The large digital consumer bank Ally Financial (ALLY -0.85%) specializes in retail auto lending, which is being watched very carefully by investors because the consumer might be headed into a more severe economy later this year or in 2024.

With new and used car prices having remained elevated since the start of the pandemic, there's a lingering question of what happens to credit quality once consumers spend down savings and the value of these vehicles drops.

For a company like Ally, this issue is front and center because of its large retail auto portfolio, so credit quality is a huge driver of the stock. Let's take a look at how credit quality is holding up in the retail auto portfolio after the first quarter of the year.

Hanging in there

After a big jump in delinquencies and loan losses in last year's fourth quarter, credit quality in Ally's retail auto book stabilized in the first quarter of the year.

Net charge-offs, or debt unlikely to be collected and a good indicator of actual loan losses, barely rose at all in Ally's retail auto portfolio in the first quarter. The net charge-off rate of 1.68% remained in management's projected range of 1.6% to 1.8%. It was also good to see 30-day delinquencies, which looks at borrowers who more recently began to miss payments, drop pretty decently in the quarter as well.

However, management noted that delinquencies in the first quarter came in elevated compared to earlier expectations, which could present headwinds in the future. The bank has set aside enough reserves to cover losses of as much as 3.6% on the entire retail auto book. The current charge-off rate is 1.68% and the current 30-day delinquency rate is 3.24%. Management also said it doesn't expect to build its reserve levels from here because it isn't expecting much balance sheet growth this year, as it tightens underwriting and approval rates.

A big driver of credit is used car prices, as management noted that a 1% drop in used car prices equates to a 2 basis point rise (1 basis point = 0.01%) in the net charge-off rate in isolation. So far, used car prices have performed exceptionally well this year due to continued low inventory.

In the first quarter of the year, Ally's Used Vehicle Value Index rose 8%. Heading into the year, management expected to see a 13% drop in used car values. Still, Ally's management team is remaining conservative and baking in a roughly 15% drop in used car prices from current levels for the rest of this year, which would equate to a 9% drop overall for the full year.

Although the outlook remains uncertain, this estimate feels conservative because other industry groups are projecting that used car values will end 2023 little changed from where they began the year. If this plays out, then that should serve as a tailwind for the company and lead to credit outperformance.

What's the verdict?

By and large, I thought Ally's credit quality was in line with expectations, albeit delinquencies did come in higher than management expected, which is a little disappointing considering how well used car prices performed in the quarter.

But it still seems like management is on top of things. Management has more recently focused its lending efforts in the super-prime market, and since the beginning of 2022 has added 7.1% to the interest rate it charges on retail loans to borrowers further down on the credit spectrum. The higher interest rate more appropriately prices in risk. In fact, Ally was originating retail auto loans at more than 10% in the first quarter to reflect the riskier environment. 

The company has also tightened underwriting and is now expecting lower origination levels, which is likely a prudent measure given the uncertainty. In the first quarter, Ally had $100 billion worth of retail loan requests and only originated $9.5 billion of loans.

There are still risks. For one, we don't know exactly where the economy is headed or how severe of a recession we may or may not enter. Ally is currently expecting the unemployment rate to peak at 4.6% by the second quarter of 2024. It's possible this comes in higher than expected. Also, the fact that the company saw higher-than-expected delinquencies in the quarter could also hint at higher-than-expected losses down the road.

However, given the conservative reserving, tightening of underwriting, and also conservative projections for used car values, I do still feel good about credit quality. If credit quality meets expectations or better, I would certainly expect Ally's stock to rise from here.