What to Watch for as This Stimulus-Fueled Industry Fails

Why the loan sometimes exceeds the price of the car... 'Kicking the trade'... A good time for subprime lenders... What to watch for as this stimulus-fueled industry fails... An upside-down used-car market... Watching out for overextended lenders...

John Schricker borrowed $45,000 to buy a $27,000 Jeep Cherokee...

In the previous few years, the 40-year-old electrician made a series of car trade-ins. Each time, he received negative equity, meaning he got less money for his trade-in than the outstanding loan amount.

With each trade-in, he added the shortfall to his most recent purchase. And finally, three trade-ins later, Schricker had to borrow $18,000 more than the purchase price of the Cherokee... just to service the negative equity.

Schricker told the Wall Street Journal that he never intended to cycle through so many vehicles. He replaced one because of high miles, switched to another when he got divorced, and bought the Cherokee because of his growing family.

His nightmare didn't end there, though... Within a few years, the Cherokee started having mechanical problems. Soon, Schricker was looking to replace it with another vehicle.

Of course, Schricker is far from alone with his financing horror story...

Adding old loan balances to new-vehicle purchases is a common practice nowadays... Car-research firm Edmunds reported that toward the start of the COVID-19 pandemic in April 2020, 44% of all trade-ins had negative equity, with the average shortfall being $5,571.

And that's not even as bad as it gets... Some borrowers are in such bad financial shape that they're beyond negative equity.

That's what happened to Joyce Parks last year. As I reported in the August issue of my Stansberry's Big Trade service...

The 63-year-old former dietary aide from Gastonia, North Carolina, was in such bad shape financially that the dealer couldn't get her qualified to trade in her Kia Soul. She owed too much money on it. But the dealership could get her qualified for a new car loan from another lender.

So she bought a Nissan Rogue SUV... and now owned two vehicles, though she couldn't afford payments on either.

In February 2020, as the Wall Street Journal reported, a salesman at Parks' local Kia dealership advised her to "kick the trade"...

That way, Parks could qualify for a new loan on a second vehicle from a second lender. Once she got the new loan, she could then stop making payments on the Soul – kicking the trade – and let the first lender repossess it.

Parks went for it.

Within a few months, though, she couldn't pay for the Nissan Rogue either. Both vehicles ended up getting repossessed – leaving her $15,000 in the hole between the two of them... and without a car. Her credit score plunged.

Unfortunately, as I (Bill McGilton) will explain in today's Digest, the dilemmas of Schricker and Parks are quite common. They're part of an ever-increasing group of Americans known as "subprime borrowers."

As you'll see, the companies offering loans to these folks – the subprime lenders – are in a great spot right now... Used-car prices are up, which is boosting business.

But the good times won't last forever... In fact, the meltdown is already beginning. And as this shift unfolds in the months ahead, it could lead to grave repercussions for subprime lenders... borrowers... and even investors.

According to consumer credit-reporting agency Experian, one in three Americans is considered subprime...

Subprime means they have a credit score of 620 or lower, based on a scale ranging from 300 to 850. It's known as a FICO score – named after the data-analytics firm Fair, Isaac, and Company that developed it.

Subprime consumers had an average credit score of 586 in the first quarter of 2021. They owed $53,000 on average – including $19,000 in auto debt.

Subprime borrowers have a higher frequency of late and missed payments. In the first quarter of 2021, 18% of all subprime credit accounts were 30 or more days past due. That compares with a miniscule 0.2% for prime borrowers.

Almost one in four subprime borrowers has filed bankruptcy in the past seven to 10 years.

In short, it's not great to be a subprime borrower...

These folks are desperate for a car because they often need transportation to get to work or somewhere else. But because of a variety of circumstances, they're risky to lend to... They tend to have poor credit histories, are less stable financially, and are usually the first to run into trouble when the economy turns.

On the other side of the equation, lenders recognize the risk and subsequently charge subprime borrowers much higher interest rates...

Rates for subprime borrowers range anywhere from 11% to 15% for a new car and 17% to 21% for a used car. Meanwhile, prime borrowers pay rates between 2.3% and 3.5% for a new car and 3.6% and 5.5% for a used car.

That's a huge difference... And on top of these higher rates, subprime borrowers often pay additional fees to get a loan.

For the business to work, subprime lenders must earn enough from higher interest rates and fees to offset the high default rate of these borrowers.

On the flip side, it's now a great time to be a subprime lender...

Subprime lenders thrive when interest rates are low and the economy is strong.

Low interest rates let these lenders capture higher spreads – the difference between what they pay for money versus what they can lend it for. And a strong economy means more subprime borrowers stay employed and are more likely to keep up with their payments.

It's a tricky business... In times of economic distress, riskier borrowers tend to default more. Then, subprime lenders amass large loan losses on their books. These losses can eat into years of profits – and even lead to bankruptcy if the distress is bad enough.

But for now, things are good... Subprime lenders have been able to get away with their risky lending practices for so long because of artificially low interest rates dictated by the Federal Reserve.

Plus, the federal government's response to the COVID-19 pandemic was another windfall for the industry... Uncle Sam pumped trillions of dollars into the financial system in the form of stimulus checks, payroll support, and expanded unemployment benefits.

The response worked as intended. From August's Big Trade issue...

Real personal income spiked. The base money in the monetary system increased almost fivefold – from around $4 trillion to $19 trillion. The average American received around $3,200 in stimulus payments. Many received payment assistance for mortgages, rent, student loans, and other expenses. They also benefited from expanded federal unemployment benefits – including an additional $600, then $300, weekly supplement. In general, consumers went out and spent the cash.

All the extra money flowing into the system helped subprime lenders make huge profits.

But the pandemic had other consequences – like supply shortages...

Workers sheltering in place caused labor shortages. That led to production slowdowns – which in turn caused component shortages. Supply chains are slowly improving, but they're still out of whack...

One of the best examples of supply-chain imbalance is the semiconductor chip shortage across the auto industry... It's a topic that I discussed as part of my April 22 Digest.

Early in the pandemic, before the stimulus efforts kicked in, automakers cut back on chip orders – expecting an extended recession. In turn, chipmakers reconfigured their manufacturing to more lucrative consumer electronics to satisfy demand from people stuck at home.

So by the time the automakers wanted chips again, they were out of luck... Chipmakers had directed their production elsewhere.

Automakers haven't been the same since... They're operating factories at a stop-and-go pace, and vehicles are sitting partially finished or are sold with fewer features.

Overall, production is way off... For example, General Motors (GM) expects to deliver 200,000 fewer vehicles in the second half of 2021 due to the ongoing issue.

The chip shortage is still expected to continue into the second half of 2022. And despite the recent "happy talk" from automakers about improving conditions, which my colleagues have touched on in the Digest, it could last even longer than that... Ford Motor (F) Chief Financial Officer John Lawler said earlier this month that the shortage could potentially carry over to a lesser extent into 2023.

As a result, there simply aren't enough new cars to meet demand across the U.S. right now. That's making used cars more valuable – or more expensive for folks looking to buy them.

Automobiles are supposed to be depreciating assets...

Over time, cars normally decrease in value from normal wear, tear, and obsolescence. But that concept got turned on its head with the pandemic...

The combination of supply shortages and massive liquidity injections has caused inflation to spike... It's now running at more than 6%. The last time inflation was this hot was in 1990.

And asset prices have risen across the board... Dramatic price increases occurred in raw materials (steel, aluminum, and copper), agriculture (corn, wheat, soybeans, and vegetable oils), lumber, plastics, energy, transportation costs, and more.

Retail investors were flush with so much cash that it even led to the "meme stock" craze in companies like GameStop (GME) and AMC Entertainment (AMC).

And in this upside-down environment, used cars turned from depreciating assets to ones that actually increased in value...

Automobile-auction company Manheim has developed an index to track the ebbs and flows in used-car prices... It's called the Manheim U.S. Used Vehicle Value Index.

We'll spare you the details about how the calculations are made. You just need to know what's happening in the market...

From April 30, 2020 to October 31, 2021, the index showed that the value of used cars increased an average of 76%. The following chart shows the skyrocketing prices over that span...

My colleague Corey McLaughlin previously reported on this phenomenon in the July 14 Digest...

The 2019 and 2020 versions of the Kia Telluride SUV are generally selling for more than $3,500 – or 8% – higher on average than a new 2021 version...

Same story with the GMC Sierra 1500 pick-up truck... and four of Toyota's most popular models that are all selling for at least 3% higher than their zero-mile versions.

Rising used-car prices were actually great for both subprime lenders and borrowers...

Higher used-car prices gave borrowers more options to sell vehicles and pay back debt to avoid repossession... And in cases when borrowers defaulted, lenders recouped more money because they were taking back an asset that had increased in value.

It also meant that borrowers had less negative equity and more easily qualified for new loans. For example, in June, Edmunds reported that 20% of car owners traded in their vehicles with negative equity. That's the lowest number of negative-equity trade-ins since 2009.

The problem is... it's going to be difficult for used-car prices to continue moving higher.

Supply-chain issues will either need to get even worse or new rounds of stimulus checks will need to land in the hands of consumers... And neither scenario is likely to occur.

Now, used-car prices likely won't drop immediately... There's still strong demand and a shortage of new vehicles hitting dealerships across the country. So elevated used-car prices will probably continue for some time.

But at some point soon, things will stop looking so good for lenders...

Subprime lenders reaped the benefits of pandemic response policies. Now, most government stimulus, extended unemployment, and forbearance programs have ended... That means less money is in the hands of consumers today.

And at the same time, unemployment levels remain high... The government's latest official number was at 4.6% in October. That's 31% higher than 20 months ago.

As a result, it will get a lot more difficult for subprime consumers to keep up with their payments. In turn, it's going to hurt subprime lenders as they amass larger loan losses.

At the same time, consumers are holding more debt than ever before...

Last quarter, U.S. household debt hit an all-time high of $15.2 trillion – including $1.4 trillion in total auto loans outstanding, according to the New York Fed. That total includes $199 billion in new auto loans made last quarter – up 25% from the same quarter two years ago.

As a group, subprime and less-than-prime (FICO scores of 620 to 679) consumers picked up the pace of borrowing last quarter... Of the $199 billion in new auto loans, $34 billion (17%) were subprime and $24 billion (12%) were less-than-prime consumers.

We're already starting to see auto-loan delinquencies edge up with reduced unemployment benefits... In October, 1.3% of all auto loans were severely delinquent, compared with 1.2% in August. And 4.6% of all subprime loans were severely delinquent, compared with 4.5% in August.

As of September, there were around 370,000 auto loans frozen – or in a nonpayment status. They're like ticking time bombs...

Because these loans are frozen, they're not yet considered delinquent. But once these loans become unfrozen, many of these borrowers won't be able to repay... And at that point, delinquency levels will get far worse.

If nothing else, I'll leave you with a simple warning for today's Digest...

Be careful if you're holding shares of subprime lenders.

By that, I'm talking about companies like Credit Acceptance (CACC), Santander Consumer USA (SC), and Capital One Financial (COF).

These companies all thrived due to the money printing and free-flowing stimulus from the Fed. Each of these three stocks is up more than 200% from their April 2020 lows.

But when this trend turns in the weeks or months ahead, you won't want to be holding shares of these companies... They're going to get crushed as loan losses start rising.

And if you're interested, there's something else you can do today...

You could also turn the lenders overextending themselves to your advantage...

You see, in Stansberry's Big Trade, I look for troubled companies that investors have overvalued... Then, I bet against these companies by buying long-dated put options.

This strategy is sort of like an "insurance policy" for your wealth... It's a way for you to protect your portfolio against the inevitable end of the current market euphoria.

For example, when investors panicked and stocks were plummeting in the early days of the COVID-19 pandemic, we booked a rapid succession of eight winners in about two months... And seven of those winners closed for triple-digit returns ranging from 122% to 197%.

Back in August, we recommended a trade designed to pay off big on the impending rise in subprime delinquencies... This company last blew itself up during the financial crisis in 2008. And after the government bailed it out, it went right back to subprime lending.

Once again, it has emerged as one of the largest banks and subprime lenders in the country. And shares are set to plummet with a spike in subprime delinquencies.

Subscribers who got in on the initial recommendation are already up 16% on this opportunity. But the good news is... it's still trading within buy range today.

Plus, it's just one of many pieces of insurance that I've recommended for my subscribers.

I've also identified ways to profit from the "retail apocalypse" – consumers moving online at the expense of brick-and-mortar stores... the reduction in travel because of the pandemic... and tech companies with major problems... just to name a few.

I'd love for you to join me at Stansberry's Big Trade. As our performance during the market panic in the spring of 2020 shows, you'll be glad to have the necessary portfolio protection when it matters most. And right now, you can sign up at an incredible discount...

You can gain instant access to all of my research and my complete model portfolio at 40% off what others have gladly paid in the past. Get all the details right here.

(If you already subscribe to Stansberry's Big Trade or if you're a Stansberry Alliance member, you can read my full report about the subprime lending space right here.)

New 52-week highs (as of 11/10/21): Automatic Data Processing (ADP), American Financial (AFG), AutoZone (AZO), CoreSite Realty (COR), Procter & Gamble (PG), PLDT (PHI), and The Shyft Group (SHYF).

In today's mailbag, a subscriber heaps praise upon our colleague Dan Ferris for his latest Digest. Tell us what's on your mind at feedback@stansberryresearch.com.

"I loved reading this, found it entertaining, informative, educational, and well-written." – Paid-up subscriber Joyce C.

Regards,

Bill McGilton
Kyiv, Ukraine
November 11, 2021