehicle into a new.  These are unsustainable trends that have left the status quo auto sector ripe for disruption.

The first logical response is for individuals to avoid the purchase of personal use vehicles altogether by using public transportation and now widely available ride-sharing programs.  This dramatically lowers transportation costs and frees up cash flow to pay off debt and build savings for other goals.  I did this myself for many years as a student and then young professional, which allowed me to pay off student debt and build savings faster.

Later, when we had small children, my husband and I shared one family car for several years in order to pay off our mortgage and save for our kid’s education.  Because of that, our now young adult children are completing university without having to take on debt, and they too have avoided buying cars to date in order to save money and stay out of debt.  They get the connection.  Debt-avoidance is a generational gift that keeps giving, and more and more people are starting to understand this.

Today, we drive an electric car (which we bought used) because it will last longer and is at least 75% cheaper to operate than a traditional ICE auto.  And I still take the train and transportation-on-demand whenever possible to increase productivity en route and share my vehicle with other family members.

Over the next decade, the spread of ride-sharing and transportation as a service will make ownership of individual-use vehicles less and less attractive.  This means that automakers, dealers and service centers are all in the mature stages of a declining industry.  Consider this when you see the multimillion-dollar showroom/service centers that have been built by legacy automakers over the last decade. Once purchased, electric vehicles have 90% fewer parts and service needs than old tech vehicles–great for owners, bad for auto sector profits.

On the upside for individuals, transportation costs as well as auto debt, are also in a period of secular decline. This is a tipping point that will help households work their way back from crushing indebtedness and increase savings and financial stability overall.  In the shorter-run, though, it’s fueling some major disruption in the transportation sector and related finance as well as fallout in the economy and financial markets overall.  Understanding these trends offers a big heads up.

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November 11th, 2019

Posted In: Juggling Dynamite

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