Credit quality might still be squeaky clean at many of the large traditional banks, but it's deteriorating much faster at Ally Financial (ALLY -1.56%), a large consumer digital bank that specializes in auto lending. Loan losses and delinquencies -- which have been extremely low thanks to pandemic stimulus and built-up savings -- began surging higher in the third quarter faster than some might have expected.
Ally received a big endorsement this year when Warren Buffett's Berkshire Hathaway opened a position in the first quarter and then bought more in the second quarter. Ally is a relatively small stake in Berkshire's massive equities portfolio, but the conglomerate now owns close to 10% of Ally's outstanding shares.
With credit now weakening and a recession on the horizon, did Buffett and Berkshire make a mistake?
What happened in the quarter
Analysts and investors are keeping a keen eye on Ally's credit quality because the bank has made lots of auto loans with larger overall loan amounts, due to heavy demand for vehicles amid the semiconductor shortage brought on by the pandemic. Used-car prices have been 60% higher than pre-pandemic levels this year.
Image source: Motley Fool.
In the third quarter, Ally saw net charge-offs -- debt unlikely to be collected, a good indicator of actual loan losses -- rise to $276 million, an increase of more than 80% from the second quarter. Nearly all of the increase came from a rise in charge-offs in the bank's retail auto portfolio, which doubled from the prior quarter. The net charge-off rate as a percentage of total loans rose from 0.49% in the second quarter to 0.85%, which is now equivalent to levels Ally saw in the third quarter of 2019.
And there could be more trouble on the horizon. The percentage of loans 30 or more days past due ticked up from 2.52 percentage points in the second quarter to 2.93 percentage points. Loans 60 or more days past due and delinquent contracts also rose sharply.
Looking at what's to come
Ally has built its reserves for future loan losses by $133 million and now has a total allowance equivalent to 2.71% of its loan book, including a 3.56% coverage ratio for its retail auto loan book. That's significantly above net charge-off levels right now and well above the coverage Ally had at the end of 2019.
Management has been expecting credit to begin normalizing in its auto book and has previously said it expects used-car prices to come down 30% by sometime next year. The company is also still projecting the net charge-off ratio to rise to 1.6% and then start to stabilize sometime in the middle of 2023. That means its coverage ratios right now are still healthy for where management expects credit to eventually head.
The other good news for Ally is that the bank has been originating auto loans at much higher levels than it has in the past, which can help protect margins and potentially offset higher loss activity.
For instance, with a similar cost of funding and projected net charge-off rate, Ally was originating retail auto loans in the third quarter of 2019 at an average yield of 7.5%. In the third quarter, that yield had increased to 8.75%. On the company's earnings call, CEO Jeffrey Brown said, "We really like the loans we're putting on the books today and think they're going to prove to be very profitable over time," even when factoring in higher loss rates.
Did Warren Buffett make a mistake?
I am still fairly optimistic that Ally's management has the situation under control when you look at its coverage ratios and the loans the bank is originating.
I expect the next couple of quarters to be dicey, but I also think the stock's valuation today is pricing in some very harsh economic scenarios. Ally only trades at 78% of its tangible book value, or net worth, which is a very low valuation for a bank, even for the times we are in -- and considering Ally is still generating solid profitability and has healthy levels of capital.
Buffett tends to like value opportunities like this. And Ally's management has been trying to prepare investors for deteriorating credit quality, even if it's come sooner than many expected. While we won't know for some time what actions Buffett and his team are taking now, it's reasonable to think they're still optimistic about Ally's potential.
