Ally Financial bets on subprime auto loans

NEW YORK (Reuters) – Ally Financial Inc, the largest provider of auto loans in the United States, hopes people have forgotten when “subprime” became synonymous with “disaster”.

Ally, formerly known as GMAC Financial Services, is preparing to go public this year and argues that subprime loans for used car buyers are not about to produce the same results they have obtained in the housing market a few years ago – – a virtual collapse of the financial system.

Auto loans have performed relatively well during the recession and demand for cars is on the rise, so auto loans are one of the few types of consumer debt that is on the rise.

Ally wants to show investors that this sets her apart from many other banks, which are struggling with weak loan demand and their own deteriorating mortgages.

The company is lending more to subprime borrowers and funding more used car purchases, both stages of higher risk. He said he wants to increase the percentage of used car loans he makes to 50% from its current 20%.

Subprime car lending is “a very attractive business today,” ally chairman William Muir told analysts on May 3. Profit margins on loans more than cover the cost of expected losses from borrowers who do not repay, he said. Plus, lending on used cars endows the dealership with the business.

It might sound like a great plan now, but similar arguments about subprime mortgages were common in 2003, analysts said.

And, Ally and its competitors can follow the pattern of past credit cycles, where lenders make increasingly risky loans at lower interest rates until waves of defaults and losses hit them. overwhelm. Loans that appear secure can deteriorate quickly.

Some banks, including JPMorgan, are already pulling the brakes on auto loans as profit margins have become too thin given the risk.

Ally needs to stretch. Its financing costs are several percentage points higher than those of most of its banking competitors, putting it at a disadvantage. Ally also uses a lot of money in volatile credit markets. And General Motors is making more of its own loans, which could make Ally’s future earnings less reliable than it is now.

Ally is the kind of company that “will likely have to call on the government’s financial ambulance at some point in the future,” said James Ellman, hedge fund portfolio manager at Seacliff Capital in San Francisco. “I don’t know if it’s sooner or later, but it will happen.”

In a commentary written for this story, company spokesperson James Olecki said, “Ally Financial’s strategy is to extend credit using sound underwriting criteria and responsible funding practices.”

“We accept retail auto contracts on the full range of credits – including non-premiums – as part of our normal business,” he said. “We place more emphasis on the high end of the non-prime spectrum and we only approve credit for qualified customers who demonstrate the ability to pay.”

RIGOROUS COMPETITION

The government ambulance picked up Ally three times during the financial crisis as Ally’s subprime mortgage book collapsed. Taxpayers pumped more than $ 17 billion into the company, which had $ 287 billion in assets in 2006 before loan values ​​plummeted.

The bailouts left the government with a 74% stake in Ally, which the Treasury plans to sell, starting with the company’s initial public offering. The deal could seek around $ 5 billion from investors in what could be the largest IPO by a U.S. lender in more than a decade, according to Renaissance Capital, an investment advisory firm.

Ally filed its initial prospectus with regulators in March, and sales of shares often occur within three months of such a filing.

SOEs face much greater pressure to increase profits, and this is where things could get tough for Ally.

“If Ally is to achieve the kind of growth shareholders are looking for, it must go beyond the blue chip lending industry,” said Kathleen Shanley, analyst at Gimme Credit. “This segment of the market is extremely competitive; hence the company’s increased focus on used cars and non-premium buyers. “

For many analysts, these steps make sense. Used car prices can be several percentage points higher than new car prices. Subprime loans add more. According to data from the Experian credit bureau, used car loans to borrowers with subprime credit scores paid more than 9% to lenders, compared to 5% or less for used car buyers with subprime credit ratings. ‘solid credit.

“Risk-adjusted returns in the used car market look very favorable,” said Adam Steer, analyst at Credit Sights.

Used car buyers who take out loans tend to be less creditworthy than new car buyers. According to Experian, borrowers who bought used cars in the first quarter had average credit scores of 663, compared to 766 for new car buyers.

It may sound worrisome, but subprime auto loans are not as risky as subprime mortgages, Steer said. Auto loan payments are smaller and more manageable for borrowers than mortgage payments, he said. In addition, the money should be repaid more quickly and the loan collateral, the cars, are more easily seized and resold than the houses.

The average used car loan in the first quarter was $ 16,636 and required monthly payments of $ 343 for 58 months, according to Experian.

“Many consumers have chosen to default on their mortgage, but stay up to date on their auto loan,” said Kirk Ludtke, analyst at CRT Capital LLC in Stamford, Connecticut.

Default rates for auto loans were relatively low from May 2007 to October 2010, according to David Blitzer, managing director of Standard & Poor’s. The maximum rate for defaults on auto loans was 2.75% in February 2009, less than half the maximum rate for first mortgages and less than a third of the rate observed on credit cards issued by banks.

Lower default rates make auto loans attractive to other lenders, not just Ally. Banks including TD Bank Group, which bought Chrysler Financial in December, and Spanish banking giant Santander, which bought auto finance units from Citigroup and HSBC, are entering the market and squeezing their profit margins by offering more choice for borrowers.

“The competition from auto loans is back in a very aggressive way,” said Marc Sheinbaum, head of auto finance and student loans at JPMorgan Chase.

Banks, especially large ones, relaxed credit standards for new and used car loans in the first three months of this year, the Federal Reserve found in an April survey of loan officers. . Banks also tended to reduce the amount they charge for money out of their own costs of funds.

JPMorgan cut new auto loans 24% to $ 4.8 billion in the first quarter from a year ago.

Ally, on the other hand, said it lent $ 11.6 billion in the same quarter to the United States, up 93% from a year ago. The company has made nearly 10% of all auto loans in the United States, according to Experian. It increased the volume of used cars in the first quarter by 128% compared to a year earlier.

In total, Ally has $ 56 billion in consumer auto loans on her books, nearly three times her net worth of $ 20 billion.

HIGHER FINANCING COSTS

Ally has a particular disadvantage because lenders’ profit margins are tight: she paid an average of 5.16% interest, annualized, on her liabilities in the first quarter, more than five times what JPMorgan Chase and Wells Fargo & Co, the second largest auto lender, paid off.

Much of the added cost comes from Ally’s reliance on borrowing heavily in the bond markets, which is more expensive than using depositors’ money.

The company advertises more deposits, but since it does not have a branch network, it has to pay higher rates than established banks to attract customers. Ally paid an average of 1.83% for deposits in the first quarter, while JPMorgan Chase paid 0.53% and Wells paid 0.38%, according to company statements for the first quarter.

Sources have said that Ally may try to buy ING Direct, which will give it more deposits, but not necessarily as cheap as those at the big banks.

Ally may also lose an important advantage: her connection with GM. Its former parent company was responsible for half of its auto loans in the last quarter. But last year, GM bought AmeriCredit to become its new internal financier for dealer inventory and customer purchases.

Ally’s special loan marketing agreements with GM and Chrysler are scheduled to expire in 2013.

Ally’s focus on used car loans comes as subprime borrowers form a larger part of the business. Industry-wide, about 40% of used car loans went to the lower ranks of subprime borrowers in the first quarter, up 8% from the previous year, according to data from Experian.

Loans and purchases have helped drive up used car prices. They are at record levels, according to Manheim Consulting, an automotive consulting firm.

The danger with record prices, said Ludtke of CRT Capital, is “there’s only one place to go and it’s going down.” Falling used car prices could translate into higher losses if borrowers default.

Auto lenders, including Ally, are more cautious than they were before the recession, said Bob Ghent, owner of Ghent Chevrolet and Cadillac in Greeley, Colo.

For example, when the Ghent dealership refers its customers to lenders, Ally and its competitors regularly call borrowers and their employers and speak to them directly. Banks also lend less than the value of the cars.

“They are smarter,” says Ghent.

But he doesn’t make any predictions about how long the caution will last: “When they want business, they lower their standards. It’s just competition.

Editing by Dan Wilchins and Robert MacMillan


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