Liquidity is drying up in the auto industry
For more than a decade I have worked as a consultant for companies in the auto industry. Back in January and again in April I wrote that the U.S. market for light vehicles is the worst that I have ever seen it and that it would likely continue to deteriorate (see article: Auto Industry Analyst: "current market for light vehicles in the U.S. is about as bad as I have seen it in the past decade."). Man has it ever. The other day I had a lengthy conversation with a smart individual who works for a major dealer group (how on Earth did I not short them?) who has worked in the industry for forty years. He / she told me that this is as bad as they have ever seen it. I have acquaintances who have worked at the same automaker for decades who are getting laid off left and right.
After sifting through bits and pieces of information that I have picked up from people at banks and automakers over the past week in my mind, I began to notice a trend. Liquidity seems to be drying up. I will change the names of the companies that I am talking about to protect the innocent.
I picked up on my first clue that there is a liquidity problem in the industry when speaking with someone who works for a luxury automaker late last week. Let's call this company "Atari". Well, Atari recently created a new captive finance company (industry lingo for a bank that it uses to finance and lease the vehicles that it produces). This individual told me that this big name in the auto industry was having a tough time getting finding for its captive arm. He or she had been in touch with over fifteen banks over the past several weeks and many of them wouldn't even bother to call him / her back. We're not talking about a broker or Bob's independent auto leasing here people, this is a major company with a quality product that can't find any banks that are willing to lend it the money that it needs.
Here's another example. Several days ago someone at a different automaker told me that the bank that they use to fund their captive finance arm, let's call them "Face" for now, just informed them that they are going to raise the base interest rate that they charge them by a whopping 100 basis points on leases and by 50 basis points on conventional loans. Keep in mind that this is happening at a time that interest rates are flat, which means that either "Face" is really hurting for money or it is very risk averse right now. Regardless of the reason, an increase of 0.5% to 1.0% in its interest rates at a time when consumers are not buying vehicles is obviously not a good thing for a car company.
These are just two examples of the things that I see going on around me. Other, public information that illustrates the same thing is right out there for everyone to see, such as General Motors (GM) burning through so much cash that it suspended its dividend, is slashing 20% of its white collar workforce, and it is looking to monazite certain assets such as selling or spinning off its foreign operations.
One major problem that I see coming down the road that I don't hear many people talking about is captive finance companies' huge residual value exposure. I don't have any specific data handy on how much exposure to leasing GMAC and Ford Credit currently have on their books, but I can assure you that they are getting hammered as the vehicles that they leased to consumers several years ago come back and aren't worth anywhere near what they had "estimated" they would be. I use the word estimated very loosely because most manufacturers have their captive finance companies artificially boost the residual values of the vehicles that they lease in order to provide consumers with attractive monthly payments and move more iron for their parent company.
For those of you who aren't familiar with how leasing works, lease payments are made up of two main parts: the depreciation portion and the interest portion. Banks publish a list of residual values, usually in percentage form, that dealers use to calculate the depreciation portion of lease payments. These percentages vary by model, term (the length of the lease), and mileage allowance (the number of miles per year the lessee is allowed to drive). The higher a vehicle's residual value percentage is, the lower its monthly payment will be. So for years, either out of ignorance of what the market is / will be like in the future or more likely in an effort to hide support, manufacturers have been making their captive finance companies artificially inflate vehicles' residual values. Now that the market, particularly for pickup trucks and SUVs, is such a disaster the vehicles that these companies are getting back at lease-end are worth thousands of dollars less than they had estimated they would be. Unless they have some sort of residual value insurance, and even if they do I doubt that it is enough, these companies are probably going to get hit with big charges as a result of this.
Times are unbelievably tough in the auto industry right now and things are almost certainly going to get worse. I have been telling myself for months that there's no way a major automaker like GM, Ford, or Chrysler is going to go bankrupt but the more I hear about these liquidity problems and the worse the market for light vehicles gets in the U.S., the less I am sure. Getting them to pay their bills is virtually impossible. If things don't start to get better for the consumer at some point in 2009 or if the credit crunch that seems to slowly be eating away at automakers' ability to fund their operations at a time when they are losing money doesn't begin to ease we could be looking at the government having to bail out the automakers in addition to the banks.
Short GM (-65% and counting) and Ford (-42.7% and counting) in CAPS
No position in either in real life