Written by Christopher Nash.
I think the title speaks for itself. The auto loan market is pretty, pretty reminiscent of the housing collapse of ’08 (Larry David voice). I wonder if there exists a financial instrument which can be used to bet against the auto loan market?
Exploring payment dates, default rates, and personally going to an auto dealer to view the process – banks do not check credit and their due diligence composes of an income source of six months, if anything. I haven’t seen too much written on this topic, and am not sure why. My initial thought is pretty straightforward: big banking. Let me explain; rather let the “Big Short” explain.
Steve Carell, a skeptical banker who’s sole purpose in life seems to be getting his revenge on Big Banking and exposing the dishonesty within the business provides his view, which I believe to be spot-on. His character can be described as hypocritical as he manages a fund under the Morgan Stanley umbrella, however, he has the experience and knowledge, and most importantly, he looks; he does not simply accept common belief, which at the time was that the housing market was too stable too collapse, I mean come on, it’s the freaking housing market, right? At one point, he reveals to the viewer the strong ties and the vast influence banks possess over the economy and world of industry today; in layman terms, the world is driven by capitalism, and money runs the world. For example, during the Financial Crisis of ’08, which was caused simply by negligence, less stringent mortgage and housing standards (FNMA, FMAC and the Community Reinvestment Act of 1978 is a good place to start), complicity, stupidity, and greed; the rating agencies did not downgrade the CDO’s until last minute in order to allow the banks to sell off the worthless bonds to unsuspecting buyers. Oh yeah, there was also a huge aspect of fraud, which basically went unpunished; punishment would portray illegality, which we can’t have in big banking (one man was arrested). Essentially, S&P among others sold ratings for a fee.
Furthermore, two unrelated managing partners of a small hedge fund, aware of the impending doom proceeded to approach a large news organization with proof of the coming financial apocalypse simply to be rejected, likely due to other interests…the money trickles all the way down to the media, and news providers; take everything you hear with a grain of salt, and remember, the government’s priorities don’t always align with the people they claim to protect and advocate for. In the case of the 2008 Financial Crisis, the government was not unaware, they knew.
Sometimes, I go off on wild tangents; I probably went on much too long there, but there are so many similarities, it had to be done. So if you clicked the link only expecting to hear about shorting the auto market, then I hoodwinked you into reading a short review of my now favorite movie “The Big Short”. I recommend this film to anyone; I was first introduced and learned about the mortgage crisis in business school; however, “The Big Short” was eye opening, and inspirational for me. It is and always will be part of the reason I began this venture. Here we’re going to do something similar to what Bill Burr and other bankers did, who were smart enough to look and be less dismissive than others.
2015 earnings were reported not long ago (VW struggled due to legal issues with their inaccurate disclosure of emissions). I do have a little past experience at a large financial media and reporting firm and some familiarity reading and reviewing financial filings, SEC reports, 10-K’s (Annual Reports), 10-Q’s (Quarterlies), etc., okay, maybe a little more than some. So maybe you want to listen.
2015, a Year of Record Auto Sales
Let me just note that 2015 was a year of record sales, driven partly by growing subprime loans (when you see subprime, think crap), low gasoline pricing, and other factors. The loans contain the prefix sub, common sense here guys.. The WSJ reported that automotive manufacturers announced they sold an astounding 17.5 million rides, a 5.7% increase over 2014, which wasn’t a bad year either for automakers. In fact, Americans spent an incredible $570B on cars in 2015, breaking a record more than 15 years old. Have a look at the financial reports of large car manufacturers; the notes section below the financial statements usually contains an entire section describing defaults on loans, accounts past due and accounts charged off. The earnings and income is always reported as long as the account is less than 90 past due. This information is publicly available via Edgar; before making any decisions, do a little research and read the statements, even though sometimes this may take a while – annual reports are often 100 plus pages. However, most of the information is irrelevant and extraneous to the situation we are discussing today, so we can flip right through it if we know what we are looking for. Analysts have also told us that it’s not unlikely we see a decrease in sales due to a rise in the federal tax rate; Bloomberg (I’m a big fan) warned us in 2013 that an increase in interest rates would lead to higher default rates, especially among less qualified borrowers. It looks the time may have come.
Subprime Auto Lending has become increasingly popular and attractive among buyers, lenders, dealers, and automakers in recent years. The reason for this is very simple; money. All involved parties make A LOT of money on automotive sales. No matter what the government says, we are not in the best of economic times; 2009-2013 was characterized by the worst four years of GDP growth dating back to the Great Depression of the 1930’s. From 2009-2013, we saw an average annual increase of just .73%; embarrassing considering the economy hadn’t seen worse times since the ’30’s during FY 2008..
Subprime lending’s boom can be attributed to the recession, lower income among families, and the government’s efforts to allow all access to cash and transportation, with the belief they are helping all involved. Not to mention, they have petitioned for the auto industry; I mean they did bail them out not too long ago. Subprime lending is a vicious animal, which targets the poor, bankrupt, and unqualified buyers. In a sense, the government and auto industry knows what it’s doing and probably just doesn’t care; short-term numbers are all that matter, instant gratification. It is also no secret that current administration is “for the people”, what usually happens is latter presidents inherit the problems of those who come before them. Why care when you look good, and can blame somebody else? As you see I am not the biggest fan of current leadership within the U.S.; we are $19 trillion dollars in debt, and without economic reform, we’re in deep trouble.
I just wanted to mention I did what Carell did in “The Big Short”; I went to a dealer and did a little research. I walked the lot, settled on a $20,000 car, and went inside. The salesman and I spoke for a few minutes, his eyes lit up, and I proceeded to emulate the perfect candidate for a bad subprime loan. I told the salesman I have a below 500 credit score (not that uncommon and I’m sure they’ve seen worse), no cash down, and have not worked in a few months, but have some prospects and a little cash in the bank. He replied with, “No problem”; we filled out the paperwork and told me that a bank they work with was willing to work with me. On a $20,000 car, five year, 60 month loan, at zero percent interest, nothing down, we have a monthly payment of around $333/month. I was quoted at $520/month; true story. The banks that offer these loans are usually smaller, less established banks; they do not do their due diligence and will offer their services to basically anybody. It’s also not uncommon for big banks, even manufacturer-affiliated banks to buy these loans from smaller banks. You wouldn’t be able to get a loan from one of those banks, but that same bank will buy up that same loan from a smaller bank; hey, anything for a profit!
The best part is these bad loans become BBB rated, if not AAA bonds. They are often bundled BBB’s, which become AAA rated because they become “diversified”. Securitization offers a fix by letting investors buy riskier assets that pay higher interest rates. At this point in the credit cycle, collateralized loan obligations (CDO’s, bespoke tranche opportunities) and auto loan securitizations are booming because these are among the safest (really?) and simplest asset-backed securities. But riskier, more complex deals involving things like subprime auto loans, CDOs and even home equity loans are getting more popular, Reynolds said (as of 2013, the cycle has continued to grow, by the way – the header above this paragraph was titled, “Gain Now, Pain Later”).
Default rates below:
As published on Bloomberg six months ago;
“As the small upstarts fight for market share, the concern is that they’ll lower their standards too much and drag established lenders with them, inviting even greater trouble down the line. Many of the new players are backed by the biggest private-equity firms, which are under pressure to produce relatively quick returns.
The question is how much farther credit standards can fall in order to keep the party going.”
Does any of this sound familiar? Hmm, I wonder if there’s anything such as a credit default swap on auto loans.
What to Do
Do what savvy investors like Bill Burr did years before the housing meltdown, short the market and invest in a Credit Default Swap. These swaps are somewhat complicated, but here, the CDS is explained in relation to the housing market. The link offers a solid description and the strategy is very similar to what I’m suggesting. Essentially, A credit default swap (CDS) is a financial swap agreement that the seller of the CDS will compensate the buyer (usually the creditor of the reference loan) in the event of a loan default (by the debtor) or other credit event. This is to say that the seller of the CDS insures the buyer against some reference loan defaulting. The buyer of the CDS makes a series of payments (the CDS “fee” or “spread”) to the seller and, in exchange, receives a payoff if the loan defaults. There you have it, by buying a CDS, you are betting against somebody holding the opposite position (consistent with investing), but hoping for a certain outcome, here a default on a loan. Remember, these things take time to pay off and are usually longer-term; it is better to get in earlier if you trust me, but will be more expensive short-term, however if I am right, the payoff will be much larger. Buy the swaps and watch the market, percentage of subprime loans, default rates, and keep reading!
Basically, you’re hoping for the collapse of a market, sounds messed up right, but hey, you’re not responsible for the fold so you can still sleep at night, and probably on a nicer mattress with all that money.
P.S. Student loans aren’t all that different, and may be a bigger issue at this time.
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