The Long and Short

Lighten exposure in Ally Financial

| September 20, 2024

This document is intended for institutional investors and is not subject to all of the independence and disclosure standards applicable to debt research reports prepared for retail investors. This material does not constitute research.

Investment grade corporate credit has trended tighter into and out of the latest FOMC meeting, particularly in the long end of the yield curve. One of the biggest beneficiaries has been Ally Financial (ALLY: Baa3/BBB-/BBB-), one of the top movers following the Fed’s decision to cut rates by 50 bp instead of 25 bp. The issuer had widened earlier in the month after management warned about weaker credit in its auto book at the Barclays banking conference. The rapid recovery in bond spreads after the Fed provides an opportunity for bondholders to lighten exposure in the name across intermediate bond maturities ahead of earnings risk when ALLY reports next month.

On September 10, CFO Russell Hutchinson warned that inflation and weak employment trends were weighing on credit quality among the company’ auto loan borrowers. Auto delinquencies were up around 20 bp in July and August while net charge offs were up about 10 bp versus the company’s previous expectations. As a result, ALLY will likely be increasing provisions for credit losses and building up reserves, which could potentially wipe out a large portion (or perhaps all) of the company’s net earnings when they report next month (September 18). The potential loss of near-term earnings is particularly concerning as management has been struggling to build out capital ratios to levels more commensurate with investment grade ratings. Although none of the direct peers (such as COF, DFS, SYF) issued similar concerns, ALLY’s disclosure was compounded by warnings from JP Morgan Chase (JPM) and Goldman Sachs (GS). JPM warned about softening net interest income trends in 2025, while GS stated that trading revenue may be weaker than expected.

ALLY’s comments triggered a sharp sell-off in the company’s stock price by about 19% initially, and quickly spread to consumer finance peers and the broader banking sector. The share price has since recovered by about 6% to 7%, while peers appear to have mostly recovered to their pre-warning levels. The market appears to be ruminating whether ALLY’s issues are idiosyncratic, or a broader indicator of a weakening consumer and credit quality trends. In the corporate secondary market, ALLY’s most liquid on-the-run bond saw spreads gap out from a recent tight level of about 200 bp to 205 bp over the Treasury curve to 220 bp on September 10. From there, spreads continued to drift out over subsequent sessions to a wide level of about 232 bp to 237 bp. After the FOMC concluded, ALLY bonds began to tighten, hitting a level of about 210 bp to 215 bp on September 19 (Exhibit 1). At this new valuation investors have a window of opportunity to reduce exposure in the name ahead of more potential volatility when third quarter earnings and guidance are released in a few weeks.

Exhibit 1: ALLY and consumer lending peers (BBB- or higher)

Source: Santander US Capital Markets LLC, Bloomberg/TRACE G-spread indications only

Early last month, Moody’s had affirmed the ratings of ALLY and its bank subsidiary, Ally Bank, and changed the outlook from Negative to Stable. The rating action reflects the efforts that management has made to build out capital levels and to acknowledge that asset quality concerns had subsided. Time will tell if Moody’s had perhaps jumped the gun in declaring that the company’s trajectory had improved enough to warrant the change. Nevertheless, capital ratios have been improving somewhat, even if they remain below ideal levels. According to Moody’s methodology, the tangible common equity ratio improved to 9.4% at mid-year 2024 from 8.7% at year-end 2022. Likewise, the tier 1 common equity ratio notched up modestly to 9.6% from 9.4% at year-end 2023. However, it is more questionable whether ALLY’s credit concerns had in fact abated leading up to the rating action. Net charge-offs in the second quarter increased to 1.4% from lows of 0.7% at year-end 2022 and are now trending above pre-pandemic levels.

The recovery rally in ALLY credit spreads in wake of the FOMC appears to be mostly two-fold. Firstly, the decision to implement the larger 50 bp rate cut could theoretically provide more relief to borrowers, which in turn could get credit quality trending back in the right direction, and therefore enabling management to continue to grow out capital levels. But those trends could take a very long time to materialize, and lower rates now don’t do anything to alleviate existing borrowers who are already under distress. The second reason that ALLY spreads likely recovered following the rate cut is the extent to which the company is highly reliant on deposit funding. Deposit funding has increased to about 84% of total funding currently from about 66% at year-end 2018. To management’s credit, they have been reducing reliance on brokered deposits, which are less consistent and more competitive than core deposits. The optimism following the Fed announcement is that further asset repricing and lower deposit costs as a result of lower rates can help bolster net interest margins, which already showed signs of improvement in the second quarter. However, when ALLY provides more detailed guidance next month, this temporary optimism could quickly evaporate if the Barclays conference warning was just the first of several shoes to drop for the lender.

Dan Bruzzo, CFA
dan.bruzzo@santander.us
1 (646) 776-7749

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