Following its recent third-quarter earnings report, Ally Financial's (ALLY -0.02%) stock sold off, as investors seem increasingly concerned about deteriorating credit quality.
Ally saw its charge-offs, or debt unlikely to be collected and a good indicator of actual loan losses, roughly double in its retail auto portfolio during the quarter. This comes as the consumer is still believed to be pretty healthy, but in a year from now, this may not be the case.
Despite the worrying credit trends, Ally still originated $12.3 billion of consumer auto loans in the quarter, and management has no intention of taking its foot off the gas. Here's why.
Ally's retail auto originations took off over the past two years, largely because a microchip shortage constrained supply, sending prices of automobiles soaring and forcing more buyers to borrow. Earlier this year, used auto prices were up more than 60% compared with 2019. Eventually, the market is expected to normalize, and with a recession potentially on the horizon, auto lenders could see a lot more credit deterioration in the future.
But management is still seeing a tremendous amount of demand in its target market, prime auto borrowers, and has been able to continue to price its retail auto loans with extremely attractive yields.
In the third quarter, the federal funds rate, which drives a lot of Ally's deposit pricing, was at pretty much the same level as it was in 2019 (2.25% to 2.50%), yet Ally's average retail origination yield in the third quarter was 8.75%, 1.25 percentage points higher now than it was in the third quarter of 2019. Management was also assuming a similar loan loss rate then as now.
Furthermore, interim Chief Financial Officer Brad Brown said on the company's earnings call that Ally continues to see yield expansion and is now pricing auto loans above 9%.
Higher interest rates do raise a number of issues for the company including higher charge-offs and a higher cost of funding. However, Ally Chief Executive Officer Jeff Brown said that the company still believes returns would be attractive if funding costs rose to 4% from the current 1.89% and lifetime losses exceeded 2% of the total portfolio (management expects loan losses to top out at 1.6%).
In this scenario, new loans could still generate a 21% return on equity and close to a 2% return on assets -- both returns that are extremely attractive. These might be "some of the most profitable loans we think we've ever originated," Brown added.
Lending is expected to slow a little in the fourth quarter, with management forecasting about $11 billion of originations. That is about the same as the fourth quarter of 2021.
Furthermore, Ally does appear to be prudently reserved for future loan losses. Management still expects the company's total net charge-off rate, which now is 0.85%, to rise and peak at about 1.6%. The company has reserved for loan losses equivalent to 2.71% of its total loan book.
Sometimes, the best defense is a good offense
Charge-offs did seem to rise faster than the market expected in the third quarter, and it's certainly reasonable for investors to be concerned given the doubts heading into 2023.
But credit trends are still within management's expectations and Ally appears to have reserved for a number of adverse economic scenarios. It may seem counterintuitive to continue lending when conditions may be worsening, but a big part of lending is ensuring that you are pricing risk appropriately. With retail auto loans now carrying a yield above 9%, it would appear that management is doing so.
If Ally can make enough money to offset loan losses and still generate healthy returns for shareholders, it's OK to see charge-offs rise in the near term. This is why Ally continues to stay on the offensive, despite deteriorating credit, and it looks to be the right move right now.