It was a light night of comedy on twitter earlier this week, which briefly distracted from the uncertainty of the US position on the Paris Climate Accord, the fallout from the recent Presidential trip overseas and the likelihood of real legislative change making it to fruition.
Markets have spent the days since the holiday in a slightly negative holding pattern and yesterday, in the Financial Times “Big Read” an article entitled “Debt pile-up in US car market sparks subprime fear” was a trigger of sorts, for me at least. The article discusses increased loan to value ratios and cranked up debt to income ratios, aggressive and pushy sales practices, “NINJA (no income, no job, no assets)” customers and poor recovery rates. While it didn’t seem like the practice is as widespread of potentially severe in impact as the lending to sub-prime borrowers for the housing market it did seem that 8 years of a soft recovery have dulled memories somewhat. As the chart below shows, there is a notable rise in the debt burden per customer, although defaults have not yet reached historic highs. When this is combined with stagnant incomes, the perils of the gig economy and lower labor participation rates, a particularly toxic cocktail may be brewing.
In private lending too we have heard of lighter covenant (and even no covenant) transactions, particularly in the larger cap segment – the less trafficked small and middle market seem to have less of an issue with this. Are standards starting to become more porous and where will the endgame be? The line between “commercial best practice” or the “necessary evil of doing business” and a dangerously inadequate set of covenants is unfortunately blurred, and, as investors, we will most likely be told what we want to hear. Default rates remain close to all time lows, and despite the rattle caused by a spike in energy defaults last year, an air of complacency has descended. In Warren Buffett parlance, the tide is high, but the article from the FT suggests that it may be turning though . . which, may happen “slowly at first” and then all at once. We need to keep asking and digging.