Loan losses just skyrocketed at Ally Financial; Did Warren Buffett make a mistake?

Credit quality may still be pristine in many large traditional banks, but it is deteriorating much faster in Allied Financial (NYSE: ALLY), a large consumer digital bank specializing in auto loans. Loan losses and delinquencies — which have been extremely low thanks to the pandemic stimulus and hoarding of savings — began to rise in the third quarter faster than some might have expected.

Ally got a big thumbs up this year when Warren Buffett Berkshire Hathaway opened a position in the first quarter, then bought more in the second quarter. Ally is a relatively small stake in Berkshire’s huge stock portfolio, but the conglomerate now owns nearly 10% of Ally’s outstanding shares.

As credit weakens and a recession looms, did Buffett and Berkshire make a mistake?

What happened during the quarter

Analysts and investors are watching Ally’s credit quality closely, as the bank has issued numerous auto loans with larger aggregate loan amounts, due to strong demand for vehicles amid the shortage of semis. -drivers caused by the pandemic. Used car prices have been 60% higher than pre-pandemic levels this year.

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In the third quarter, Ally saw net write-offs — debt unlikely to be collected, a good indicator of actual loan losses — hit $276 million, an increase of more than 80% from the second quarter. Almost all of the increase came from an increase in charges in the bank’s automotive retail portfolio, which doubled from the previous quarter. The net write-off rate as a percentage of total loans fell to 0.85% from 0.49% in the second quarter, now on par with the levels Ally saw in the third quarter of 2019.

And there could be more trouble on the horizon. The percentage of loans past due for 30 days or more fell from 2.52 percentage points in the second quarter to 2.93 percentage points. Loans overdue by 60 days or more and delinquent contracts also increased sharply.

Watching what’s to come

Ally has built up its reserves for future loan losses by $133 million and now has a total provision equivalent to 2.71% of its loan portfolio, including a coverage ratio of 3.56% for its portfolio. retail car loans. That’s significantly above net charge levels right now and well above the coverage Ally had at the end of 2019.

Management expects credit to begin to normalize in its automotive book and has previously said it expects used car prices to drop 30% by next year. The company also still expects the net write-off ratio to increase to 1.6% and then begin to stabilize around mid-2023. This means that its coverage ratios are currently still healthy for what management expects. that the credit ends up directing itself.

The other good news for Ally is that the bank has extended auto loans at much higher levels than in the past, which can help protect margins and potentially offset higher loss activity.

For example, with a similar projected net funding cost and write-off rate, Ally originated retail auto loans in the third quarter of 2019 at an average yield of 7.5%. By the third quarter, that yield had risen to 8.75%. On the company’s earnings call, CEO Jeffrey Brown said: “We really like the loans we’re putting on the books today and believe they’ll prove to be very profitable over time.” , even taking into account higher loss rates.

Did Warren Buffett make a mistake?

I’m still pretty optimistic that Ally’s management is in control when you look at its coverage ratios and the loans the bank is originating.

I expect the next two quarters to be risky, but I also think the stock’s valuation today is factoring in some very tough economic scenarios. Ally only trades at 78% of its tangible book value, or net worth, which is a very low valuation for a bank, even in the times we are in – and given that Ally is still generating solid profitability and has healthy levels of capital.

Buffett tends to like value opportunities like this. And Ally’s management has tried to prepare investors for the deterioration in credit quality, even if it comes sooner than expected. While we won’t know for a while what steps Buffett and his team are taking now, it’s reasonable to assume they’re still optimistic about Ally’s potential.

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Ally is an advertising partner of The Ascent, a Motley Fool Company. Bram Berkowitz has no position in any of the stocks mentioned. The Motley Fool holds positions and recommends Berkshire Hathaway (B shares). The Motley Fool recommends the following options: $200 long calls in January 2023 on Berkshire Hathaway (B shares), $200 short puts in January 2023 on Berkshire Hathaway (B shares) and short calls of $265 in January 2023 on Berkshire Hathaway (B shares). The Motley Fool has a disclosure policy.

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