Will The Coming Subprime Auto Loan Calamity Affect Tesla?

With subprime loan saga rearing its ugly head once again, auto lenders, as well as automakers, face the risk of suffering a backlash. Is Tesla Inc TSLA, which has an altogether different sales model, immune to the nascent subprime crisis that could grow into a full blown one if left unattended?

To understand this, let's look at how subprime loan crisis affects traditional automakers.

How Subprime Loans Could Hurt

Major automakers have their own captive financing arms that extend finances to car owners for buying vehicles. In a bid to boost sales, automakers dole out generous incentives to consumers, relaxing credit terms, as the benefits are two-pronged — interest on the loans and proceeds from product sales.

A Bloomberg report, quoting the New York Federal Reserve, said vehicle loans reached a record $1.16 trillion in 2016. However, Fitch estimates that the U.S. vehicle sales have reached an inflection point and could fall by 0.5 million units to 17 million in 2017.

"As asset performance slows, rising used vehicle supply from both lease returns and increasing repossessions will drive depreciation higher, putting downward pressure on recovery rates and accelerating loss severity and loss levels," Fitch said.

Automakers such as Ford Motor Company F, General Motors Company GM and Fiat Chrysler Automobiles NV FCAU, along with their captive finance units account for one-half of all car loans advanced these days, with these companies underwriting three quarters of loans to subprime vehicle buyers, Bloomberg said.

Subprime loans are advanced to borrowers with low credit ratings, with lenders charging higher-than-normal interest rates to compensate for the higher-than-normal risk assumed.

According to Experian's State of Automotive Finance Market report for the fourth quarter of 2016, total open automotive loan balance stood at $1.072 trillion in the fourth quarter of 2016.

And the sources of origination are as follows:

• All Banks: $364 billion or 34 percent of the total.
• Captive Auto: $252 billion or 24 percent.
• Credit Union: $277 billion or 26 percent.
• Finance: $179 billion or 7 percent.

Among the vehicles financed, 53.62 percent of the units financed are used vehicles compared to 46.38 percent new vehicles. About 28.94 percent of the used vehicles financed are leased.

When these subprime buyers default on their payments, automakers are left saddled with losses. Another way these companies could be impacted would be through the effect of falling used car prices. The loans automakers originate go into financing used as well as new vehicle purchases and leases. With car prices climbing 13 percent to $34,067 over the past five years, thanks to pricier trucks and SUVs, leasing provides consumers with a cheaper option to own new vehicles.

When used car prices fall, the value of the collateral on the loan extended declines. This results in companies increasing provisions against future losses. Additionally, lower car prices suggest that finance companies can recover only less amount on repossessed cars.

Apart from automakers, pure play finance companies such as Ally Financial Inc ALLY, Credit Acceptance Corp. CACC, Santander Consumer USA Holdings Inc SC and Capital One Financial Corp. COF could also face the music.

What Does All This Mean For Tesla?

Edmunds.com's analysis of pre-owned registration data showed that Tesla is spreading its wings beyond California and its traditional buyer base of wealthy, trend-setting customers.

Gravitating Toward Used Cars

• The analysis done based on 2015 data showed that 25 percent of new Model S buyers earned less than $100,000 per year. With respect to used Model 3 buyers, about 36 percent fell in the less than $100,000 per year earning-category.
• Millennials, those belonging to the 18–34 year-category, accounted for 10 percent of pre-owned Model S buyers compared to six percent of new Model S buyers. This reflects the proclivity of this category for used cars.
• The percentage of Californian buyers accounted for 42.5 percent of all new Model S sales compared to 30.5 percent for used Model S sales.
• Tesla began offering the option of buying pre-owned cares on its website in April 2015, a time when several of its leased-out vehicles entered the used car market.
• According to Auto List, used Tesla Model S sells the fastest overall among the best selling vehicles from the three companies.
• Tesla takes 87 days to sell compared to 88 days for Ford Fusion, 93 days for Chevrolet Silverado 1500, 103 days for Chevrolet Malibu and 104 days for Ford F-150.

Direct Sales Model

Tesla has shied away from the traditional model of selling through dealership. The company instead has retail locations, which are self-owned and are located in shopping malls. These stores, now available in 22 states and Washington, D.C., serve merely as places, where customers know about the company and product, while purchases are made online.

"We knew we couldn't rely on dealerships to promote our mission, to operate the business the way we wanted to, to provide this great customer experience," said Fast Company, quoting Ganesh Srivats, Tesla's vice president of North American sales.

This unique sales model has put the company at loggerheads with some states such as Michigan, which mandates that sales are routed through dealership networks.

Tesla could be relatively immune if a subprime meltdown materializes. Despite the pick-up in the sales of pre-owned cars, buyers are mostly affluent, reducing the risk of a default. Tesla's business model of production based on orders prevents inventory pile up, unlike traditional car makers.

Unlike traditional automakers, which are left grappling with an industry approaching an inflection point, and heavily reliant on an incentivized selling environment and subprime borrowers to push sales, Tesla's order book is overflowing. This is evident from the 400,000 reservations the company confirmed in June 2016.

Riding a Tesla now seems a safer bet than any of the traditional automakers despite the many concerns raised regarding the safety aspect of its autopilot feature.