Something big is lurking in the financial markets.
As an investor, I make sure to stay updated on what's happening in the market. I spend a lot of time reading and listening to podcasts every day. To get a broader perspective on the overall market trends, I also subscribe to financial publications that conduct extensive research.
Back in April of this year, I listened to a podcast with Car Dealership Guy, who talked about problems arising in the subprime auto loans sector and how one of the largest lenders in the automotive financing is siginificantly reducing its exposure to the sector. Since then, I've been noticing more and more articles and podcasts discussing an emerging trend of credit tightening in the auto loan industry.
In a recent edition of one of the services I subscribe to, the topic of discussion revolved around the growing concern of a potential bubble in the auto loan market. This raises an important question: Could we be approaching a situation where more and more Americans find it difficult to make their loan payments? In addition to the rising costs of renting and mortgage payments, people are soon going to face another financial burden as the moratorium on student loan payments ends in October of this year. This will result in an additional expense affecting people's income statements this fall. This could spell trouble for the auto industry.
Current situation in the auto loan sector
In the past two years, consumers have been borrowing a lot of money to buy cars. The total amount of auto debt reached a record high of $1.56 trillion in the first quarter of 2023, up from about $1.4 trillion last summer.
The interest rates on car loans have also increased significantly. According to Edmunds, the average interest rate for new car loans rose from 4.4% in the first quarter of 2022 to 7.0% this year. For used car loans, the average interest rate increased from 7.8% to 11.1%. Subprime borrowers, those with lower credit scores, are facing even higher rates, with averages reaching 14% and 21% respectively.
The combination of rising interest rates and soaring car prices has led to higher monthly payments. Bloomberg reports that the average monthly payment for new vehicles reached nearly $800 in the first quarter, almost double the average of the past decade. A record 17% of borrowers, or more than one out of every six, now have monthly payments of $1,000 or more, compared to just 6.2% in 2021.
Many borrowers are finding themselves in a situation where they owe more on their car loans than the actual value of their vehicles. Data from Edmunds shows that the average "negative equity value" on trade-ins, indicating how much borrowers are underwater on their loans, increased by around 30% to over $5,300 at the end of last year.
Late payments on auto loans have also increased, especially among subprime borrowers. Fitch Ratings reports that the percentage of subprime borrowers more than 60 days late on their payments rose to 5.93% in January, surpassing the peak of the Great Financial Crisis in 2009.
Younger borrowers, in particular, are facing financial pressures. The Federal Reserve Bank of New York's Quarterly Report on Household Debt and Credit reveals that nearly 4.6% of borrowers under 30 years old are in "serious delinquency," having missed at least 90 days of payments on their auto loans. This figure is comparable to the peak during the Great Financial Crisis.
2020-2022. Everybody wants a vehicle.
Between 2020 and 2022, there was a surge in car purchases, with nearly everyone getting approved for loans. The rejection rate was minimal, measuring at around 1% according to Bloomberg in 2021. However, the situation has changed drastically today, with rejection rates now hovering around 10%. Even Capital One, known for its selectiveness in lending to car dealers, started working with dealers they may not have considered in the past, lowering their lending standards according to the Car Dealership Guy.
In recent months, prominent lenders and dealers have made significant adjustments to their involvement in the market. Citizens Bank announced a plan to reduce its auto loan portfolio by nearly 60% within the next year, while Mechanics Bank decided to close its entire auto lending business. Capital One, one of the largest auto lenders in the U.S., also made changes by discontinuing "floor plan" credit to dealerships due to mounting losses. Wells Fargo laid off junior auto loan underwriters and tightened lending standards. In April of this year, U.S. Auto Sales, a major subprime used car dealer, abrubtly closed all 39 of its dealerships indefinitely. Additionally, Citizens Bank updated its plans to exit the auto lending business entirely.
These developments indicate a significant shift in the auto loan market, highlighting the challenges and consequences of rising delinquencies and the need for tighter lending practices. The tightening of credit in the auto loan industry is becoming apparent. Dealers are originating fewer loans, and lenders are beginning to take notice. While a majority of the auto loan sector remains healthy, the rise in delinquencies is concerning.
Cracks are appearing in other areas too
This week, several major US banks will be announcing their Q2 earnings results. As reported in a recent article from yesterday's Financial Times, the six largest banks in the USA are anticipated to report a combined write-off of $5 billion due to loan defaults during the second quarter of this year. Additionally, these banks are expected to allocate an extra $7.6 billion to account for potential bad loans, which is twice the amount set aside in 2022.
The rise in interest rates is starting to impact people's financial statements. The article specifically points out that credit cards have become a significant source of concern for several banks. JPMorgan, for instance, is expected to report $1.1 billion in credit card bad debt for the second quarter, compared to $600 million during the same period last year.
The commercial real estate sector, especially the office segment, continues to face challenges. Large companies are subleasing substantial amounts of downtown office space that remains unoccupied, creating difficulties for the sector as a whole.
In Canada, we are eagerly awaiting the upcoming rate decision by the Bank of Canada (BoC) this Wednesday. An additional rate increase would only exacerbate the challenges faced by an already struggling sector. Numerous individuals are currently experiencing the distress of witnessing their mortgage payments rise with each rate increase. According to a recent article in the Toronto Star, homeowners with variable mortgages but fixed payments are resorting to extending their amortization period up to 90 years just to maintain their current payment amount.
Central bankers find themselves in a challenging situation as they strive to bring inflation under control through interest rate. While their objective is to cool down rising prices and tame inflation, each rate increase poses additional challenges for homeowners, businesses, and those with outstanding debts. As per the latest MNP Consumer Debt Index report, the proportion of Canadians who report being insolvent has reached and all-time high. How many more rate hikes can our economy sustain before something breaks? I don't know about you, but I see dark clouds gathering on the horizon.
Trendpost Takeaway
My newsletter, "Something to Consider," serves as my investment journal, where I openly contemplate market trends and determine the best strategies moving forward. Currently, I perceive that we are in the midst of an "everything bubble" with risks apparent in various sectors of the economy. Factors such as high consumer debt, layoffs, variable mortgage payments skyrocketing in Canada, the impending end of the student debt moratorium in the USA, and increasing delinquencies all contribute to this view.
Given the circumstances, it doesn't seem prudent to start buying stocks at the moment. I see several looming challenges and, while a market meltup is possible, where stock prices continue to rise, I anticipate a shift from a bullish to a bearish market within the next twelve months. I would not be surprised to witness a sell-off between now and the end of 2023.
Consequently, my strategy remains one of patience, waiting for a substantial market decline before deploying my hard-earned capital. Here is a tool I personally use to safeguard my cash while awaiting a market crash.
The cash in my portfolio is currently parked in various savings products that pay between 4.05% to 4.65% annually. The Royal Bank of Canada (RBC) offers a savings account instrument akin to a Money Market Fund, where units can be purchased at $10 each, presently yielding 4.30% annually. The symbol is RBF2010. This account allows the option to receive interest payments in cash or units. Personally, I have opted to receive my interest payment in units, enabling a portion of my cash holdings to earn compound interest. Additionally, I hold cashable and non-cashable Guaranteed Investment Certificates (GICs) earning interest rates of 4.05% and 4.25% respectively. For the USD funds in my portfolio I use RBF2014.That product is currently yielding a juicy 4.65% annually.
My current holdings
| Instrument | Current yield | Cashable |
|---|---|---|
| RBF2010 | 4.30% | Any time |
| SCOTIA BANK 1yr GIC | 4.25% | After 1 year |
| RBC 30-Day GIC | 4.05% | After 30 days |
| RBF2014 ($USD) | 4.65% | Anytime |
In my assessment, the market is currently caught up in a state of hype. While there may still be potential gains to be squeezed in this ongoing bull run, I believe it is only a matter of time before the market turns bearish. Therefore, my preference is to stay on the sidelines, earn interest on my cash, and patiently await the opportunity of a lifetime.
There are some early warning signs pointing to a potential recession, such as the tightening credit conditions in the commercial real estate and auto loan sectors. These indicators further reinforce my decision to maintain a 100% cash allocation in my 2023 Fund. By doing so, I position myself to navigate the uncertain market conditions and be prepared to seize favorable investment opportunities as they arise.