Why the automotive industry's good times could end in a crash

It’s seemingly a new golden age for gearheads — between cars like the Ford GT and Acura NSX basking in the spotlight at the 2015 Detroit auto Show, and the 707-horsepower Dodge Challenger Hellcat selling briskly. With the revival of General Motors and Chrysler from the brink (albeit, at an $11 billion cost to taxpayers), the recession in 2008 is fading as a distant memory.

Yet underneath all the fanfare of a recovery, the automotive industry isn’t as healthy as it seems, and could get a lot worse.

Ridiculous click bait you may say, citing how companies like Honda posted all-time annual sales records in 2014, or how oil prices threaten to drop down to $40 a barrel. The professional forecasters expect U.S. auto sales to hit 17 million this year, a near-record level. Yet dig into the data though and a more ominous picture emerges — here are five points why:

1. Consumers aren’t making any more money, but are buying pricier cars: The average price of a car reached a new high of $34,367 in December last year according to Kelly Blue Book. That’s in spite of stagnant wages, which although increased by about 2 percent, cancels out when factoring inflation based on the Consumer Price Index (CPI). Some would argue CPI understates inflation since it changed how it calculated quality and substitution adjustments back in 1996—which would mean the middle-class has been on the decline since 2008. That’d be consistent with how the majority of Americans feel like they’re falling behind the cost of living.

2. Expensive rides are increasing the debt burden of consumers: If people aren’t making any more money, how can they afford an Audi A4, which starts at $35,000? In a word, debt. Conventional wisdom says to buy based on the 20/4/10 rule — a 20 percent down payment, a 4-year loan and the total cost adding up to no more than 10 percent of the gross annual income.

But given stagnant wages, it’s no surprise that a 20 percent down payment isn’t feasible for many, especially when considering the average amount in a savings account is below $7,000. Hence, more and more buyers rely on longer-term loans with little down payment. According to Experian Automotive, one fourth of all new-car loans were 6 to 7 years long in 2014 — with faster growth than any other type of loan — and the average length for a car loan reached an all-time record of 66 months last year. Why should that be a cause for concern? Because of the dreaded “S” word.

3. Subprime automotive lending at its highest since the subprime housing crash: Loans purchased with poor credit are on the rise, according to Equifax, and make up 30 percent of all loans. Analysts are quick to defend the data, saying only 0.71 percent of subprime loans are in default. But there’s no sign of abating, and 8.4 percent of borrowers who took out loans in the Q1 of 2014 and had weak credit and missed payments by November, according to Moody’s analysis of Equifax’s data. That’s the highest since 2008, when the subprime housing market came crashing down.

Granted, automotive subprime doesn’t nearly have the same risks as housing subprime because it’s much easier to reposess a car than a house, and there's no counterpart to toxic mortgage-backed securities. But as recent Federal Reserve figures show with the $15 billion increase in non-revolving credit, the burden for auto loans is only getting worse. Plus, unlike houses, cars are a depreciating asset that drop in value as soon it goes off the lot. So if somebody goes underwater in payments three years into a six-year loan, the person might be inclined to just hand back the keys.

4. The trap of low interest rates. How can I be such a Debbie-downer, in face of all the sunshine rhetoric about recovery? Much of it comes down to the Federal Reserve’s policy of zero-percent interest. The Fed chair—both Janet Yellen and her predecessor Ben Bernanke—have insisted that the rate depends on progress of the economy, namely, inflation and unemployment. The drop in unemployment to 5.6 in December has some cheering from the rooftops, but the labor participation rate is at its lowest since 1978 at 62 percent. At best, the recovery is fragile; at worst, it's exacerbating the rise of non-revolving debt.

Yellen has said she’ll bump up interest rates later this year to keep inflation in check and prevent another housing/asset bubble, but even if they were to revert back to 5 percent interest as it was in 2006—as opposed to the 10+ percent in the ‘80s—the market for those fully loaded Ford F-150s would shrivel up given the lack of consumer liquidity. New-vehicle loans are stretching out when the average interest rate for buyers with great credit is 2.6 percent; would we see 9-year car loans if those rates rose to 4 or 5 percent? And even if unemployment, labor participation rate and wages start recovering, it wouldn’t be the same, because…

5. The younger generation is broke. Generation Y has no money to drop a hefty down payment on a car, or afford a shorter-term loan to offset the inevitable rise in interest rates. Adults under 35 have a negative savings rate of 2 percent, and have been burdened by spiraling student loans, which have increased by more than 500 percent since 1999. Oh and that 5.6 percent unemployment rate? Much of that comes from the older generation reentering the workforce, while labor participation for those 35 and under has dropped by 4 percent. Maybe that partially explains the decline of the youth-oriented Scion brand.

What does it all mean to average American? These are longer-term trends, whose effects may take years to materialize — at least, while the economic turmoil in Europe keeps the U.S. dollar strong. Housing starts alone may keep the U.S. pickup market soaring in 2015, and the pent-up demand for new vehicles among wealthier buyers has proven durable so far. So you probably won’t wake up Sunday morning to a headline in your Facebook or Twitter feed that the auto industry suddenly tanked. But on a practical level, there’s always this sage advice: live within your means — even if it means forgoing that Sublime Green Dodge Challenger Hellcat glistening at the dealership.