One of the top priorities when evaluating any bank stock is having good clarity on credit. Loan losses are one of the leading causes behind bank failures and can also lead to hefty losses if not monitored correctly, which in turn can destroy shareholder equity.
While certainly not the only concern among investors when it comes to the digital consumer bank Ally Financial (ALLY 0.88%), which specializes in auto lending, it has weighed heavily on shares as investors wonder how the bank's retail auto portfolio will hold up in a tougher economy.
Used vehicle prices are on the decline, and there is significant uncertainty surrounding the consumer. How Ally manages credit is ultimately going to determine how the stock performs.
Loan delinquencies and losses are on the rise
As the consumer spends down its excess savings and deals with the ramifications of inflation and higher borrowing costs, banks are starting to see credit normalize. Consumer loans such as credit cards, personal loans, and auto loans typically see higher loss rates (net charge-offs) than other kinds of lending.
Image source: Ally Financial.
The rise in delinquencies and the net charge-off rate that Ally saw in the fourth quarter are certainly not small increases, especially when you look at retail auto, a portfolio that Ally has grown a lot in recent years.
The trend is also being driven by a decline in used-car prices, which have soared in recent years thanks to the chip shortage that came about from the pandemic. Ally's management team expects used car prices to fall another 13% this year, which would put them down about 30% since the end of 2021, which is in line with management's expectations.
Ally said that in its retail auto portfolio, originations made prior to the third quarter of 2021 have performed very well, while originations after that until the second quarter of 2022 have underperformed versus management's expectations. But originations since that time have been made intentionally with the purpose to "mitigate and curtail underperforming segments." In the fourth quarter, Ally only originated $9.2 billion of auto originations, the lowest amount in more than a year, so the bank likely tightened underwriting in the quarter.
Overall, the 1.66% retail auto net charge-off rate is roughly in line with past expectations from management, which expects the net charge-off rate to peak for now and see a rise later in the fourth quarter of the year.
The expectation moving forward
Ally is basing its modeling on several assumptions, including that there will be a mild recession this year, which includes negative economic growth in the first half of the year. Ally also expects the Federal Reserve's benchmark lending rate to peak at 5% this year and for unemployment to peak at 5% as well.
So, the way to think about this is that if the economy performs worse than these assumptions or used car prices fall more than 13% this year, Ally could see elevated loan losses, which would hurt earnings, as well as investors' confidence in management. If the economy performs better than Ally's economic assumptions, expect loan losses to come in lower than expected.
The somewhat good news is that Ally does have a healthy capital position and is reserving for loan losses prudently. The bank has enough reserves on hand to cover retail losses equivalent to 3.6% of the total retail auto loan portfolio. It also has enough reserves to cover losses equivalent to 2.7% of total loans, so it does have some flexibility to deal with a downside economic scenario.
Uncertainty remains
The market seems to be pleased with Ally's management of credit so far, with the stock rallying 20% after the company reported fourth-quarter results. Ally's stock also trades at a pretty cheap valuation.
But there is still a lot of uncertainty in the air and a wide range of potential economic scenarios, given that the Fed has never raised interest rates so aggressively in such a short period of time. At this point, unemployment could still finish well above or below 5%.
But I am cautiously optimistic about management's ability to keep managing credit effectively and to be able to deal with a worse-than-expected economic outcome.
