Published: November 3 2008 12:37
Last updated: November 3 2008 12:37
The discussion in Washington about facilitating the merger of Chrysler and General Motors highlights the turmoil plaguing the US automobile sector. But there is also an emerging automotive finance crisis. The credit crash has triggered a precipitous decline in new car sales, caused in part by a rapid reduction in automotive financing. This in turn threatens to spark additional large write-downs in the financial sector. Rather than allow this systemic risk to spread through our entire economy, the Federal Reserve should move quickly to draw on past practice and create a conservative, well-established financing body that can bring relief to the auto finance sector, before it is too late.
The automotive industry is the largest manufacturing industry in the US. It accounts for an estimated 20 per cent of all US manufacturing gross domestic product, more than 1m jobs and an estimated 4m-6m additional jobs on an indirect basis. It is a cornerstone of the US economy.
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But the sector has been hammered by the freeze in the credit markets. Consumers are facing higher interest rates on loans and dealers cannot obtain the financing needed to purchase inventory. New vehicle sales plunged 23 per cent year-on-year in September and are forecasted to fall by approximately 30 per cent in October. Total sales this year are expected to be just 11m vehicles – the lowest level since 1983.
The fundamental issue is auto loans, or rather the absence of them, since 94 per cent of consumers finance their car purchases. Finance companies cannot sell or finance auto receivables in the wake of the worst financial crisis that the asset-backed securities market (ABS) has ever seen. That has left these companies with little choice but to curtail lending, which is contributing to the precipitous drop in car sales.
The double whammy of declines in lending and in car sales will deal another punishing blow to the already beleaguered auto sector and will create profound risks for the US financial system. Consider this: for the past decade, domestic automotive sales have averaged 16m-17m units per year and that translates in to the extension of approximately $375bn of auto financing each year. Given that the average life of an auto loan is 2 years, an estimated $700bn-$800bn of exposure is currently thrashing around our financial system.
This exposure exists in a variety of forms. Regional and national banks, as well as credit unions and finance companies, are holding these loans on their balance sheets. Banks also have exposure to auto financing through conduits, structured investment vehicles and collateralised debt obligations, whose value is tied to automotive loans or ABS. In recent years, annual issuance of these securities has approached $100bn. And in 2008 these securities have accounted for more than 25 per cent of all ABS (only the credit card sector has issued more). Insurance companies, mutual funds and pension funds alone are estimated to have $80bn of exposure and the banking sector’s exposure is in excess of $200bn.
But reduced auto financing deprives the financial sector of a massive revenue stream and will deliver another shock to our financial system.
Even worse, the pain will be intensified because the banks have not hedged their exposure to auto loans, given the absence of any benchmark index comparable to the asset-backed securities index, which is used for mortgage portfolios. While the causes of the problems facing the auto and real estate sectors are very different – the auto sector has not been hampered by sloppy underwriting standards, for example – the common denominator is that downturns in both sectors threaten the stability of the US economy.
Sounds pretty scary, and it is. But we have the ability to prevent the auto finance crisis from spinning out of control as has been the case with the sub-prime crisis. Allowing the Big Three’s finance companies to become bank holding companies on an expedited basis – a step that press reports indicate is under discussion – is an ideal solution. This would allow them to obtain funding from the myriad programmes established by the Treasury and Fed.
Another way would be for the Fed or Treasury to do what they have done before when restricted markets need financing – provide loans on a direct basis. Here is how it would work: allow troubled auto finance companies to establish a new entity, to which the Fed would provide debt capital that could be used to originate auto loans. In turn, this finance company would manage all new loans. Unlike the sloppy lending standards in the home mortgage industry, auto lenders tend to be much more conservative. The majority of the loans would have highly predictable performance characteristics. So government would be unlikely to sustain any significant losses and could actually earn a very healthy return on its capital.
By providing capital, the Fed would help auto companies increase their loan volume, which in turn would help them reduce their cash burn and would shrink the ultimate size of the riskier government guarantees needed by the Big Three to ensure their survival. The government would simply be serving its appropriate role as “lender of last resort,” against good collateral and in a manner that would be profitable to the taxpayers.
At a time when the US economy is coping with the fallout from a deeply depressed housing market and turmoil in the banking sector, the last thing it needs is another shock to the system in the form of a meltdown in the auto financing sector. The Federal Reserve, having been late to recognise the implications of the subprime mortgage fallout, now has an opportunity to redeem itself and take an important step toward restoring the stability to auto finance.
The writer was US secretary of energy from 2001 to 2005 and senator from Michigan from 1995 to 2001, during which time he was chairman of the Senate Subcommittee on Manufacturing and Competitiveness. He is currently chairman and chief executive of The Abraham Group, LLC