Ally Is Racing to Outrun Auto-Loan Losses; Though net charge-offs are projected to jump, Ally Financial also expects a boost from higher rates

More borrowers are likely to hit the skids on their car loans this year. But that doesn't necessarily mean the end of the road for auto lenders.

Ally Financial, one of the U.S.'s major auto finance providers, said on Friday in its fourth-quarter earnings report that it expects its net charge-off rate on retail auto loans to rise this year. Ally anticipates an annualized net charge-off rate of 2.2% in retail auto lending in the fourth quarter of 2023, versus 1.7% in the fourth quarter of 2022. Its fourth-quarter average was just 1.6% in the couple of years before the pandemic.

This is yet another indicator that the long-awaited

normalization of consumer credit risk is finally arriving this year. Likewise, consumer lender Discover Financial Services this week said it expects its net charge-off rate to jump from 1.8% in 2022 to a full-year average in the range of 3.5% to 3.9% in 2023.

But Ally also expects a boost from higher rates. Ally says its consumer auto loans originated in the fourth quarter are expected to yield about 9.6%—well above the roughly 7% level on loans originated in the same period in 2019. Plus, Ally says that the transformation of its business toward deposit funding and away from wholesale funding is going to benefit the company's ultimate net interest margin, which measures its earning yield net of funding costs.

Ally's cost of funds was at 1.7% in 2022, the company said, down from roughly 2% in 2020 and 2.3% back in 2018. This despite the Federal Reserve's tightening.

All in, Ally says it expects its net interest margin to hit around 3.5% in 2023. That would be a drop-off from above 3.8% in full-year 2022, but analysts were forecasting just around 3.4% for 2023, according to estimates compiled by Visible Alpha. Ally then says the ratio could head toward 4% in 2024. That as much as anything likely explains the big reaction in the market, with Ally shares up roughly 19% on Friday.

Credit fears were also priced in already. For much of the past year, Ally has been trading at a steep discount to book value, dipping under 0.7 times late in 2022, according to FactSet. Such discounts often reflect fears of loan losses in excess of what a lender anticipates. Ally said its economic outlook assumes a mild recession and the unemployment rate to approach 5% by the end of this year.

So the quarterly pace of retail auto net charge-offs rising to 2.2% in that scenario may actually be viewed as relatively good news, with the bank's current loan-loss reserve levels in consumer auto finance sufficient to cover annual losses of 3.6%.

Certainly not all questions are answered yet. Whether a potential recession moves from "mild" to something worse is obviously one unknown, as is whether the Fed decides to start cutting rates, how fast deposit rates could jump or if consumers start to reject higher loan rates.

But for now, many consumer lenders are rallying so far in 2023, perhaps reflecting just how dire expectations were getting .

Discover is up more than 7%, card giant Capital One Financial is up more than 10% and buy now-pay later provider Affirm is up some 45%. As is often the case in markets, finally having a firm idea how bad things might get can itself be a form of relief.