The digital consumer bank Ally Financial (ALLY -2.95%), which specializes in auto lending, has had a tough year, with its stock falling about 50% in 2022. That drop came despite the bank putting up excellent returns since the pandemic, buoyed by surging demand for new and used vehicles brought on by the chip shortage from the pandemic.
But investors tend to buy based on future performance, and the market is increasingly concerned that a tougher economy and a slowdown in the used vehicle market could result in Ally experiencing heavy loan losses. Investors will be paying attention to fourth-quarter earnings results closely when they are released on Jan. 20. Here are the most important numbers I'll be watching.
Loan losses and delinquencies
At one point in 2022, used car prices had shot up more than 60% from pre-pandemic levels due to the shortage of inventory as normal life more or less resumed from the initial stages of the pandemic.
Now, investors are worried that as prices normalize, borrowers could find themselves in trouble, especially if the value of a car drops below the principal loan amount. There are also concerns about the consumer in general, as the economy potentially heads for a recession in 2023. The key numbers to keep an eye on when Ally reports its fourth-quarter and full-year financial results are delinquencies and charge-offs, specifically for its retail auto loan portfolio.
A delinquency occurs when a borrower hasn't made a payment on their loan for at least 30 days. Delinquencies then turn into charge-offs, or debt unlikely to be collected, when payments haven't been made for an extended period of time, say 120 days. Charge-offs are ultimately a good indicator of actual loan losses, although they can be recovered if borrowers suddenly turn things around and make payments. In the third quarter of 2022, delinquencies and charge-offs started to meaningfully move higher.
Image source: Ally Financial.
Looking at management's expectations
The key to assessing credit quality at a bank is not solely looking at the numbers but seeing if management can reserve properly for loan losses and ultimately run the company well even if losses are moving higher.
Ally's management team understands that used-car prices are going to come down. In fact, baked into their assumptions is the idea that used-car prices will fall by 30% by some time in 2023. Recent inflation data from November shows that used-car prices have started to decline and were down by about 3.3% year over year.
Now, the big question is whether Ally will ultimately have reserved properly for future loan losses. Keep in mind that charge-offs are still below pre-pandemic levels and are expected to normalize and potentially rise above pre-pandemic levels because of the Federal Reserve's rapid interest rate hikes and a deteriorating economic outlook.
Ally's CEO Jeff Brown said on the company's third-quarter earnings call that he thinks charge-offs could start to stabilize by mid-2023, but it does partly depend on how the Fed continues to move with interest rates. He also said the company projects its companywide net charge-off rate to top out at around 1.6% of total loans. At the end of Q3, Ally's consolidated net charge-off rate was 0.85%, so Ally is expecting its net charge-off rate to nearly double from Q3 levels. The consolidated coverage ratio in Q3 was about 2.7%.
At the end of Q3, Ally had a retail auto coverage ratio of about 3.56%, meaning the bank has reserved enough capital to cover losses on that much of the retail auto loan book. As you can see in the chart above, the retail auto net charge-off rate is currently 1.05%, but the 30-day delinquency rate is almost at 3%.
Intel from results
Ultimately, delinquencies and charge-offs likely rose in the fourth quarter of 2022. The big question is by how much and will the rise lead the market to question management's earlier assumptions regarding when charge-offs will begin to level off and the expected peak rate of 1.6%.
These are the big things to watch, and Q4 data from charge-offs and delinquencies can give us intel on these projections.
If Ally is right, then their earnings going forward can still be pretty good. But if management is wrong, higher charge-offs and reserve levels will cut into earnings, and analysts will likely revise their earnings estimates lower, which will hurt Ally's stock price.
