Prepare for an exploding supply of used automobiles… And like most economic disruptions these days, it’ll be thanks to the pandemic.

COVID-19 brought about never-imagined lifestyle changes. Families that used to live in crowded apartments and concrete jungles made the move to suburban areas with yards and trees. And trains, subways, and shuttle buses were no longer reliable forms of transportation.

Everyone needed cars.

This change in demand (along with global supply-chain issues) made cars a precious commodity. Prices nearly doubled as a result.

But recent indicators show the car market’s strength is starting to fade. And for the first time in years, prices are about to fall.

Let me explain…

Before we go any further, remember… this isn’t the housing crisis in 2008. It’s a car crisis in 2022. If the housing bust hit us like a right hook, a collapse today in the used-car industry might be more akin to a left jab.

Still, the change we’re seeing is dramatic.

It used to be that a vehicle would start to depreciate as soon as you drove it off the lot – at least, that was the case until early 2020. Fast-forward to this year, and a car you bought two to three years ago is likely to earn you a better return than your 401(k).

The chart below shows what the value of a used vehicle purchased in 2020 should be today, based on the typical depreciation (dashed line)…

Now, look at the bright blue line – the actual value of what that car is worth today. It’s not even close to the trend.

It’s hard to imagine, but the used-car industry has swollen to a size that’s simply unsustainable on a long-term basis.

But what’s the catalyst for change? The answer lies with consumers. A troubling number of folks today can’t afford their car payments…

Edmunds, an online automotive inventory and information resource, reports that about 13% of new-car buyers are making payments of at least $1,000 per month. Cox Automotive and Moody’s Analytics say these numbers are the highest on record… And keep in mind, this is for an asset that’s historically considered a terrible investment.

For comparison, the median monthly mortgage payment is $1,600.

Consumers’ disposable incomes increased as the pandemic brought about debt forbearance, stimulus checks, and better unemployment benefits. But as those benefits dried up, car buyers were left holding the bag. A lot of buyers are now defaulting on auto loans from 2020 and 2021.

According to Barron’s, the nation is experiencing a surge in repossessed vehicles over the last year. Auto dealers are seeing repossessed vehicles go to auction where the buyer’s loan-to-value (“LTV”) ratio was north of 130%. (And that’s our conservative number… Barron’s quoted one dealer who’s seeing ratios at 140%.)

LTV is the loan amount versus the value of the actual vehicle. So in other words, buyers are defaulting on car loans of $26,000… on vehicles worth only $20,000 (130% LTV).

What’s alarming is that this isn’t limited to subprime borrowers. Yes, subprime borrowers’ default rate is still higher than prime borrowers’ (those who have good credit)… But Barron’s reports that both groups saw their default rate double since 2020. Subprime borrowers’ default rate increased from about 6% to 11%, while prime borrowers’ increased from 2% to 4%.

It gets worse when we zoom out. According to a Consumer Reports investigation in 2021, 25% of loans were given to borrowers who might not be able to afford them. Income and employment verification only happened 4% of the time.

Consider these locality default rates… 8.7% in California, 10% in Texas, and a shocking 23% in Washington, D.C.

These numbers are all for loans that are 30 days or more past due. And they’re concerning. These states are major economic centers. California and Texas account for roughly 23% of national output.

So, while the data doesn’t paint a promising economic picture, it does tell us what’s coming for the used-car market. It’s quickly moving from no supply to a flood of inventory… And that means the high prices we’ve seen since the pandemic are nearing their end.

Good investing,

— C. Scott Garliss

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Source: Daily Wealth