Consumer Credit Is a Ticking Time Bomb for the Banks

 | Sep 24, 2024 02:40AM ET

“Over the course of the quarter, our credit challenges have intensified…our borrower is struggling with high inflation and cost of living and now, more recently, a weakening employment picture.”

– CEO of Ally Financial (NYSE:ALLY)

Earlier this year I recommended Ally Financial (ALLY – $34.79) as a longer-term short. On Tuesday this past week at an investor conference, the CEO of ALLY admitted that the auto delinquencies and charge-offs jumped considerably more than its internal risk-control model led management to expect in July and August. He added further that the Company expects charge-offs to rise going forward and acknowledged that ALLY’s “borrower is struggling with high inflation and cost of living.” The stock plunged, closing down 17.6%.

The ALLY CEO’s admission spilled over into stocks like Credit Acceptance (NASDAQ:CACC), which I’ve presented as a short in the past, CarMax (NYSE:KMX) and AutoNation (NYSE:AN), which I’ve also presented as shorts, Capital One (NYSE:COF) – same – and the big Wall Street banks.

In general, the delinquency rate for the subprime segment of auto loans is slightly higher than it was at its worst during the great financial crisis (I think the rate peaked in 2009 or 2010). But more recent subprime auto loans are imploding quickly. Of the subprime auto loans that originated in 2023, 13.4% are 30+ days to 90+ days overdue. The other problem facing auto lenders is the recovery rate on foreclosed loans (the amount of the loan less the amount received from selling the repoed vehicle) is the lowest on record.

In short, companies like ALLY and CACC are going to experience a rapid increase in delinquencies, defaults, and an increasing degree of loss severity on their auto loan portfolios.

But this problem is not confined to just auto lenders. The same dynamic is affecting credit card lenders like Capital One (which is merging with Discover Financial). Even the delinquency and default rates for residential mortgages are starting to rise. I suspect it’s higher than the banks are willing to disclose but at some point, the truth will rear its ugly head.

The above issues address only the rising consumer debt distress. On top of that is commercial real estate distress, from which the big Wall Street banks are not immune, and the debt sitting on big bank balance sheets from the private equity bubble in which the PE firms were making leveraged acquisitions of private companies. Concerning LBO and CRE debt, it’s not a predominant part of the Too Big To Fail bank balance sheets. But in aggregate both categories are in the $100’s of billions and the ability of borrowers to service the debt is in a
state of collapse.

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Add to that the $1.832 trillion in loans extended to hedge funds by Goldman Sachs, JP Morgan and Morgan Stanley (link). Those numbers are as of the end of March and the amount is likely even higher now. All three of those banks would have perished in 2008 if the Fed and the Treasury had not bailed out the banks with printed money and taxpayer money.

Then, on top of that is the OTC derivatives. Every loan category discussed above has a massive amount of OTC derivatives connected to the loans. The supposed changes made in the 2010 Dodd-Frank Act, which was supposed to implement more transparency and accountability in the banking and financial system as well as put “guard rails” around big bank derivative issuance and risk exposure, also made it easier for banks to hide their derivatives exposure off-balance-sheet.

According to a report from Wall Street On Parade, based on numbers from the Federal Financial Institutions Examinations Council, the biggest Wall Street banks held over $192 trillion in derivatives as of the end of 2023. In that order, Goldman, JP Morgan, Citigroup, and Banks of America were the four largest. Granted, the argument is made by the banks that their derivatives exposure is offset or hedged via laying off the risk to counterparties. But that was the argument in 2008. The models in 2008 underestimated counterparty default risk in 2008 and, without doubt, have done so again.

The point here is that all of the financial bombs that detonated in 2008 could detonate again. Except this time the amounts outstanding are significantly larger and, thanks to changes in credit rating and accounting standards, in general, the credit quality on the overall pool of loans and derivatives counterparty risk is lower.

David I. Kranzler

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