Updated: Oct 20, 2020
New York | This week we give our readers a little taste of the new content in the Premium Service of The Institutional Risk Analyst. For this purpose, we focus on the latest member of The IRA Bank Dead Pool, namely Ally Financial Inc. (NASDAQ:ALLY). We assign a negative risk rating, as discussed below.
Disclosures: NLY, CVX, NVDA, WMB, BACPRA, USBPRM, WFCPRZ, WFCPRQ, CPRN
Review & Outlook
ALLY has all of the required attributes for inclusion in The IRA Bank Dead Pool, including poor equity market performance, wide credit spreads, a weak funding profile and a lack of clarity in terms of forward business model. The market’s assessment, as usual, is correct as illustrated by the fact that ALLY trades at a bit more than half of book value. Like most banks, the ALLY common equity is down 30% YTD.
American Express Company
Capital One Financial
Peer Group 1
Ally Financial describes itself as “is a leading digital financial-services company with $180.6 billion in assets as of December 31, 2019” in its most recent 10-K. Like many SEC filings you can see today, a good deal of the ALLY 10-K document is marketing fluff with little meaning much less relevance to investors. The recent IPO of Rocket Mortgage (NYSE:RKT) shares this unfortunate characteristic of fluff over substance in public company disclosure.
Note, first and foremost, that Ally has grown assets modestly in the past decade, even as the composition of those assets has changed. But the bank is still basically a monoline auto finance provider. Here’s what the ALLY 10-K said regarding the business back in 2011:
“Global Automotive Services and Mortgage are our primary lines of business. Our Global Automotive Services business is centered around our strong and longstanding relationships with automotive dealers and supports our automotive manufacturing partners and their marketing programs. Our Global Automotive Services business serves over 21,000 dealers globally with a wide range of financial services and insurance products... In addition, we believe our longstanding relationship with General Motors Company (GM) and our recent relationship with Chrysler Group LLC (Chrysler) has resulted in particularly strong relationships between us and thousands of dealers and extensive operating experience relative to other automotive finance companies. Our mortgage business is a leading originator and servicer of residential mortgage loans in the United States.”
The focus on automotive in early 2012 was deliberate, of course, since the ResCap unit of General Motors (NYSE:GM) had become the Chernobyl of the mortgage world. Laden with late vintage Alt-A no doc loans, the ResCap book set new standards for fraud. The May 2012 bankruptcy filing by the ResCap unit of ALLY was an important event in the resolution of the subprime mortgage mess.
The ResCap bankruptcy also enabled ALLY finally to break free of GM, which had been rescued by the Treasury in 2009 after filing for bankruptcy itself in June of that year. In a 40-day whirlwind process, GM intimidated the firm’s creditors and swiftly emerged from bankruptcy as a ward of US Treasury under Secretary Timothy Geithner.
Our testimony in 2009 to the Senate Oversight Committee chaired by Elizabeth Warren (D-MA) was that it would be difficult for ALLY’s predecessor to make the transition to an independent company. ALLY was the captive financing unit of the world’s biggest automaker, GM, but today is a monoline issuer of auto loans/leases, credit cards, unsecured loans for consumers and insurance and floorplan financing for independent dealers.
A decade later, our judgment seems to be borne out in the financial performance of the 21st largest bank holding company (BHC) in the US. The major automakers simply must capture the spread paid on financings in order to survive themselves. This leaves precious little market left over for firms such as ALLY, that seek to finance some of the other independent dealers and compete with the major banks for auto leases.
A review of public benchmarks suggest that the performance of ALLY is mediocre. In addition to trading at a book value multiple of equity ~ 0.6x, ALLY has a beta of 1.6x the average market volatility and a forward dividend yield of 3.25%, according to CapIQ.
At the close on Friday September 25th, ALLY had an implied credit default swap (CDS) spread of 132bp over the curve or twice the spread for the largest banks. That CDS spread generated by Bloomberg maps to about +BB plus in a rating agency equivalent.
Looking at ALLY’s credit portfolio of $118 billion, $65 billion is in loans to individuals, $30 billion in C&I and $20 billion in real estate loans, mostly 1-4s. The net default rate at 71bp is a good bit higher than the average for Peer Group 1 but well below more aggressive (and efficient) issuers such as American Express (NYSE:AXP) and Capital One Financial (NYSE:COF), as shown in the chart below.
Ponder the fact that AXP has a net default rate that is 3x Citigroup (NYSE:C), which we have rated negative, but has an equity book value multiple of 3.6x or 7x that of the larger Citi. The reason that AXP shareholders pay a 3.6x book value multiple for its equity comes down to basic factors such as operating efficiency and risk management. The reason that Citi, COF and ALLY trade below book is the same. In both cases, the market is right.
In business model terms, ALLY, AXP and C are more finance company than traditional depository. One of the key indicia of this risk factor is the gross spread on the loans and leases of the bank. By examining the gross spread on a bank’s lending book, you can pretty quickly determine the business model. This is a little qualitative nuance we developed with Dennis Santiago years ago at Institutional Risk Analytics. The chart below shows the gross loan spread of ALLY and the comparable companies in this report.
Notice a couple of things about this chart. First, COF has a gross spread that is almost double digits and suggests a “B” rating equivalent for the bank’s loan book. Three of the four issuers have seen their loan spreads compress in the past several quarters, but AXP has actually expanded its gross loan yield. Finally, note that ALLY’s loan pricing is just a bit over the Peer Group 1 average and well below Citi, AXP and COF.
The pricing that a bank gets for its loans & leases says a lot about the internal credit targets of the bank and also its competitive position. For example, the pricing on ALLY’s book is decidedly prime, but can the bank make money at these spreads? When you factor in SG&A and, most important, funding costs, we get an answer to that question. The chart below shows the relative funding costs of ALLY and the comparable banks.
As we like to say, the data tells the story. The chart above suggests that ALLY has gotten little if any benefit from the decline in interest rates over the past several quarters. Hello. Meanwhile, most of the 126 other banks in Peer Group 1 seem to be benefitting significantly based upon the unweighted average calculated by the FFIEC. A couple of points:
First, ALLY has core deposits of $108 billion or a little more than half of the balance sheet. The rest of the balance sheet is funded in the markets. ALLY has just a tiny bit of term debt at just $3 billion. ALLY just priced three-year debt at +110bp over the Treasury curve.
Second, the bank has no – zero – non-interest bearing deposits, the mother’s milk of money center banks. The free float from typical commercial balances is a vital source of revenue and liquidity for any bank and a key component of a successful C&I lending strategy. ALLY does not seem to be following that script.
Third, there appears to be some idiosyncratic factor, perhaps an inappropriate interest rate hedge or other expense, that is increasing ALLY’s funding cost even as the peer group sees interest expense fall dramatically. This is a big issue for the bank, both with respect to auto lending and its venture into lending to private equity portfolio companies. Indeed, since 2017, funding costs have risen twice as fast as financing revenue.