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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.
Comparable Companies
American Express Company
Capital One Financial
Citigroup
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.
Quantitative Factors
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.
Source: FFIEC
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.
Source: FFIEC
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.
Source: FFIEC
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.
ALLY states: “Interest expense was $2.7 billion for the year ended December 31, 2019, compared to $2.5 billion for the year in 2018. The increase was primarily due to higher funding costs and growth in our consumer automotive loan portfolio.” So, when we consider that ALLY has lower gross spreads on its loans and higher funding costs than do these larger banks, what conclusion does that suggest? Again, the data from FFIEC tells the story as shown in the chart below.
Source: FFIEC
The data shows clearly that ALLY has tracked below Peer Group 1 in terms of this key measure of profitability and asset returns. AXP is still profitable as is Citi and Peer Group 1, but ALLY and COF have reported losses in recent quarters due to higher loan loss provisions. These two banks simply lacked the earnings power to offset rising credit costs.
Qualitative Factors
Looking at the qualitative factors of ALLY, the emphasis on credit card and individual lending is a negative given the small market share and pricing of the bank’s products. The overhead expenses of ALLY are dead center of the peer average, but frankly the risk of the franchise is higher than your typical commercial bank.
In the bank’s most recent 10-K, it talks about “our ability to innovate, to anticipate the needs of current or future customers, to successfully compete, to increase or hold market share in changing competitive environments, or to deal with pricing or other competitive pressures,” but ALLY management never discusses overall market share. The word “competitor” never appears in the ALLY document.
In the 10-K, ALLY provides this description of their business: “Our automotive finance services include purchasing retail installment sales contracts and operating leases from dealers, extending automotive loans directly to consumers, offering term loans to dealers, financing dealer floorplans and providing other lines of credit to dealers, supplying warehouse lines to automotive retailers, offering automotive-fleet financing, providing financing to companies and municipalities for the purchase or lease of vehicles, and supplying vehicle-remarketing services. We also offer retail VSCs and commercial insurance primarily covering dealers’ vehicle inventories. We are a leading provider of VSCs, GAP, and vehicle maintenance contracts (VMCs).”
This sounds an awful lot like a captive financing unit of a major automaker, again raising the question about the core business model. Note that the relationships with GM and Chrysler are now discussed in the past tense and the client list includes Ford Motor (NYSE:F) and a variety of offshore automakers:
“The Growth channel was established to focus on developing dealer relationships beyond those relationships that primarily were developed through our role as a captive finance company for General Motors Company (GM) and Fiat Chrysler Automobiles US LLC (Chrysler). The Growth channel was expanded to include direct-to-consumer financing through Clearlane and other channels and our arrangements with online automotive retailers. We have established relationships with thousands of Growth channel dealers through our customer-centric approach and specialized incentive programs designed to drive loyalty amongst dealers to our products and services. The success of the Growth channel has been a key enabler to converting our business model from a focused captive finance company to a leading market competitor. In this channel, we currently have over 11,800 dealer relationships, of which approximately 88% are franchised dealers (including brands such as Ford, Nissan, Kia, Hyundai, Toyota, Honda, and others), or used vehicle only retailers with a national presence.”
In one of the few bits of detail on ALLY’s actual business, the bank provides these details: “For consumers, we provide automotive loan financing and leasing for new and used vehicles to approximately 4.5 million customers. Retail financing for the purchase of vehicles by individual consumers generally takes the form of installment sales financing. We originated a total of approximately 1.4 million automotive loans and operating leases during both the years ended December 31, 2019, and 2018, totaling $36.3 billion and $35.4 billion, respectively.”
Those volume numbers in the last sentence reveal a key aspect of the ALLY business model, namely that the assets run off fast and must be replaced with new production. One of the interesting measures of this is loan commitments, which totaled $29 billion as of June 30, 2020, up from $19 billion a year ago.
Yet as a percent of total assets, loan commitments by ALLY are actually below the Peer Group 1 average, suggesting poor volume and utilization of assets compared to its peers. Look at COF, for example. Forward loan commitments were 96% vs average assets, almost 100% turnover as you’d expect from a national credit card business. ALLY was 16% at June 30 vs 21% for all of Peer Group 1. AXP, by comparison, had loan commitments equal to 167% of total assets at June 30, 2020. The same measure for Citi was 50% of total assets.
Thankfully ALLY has virtually no derivatives exposure, but neither does it have any meaningful participation in the largest consumer markets of all, namely 1-4 family mortgages, which are currently booming. The bank’s capital at 10% is in the bottom quartile of Peer Group 1, which is a concern because the credit profile of ALLY has losses significantly above peer. The bank has almost $9 billion in insurance assets (P&C) that generate some income.
Most of ALLY’s small servicing book is in auto loans and a small amount in 1-4s. The bank’s sales of prime auto loans, which tend to generate a net loss, have been trending lower along with the larger trend in the industry toward lower loan sales. Again, the poor execution available in the secondary market for auto loans informs our view of the ALLY business and the industry, where many small banks have fled prime auto in recent years.
Assessment
We assign a negative risk profile to ALLY based upon the poor pricing of its products, modest market share and the relatively high cost of credit and funding. ALLY competes with the captives of the major automakers and the larger banks, a fact that is reflected in its poor loan and lease pricing.
The decision by ALLY a decade ago to exit the toxic business of sub-prime, no-doc mortgage loans may have been appropriate at the time, but we cannot help but think that ALLY would benefit from a solid government loan business in the Ginnie Mae market right about now. A merger with a broad-line mortgage lender with a strong retail base and a Ginnie Mae seller/servicer ticket might make sense for ALLY. Think of ALLY as a SPAC with a banking license.
Overall, we believe that ALLY needs to find ways to lower its funding costs and at least track its peers in terms of interest rate sensitivity. The fact that ALLY’s funding costs are going sideways while the rest of the industry benefits from the FOMC’s aggressive actions is a concern.
In our view, this monoline BHC needs better liability management and a more aggressive approach to generating and pricing new assets. Don't hold your breath waiting for Sell Side Street analysts to ask about any of these issues. Indeed, as credit costs rise in 2021, the lack of basic net profitability at ALLY may become an issue. Right now ALLY CFO Jen LaClair says that "we are still expecting kind of that 1.8% to 2.1% retail auto [net charge off] NCO rates that we put out in the first quarter." Cross your fingers.
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