US auto industry could trigger crisis

14/05/2008 - 22:00


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US auto industry could trigger crisis

BRIEFCASE, having recently returned from a visit to the land of the free, has identified the source of a possible new financial scandal in the US, which holds the potential to rock the market in the same way that sub-prime lending for housing has done.

The issue surrounds the US's automobile finance industry, specifically arrangements pertaining to automobile sales.

The two most valuable items most Americans will endeavour to buy are a house and a car.

Last year, we saw how the housing industry had been straining to keep sales running by issuing dodgy debt to folks who had no hope of ever repaying it.

Now we see a similar phenomenon in the auto financing industry, which is sure to cause more pain when it eventually collapses.

New auto sales in the US currently run at about 14.5 million units per year, and Briefcase understands that about 80 per cent of sales are made on finance, which is usually available for the total sales price of the car.

In effect, very few people in the US actually pay for a car outright, they simply sign up to a finance agreement and drive away with a monthly payment plan.

Sales folks don't quote a car price; they talk monthly payments, with scarce regard to the interest cost.

Briefcase suspects that the whole US auto sales industry is a giant ponsi scheme, in which money goes around from the car user to the finance and insurance companies and then to auto makers, with fees spinning off to those selling the cars, along with the finance and insurance packages, while the auto manufacturers are actually not making anything like a reasonable profit and those funding the finance companies do not fully appreciate the risks they are taking.

In order to get finance, a car buyer must also sign up for gap insurance.

This insurance covers the difference between the value of the car, should it be written off, and the value of the finance package.

In effect, this insurance acknowledges that the car is being sold for a price which is more than its replacement value.

Finance packages vary, depending on an individual's allimportant credit rating, and can range from 11.75 per cent a year up to 21 per cent a year.

In order to keep monthly payments down, finance packages for six years are now on offer.

Briefcase calculates that this type of funding would result in the car owner paying a multiple of the purchase price for a vehicle over the term of such a contract, if in fact it was held for the full 72 months.

In order to facilitate these 'sales', the auto makers have become huge players in the finance market; in fact, much of their profit comes from this activity, and not manufacturing.

Up until recently, GMAC was a wholly owned finance subsidiary of General Motors, which has a 22 per cent share of total US auto sales.

In 2006, 51 per cent of GMAC was sold to a private equity consortium, led by Cerberus Capital.

GMAC has about $US250 billion of assets globally.

Others in the industry include Nissan Motors Acceptance, PRIMUS, HSBC, Bank of America, Wells Fargo, Americredit, and Mercedes Credit Corporation, and so the list goes on.

A tour of the car yards in Dallas reveals hectares upon hectares of unsold Mercedes and other high-value vehicles.

The trend now is to take out a term lease on a car and, just when the car is about to be repossessed for nonpayment, you drive it into the car yard and refinance yourself into a new set of wheels.

The industry is completely complicit in this behaviour, which resembles the sort of action which brought subprime lending into disrepute.

Refinancing means that the sales person gets a commission, the lease company gets a commission and the auto maker records a new sale.

What happens to the second-hand vehicle Briefcase is not sure, but I suspect it makes its way to South America somewhere.

We are talking about huge numbers here.

Briefcase calculates that 11.8 million cars (80 per cent of total annual sales) at an average price of $25,000 each, equals about $US290 billion a year, so the total amount outstanding in the market, assuming an average of, say three years of vehicles under finance, might be close to $US870 billion or up to $1 trillion.

All this is good business for the finance companies, where even after allowing for repossessions, which ran at 1.6 million vehicles in 2007, must average a decent return at the rates charged.

The whole circus enables the weak US auto makers to continue to record sales and at least pay for wages and materials consumed, if not make a profit for shareholders, while an army of sales people and other ticket clickers are all feeding at this synthetic trough along the way.

Sooner or later the whole ponsi scheme will certainly collapse, with dire impacts on the finance companies and those who lend money to them via their debentures and junk bonds.

Reverberations through the US economy will be severe.

--- As reported two weeks ago, professional investors in the US are reportedly sitting on record levels of cash, which would indicate that there is plenty of firepower waiting in the wings and available for investments in the right product at the right time.

Contradicting this bullish stance is the record level of short positioning in the US market.

Logically, one might expect that those cautiously sitting on cash might also be the same folks who are holding short positions, expecting the market to fall further.

Therefore, it is unlikely that significant amounts of new cash will enter the market until the shorts are covered, since to do so would push the market higher and kill the shorts.

However, it may be that market sentiment is currently being driven by market players who have only been in the game for less than 20 years, and who have not experienced a serious market pullback.

This is why the current market rally may still represent a bear trap.

I have not seen the bulls being totally vanquished yet.

Bear Stearns, Opes Prime, Lift Capital and the like all add to the negative mood, but I still have not seen the negative impacts of the current economic downturn filtering widely into the local economy.

Sure, there is pain in the mortgage belt, but we have not yet seen the sort of pain that might normally be associated with a serious economic pull back, if indeed that is what we will experience.

Let's wait to see how it unfolds.

While recent action looks increasingly bullish for the market, Briefcase cannot bring itself to cry 'buy'.

--- - Peter Strachan is the author of subscription-based analyst brief StockAnalysis, further information can be found at


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