December 1, 2023

Car Auto Finance

Car Auto Finance FOR Everyone

Why Ally Financial’s Lousy Q2 Could Signal a Problem for Carvana

The auto loan market is showing signs of unraveling.

That’s one of the big takeaways from Ally Financial‘s (ALLY -3.29%) recently posted second-quarter results. Although the bank topped its earnings estimates for the quarter, the top line’s year-over-year tumble of 7% led to a near-halving of its net income. Charge-offs grew to 1.16% of its loan portfolio from 0.49% in the prior-year period. It also continued to expand its provisions for future loan losses, in step with the growth in delinquencies. Souring loans in its auto segment — by far Ally’s biggest business — were the key culprit behind last quarter’s lousy numbers.

Ally’s deteriorating vehicle-lending business, however, should be just as much of a worry for Carvana (CVNA -4.31%) shareholders as it is for Ally’s. Not only is Carvana in the car business, but a key component of its profit mix depends on a healthy auto loan market.

And Ally’s isn’t the only red flag waving on this front.

Carvana: A lending middleman that also sells cars

The auto loan market is more complicated and sophisticated than you might think. It’s chock-full of lenders that are not only competing for business, but also attempting to calculate exactly how much risk each would-be borrower poses against a quickly changing economic backdrop.

A bunch of car loan companies are also middlemen, making individual loans to buyers and then bundling those loans up into packages that they sell to institutional investors. In exchange for regular interest payments on the bundled debt, these investors take on the risk of the borrowers on the underlying loans defaulting on them. 

If those bundles of auto loans sound a lot like the collateralized mortgage obligations (or CMOs) that were so hot in the years before the 2007-2008 subprime mortgage meltdown, that’s exactly what they are. They’re just using vehicles as collateral rather than real estate.

Carvana is one of these loan-bundling middlemen. Through the first six months of 2023, it sold more than $3.1 billion worth of auto loans made to its car buyers to third parties. Better still, these loans only cost the company a little over $2.9 billion. Nearly half of its per-car gross profit on vehicles it sold to retail customers, in fact, came from the sale of these loans.

Image of Carvana's Q2-2023 cash flow statement showing sales and cost of loans sold to institutional customers.

Image source: Carvana Co. Q2-2023 letter to shareholders.

Of course, being able to extend these loans also makes Carvana’s car-selling service a more marketable one.

The thing is, for Carvana to continue generating this sort of profitable revenue, investors must remain confident that these bundled loan instruments offer enough reward compared to their risk. In light of a couple of recent developments that are largely being ignored, this is no longer a foregone conclusion.

Red flags are already waving

The first of these developments is the possibility that a huge batch of similarly bundled auto loans is on the verge of disaster. On July 5, Bloomberg published an article headlined “Subprime Auto Bondholders Face Possible First Hit in Decades.” The post-headline bullet points went on to explain that “Holders of riskiest parts of three ABS [asset-backed securities] deals may see losses” and “Consumers are not repaying their debt after lenders shut doors.” The wording left no doubt as to the causes of the issue or its prospective impact.

That story wasn’t about Carvana or the loans it bundles to sell to investors. That doesn’t make the company immune to a similar prospect, however. Trouble often takes shape in the subprime segment of the credit market. If it’s rooted in economic weakness though, it eventually spreads to other tiers of borrowers.

Indeed, overall car loan defaults are well above long-term norms now. S&P Global Mobility reported in June that the first quarter’s auto loan delinquency rates were as high as they’d been since the Great Recession, which jibes with Ally’s growing loan-delinquency data.

Ally Financial's defaults, delinquencies, and charge-offs are all rising thanks to souring automobile loans.

Image source: Ally Financial’s Q2 2023 earnings supplement.

And the other red flag? Even if they’re not touting the shift, lenders are tightening their lending standards. Evidence of this reality is supplied by the Federal Reserve, which reported that over the course of the 12 months ending in June, a record-breaking 14% of automobile loan applications were denied.

Granted, what some see as a crisis, others see as an opportunity. Ally Financial CEO Jeffrey Brown commented during last week’s earnings call that Carvana is planning to capitalize on the fact that several other banks and credit unions are backing away from the increasingly risky auto lending business. This willingness to take risks other lenders won’t has its merits.

There’s a reason a slew of other lenders are thinking more defensively and less aggressively in the current environment, however. Never mind that the underlying assets backing these auto loans always depreciate in value.

Betting big means nothing if it’s an ill-advised bet.

Carvana’s running out of gas

Is Carvana doomed? No. All industries run hot and cold. All companies have their ups and downs. This one is no exception. Besides, auto loan sales provide only one piece of Carvana’s gross profits. It still turns profits just by selling vehicles to consumers, as well as selling them on a wholesale/auction basis.

In many ways, though, the company’s touting of its per-vehicle profitability could come back to haunt it now that it’s increasingly looking like its auto loans are becoming more of a liability and less of an asset. Nearly half of last quarter’s per-sold-vehicle gross profit ($3,005 of the $6,520 gross profit per retail unit, or GPU) stemmed solely from the sale of bundled auto loans that could soon fall out of favor in a big way. Asset-backed securities’ prices are pretty sensitive to the quality of their underlying collateral, after all, as are loans bundled into securities. 

Image showing Carvana's changing GPU sources.

Image source: Carvana’s Q2 2023 earnings call slide deck. “Other GPU” denotes the portion of each quarter’s gross profit per retail unit (GPU) sold that stemmed from the sale of loans extended to car buyers. 

The fact that lenders are now tightening up their lending standards — and reducing the number of loans they’re willing to make — only underscores the industrywide headwind now blowing against Carvana.