Skip to main content

Time to Equity

Time to Equity

By Daniel Ruiz

My approach to analysis consists of starting with a specific sector of the auto industry then peeling back one layer at a time until I truly understand how it works. More often than not, I find used vehicle values staring back at me by the time I get to the core of various sectors. This is why I’ve said many times that used vehicle values are the foundation for the entire auto industry. I’ve devoted a lot of time and effort in the search for data to support this theory. I knew that if successful, I could use that data to better understand the cyclical nature of the industry and to more accurately predict future performance. I now feel very confident that I’ve found what I was searching for. I’ll start with a quick recap for those that are unfamiliar with my work.

Why Used Vehicle Values?

I believe that only jobs and credit are more important than used vehicle to the health of the automotive industry. I say this because 86% of new-vehicle sales are financed, and under normal conditions, those vehicles are traded within three years.

Knowing that most car loans have a 60-72 month duration, we can assume that the majority of vehicles traded at the 3-year mark are not paid off. The level of equity in these loans directly affects consumer behavior and in large part determines when the vehicle will be traded for another new vehicle. The frequency, with which this very large group of consumers replaces their vehicles has a direct impact on new-vehicle sales velocity.

The Search For Evidence

I thought to myself, the theory sounds good, it makes sense, I’ve seen it in action many times throughout my career in retail automotive sales, but is there any evidence out there to support it? To find this evidence, I knew that I would have to figure out a way to measure equity on new vehicle loans at the 3-year mark. So how do I do that? Well, I started by constructing loans using average new vehicle transaction prices, average interest rates and average loan terms for each year going far back as I could. I then took that information and plugged it into an amortization calculator. But there was one still one missing piece, the average value of 3-year-old used vehicles (Luckily I know someone who’s a bit of an expert on that subject). After many hours of research and brainstorming, I developed a formula that very accurately measures the historical value of 3-year-old vehicles. I then went back to the amortization chart, compared the principal balance owed at 36 months to the average value of a 3-year-old vehicle for each calendar year and PRESTO! I had my answer to the equity question. From that point, a little further analysis was necessary to find the month in which the value of the vehicle exceeded the principal balance owed on the loans. The end result is what I will refer to from now on as time to equity.

Does Time To Equity Impact The Performance Of Auto Loans?

While discussing my theory about used vehicle values and how they affect the health of the auto industry, I couldn’t help but notice the growing concerns about subprime auto loan delinquencies. I began to wonder if the value of the asset which backs the loans might have something to do with it. So I decided to compare subprime delinquencies at auto finance companies to my time to equity calculations. The results were encouraging to say the least.

As a general rule, the longer the loan, the higher the risk of default, since the ability of the borrower to repay the is more likely to change. However, when one takes into consideration that few auto loans are held till maturity, I think it’s fair to say that time to equity is more relevant to risk than than the length of the loan. So what’s most capable of changing how long a loan reaches equity? You guessed it, used vehicle values.

Aside from credit worthiness and employment status, auto lenders rely mostly on LTV ratios and maturity variations to measure risk. However, little attention is given to the performance of the asset that backs the loans. In my opinion, this leads to reactive lending behavior with a tendency to tighten credit standards when risk is at its lowest and to loosen when risk is at its highest.

Perhaps some good used vehicle value analysis could be of value...

Higher Prices Come With Consequences

Time to Equity is affected by more than used vehicle values. The ever-increasing price of new and used vehicles has forced consumers to extend their loan terms to all-time highs in order to afford their monthly payments. Extending the length of a loan slows down the rate at which the principal balance is payed down and therefore increases the time to equity. Here's a look at what's to come:

Could Credit Scores Provide Further Clues And Tie It All Together?

I want to be very clear that what I say next is an observation of behavior and not an attack on people with poor credit scores. I am well aware that bad things happen to good people (job loss, illness, etc) and a bad credit score can be the unexpected result. With that said, the data clearly shows that borrowers with credit scores <620 tend to be less responsible than those with higher credit scores.

The longer it takes borrowers with credit scores <620 to reach an equitable position on their auto loans, the higher the risk of default. On the other hand, the borrowers with higher credit scores don’t tend to default on their loans when it takes longer to reach an equitable position; they keep their vehicles longer which slows new-vehicle sales velocity.

In simple terms:

Less Time to Equity = Lower Credit Risk and a Faster Velocity of New-Vehicle Sales.
More Time to Equity = Higher Credit Risk and a Slower Velocity of New-Vehicle Sales.

I hope this article was helpful. As always, thank you for your time and consideration.

These are my opinions and the content contained in or made available through this article is not intended to and does not constitute investment advice. Your use of the information or materials linked from this article is at your own risk.


Popular posts from this blog

Used Vehicle Values - The Foundation For The Automotive Industry

The Perfect Storm By Daniel Ruiz Blinders Off, LLC

Please start with the following video to better understand my analysis:
Auto Market Projections

The following topics all have their part in fueling the storm to come:

1) Trade Cycles and How They Affect New Vehicle Sales Velocity

Used car values determine in large the velocity of new car sales. Most new car transactions involve a trade. The level of equity in the trade oftentimes determines whether a new vehicle transaction will be successful or not. Inclining used car values lead to faster trade cycles while declining used car values lead to slower trade cycles. Dismal new car sales volume during our last recession created a shortage of used cars. This created a large supply and demand imbalance that made used car values soar from 2009 till 2014 as seen on this chart.

This time period was extremely favorable for new car sales because consumers found themselves in an equitable position on their vehicles in a very short period of time. To illu…

CarMax Fights Outside of It's Weight Class

CarMax Fights Outside of It’s Weight Class

By Daniel Ruiz Blinders Off, LLC

Carmax is undoubtedly the most efficient and dominant used car retailer in the US. They outsell the next 3 volume leaders combined.

However, something has changed. Please consider the following:

Will the inventory turn at CarMax outpace the depreciation?

This is a snapshot of CarMax’s inventory on March 22nd 2017:

As of May 20, 2017, their inventory has grown by over 18%.

Will CarMax report an 18% increase in volume for Q2? In 2016, there was a 4% volume increase from Q1 to Q2.  If sales velocity is lost, CarMax will be left holding excess inventory while new car manufacturers put massive pressure on used vehicle values.  

No longer just competing against other used car dealers.

The day supply problem created by new car manufacturers is now a used car retailer’s greatest threat.

To better understand the effect, we need to put ourselves in the shoes of the consumer.

The Perfect Storm 2 - Autonomics

By Daniel Ruiz Blinders Off, LLC
To better understand why the automotive industry is in the middle of a perfect storm, first go back and consider the also perfect set of events that led to a robust recovery and a record setting 2016 sales year.
Our Last Recession In 2009, the automotive industry faced a great challenge. New light vehicle sales dropped to 10.4 million, GM and Chrysler went through bankruptcy reorganizations, retail dealers closed and many folks lost their jobs. The US  government felt the need to act in order to support the very vital automotive industry (3% of GDP & 10% of manufacturing). The Fed also stepped in to help stimulate the overall economy by reducing interest rates.
Consumer Purchasing Power For the purpose of this piece, the central focus will be placed on the purchasing power of the consumer. With no bottom in sight for falling new vehicle sales, our government attempted to stimulate demand by approving the 3 billion dollar Cash for Clunkers program begin…