Investment Riches Built on Subprime Auto Loans to Poor
dealbook.nytimes.com
dealbook.nytimes.com
Last time I checked, the most senior (AAA) tranches of subprime auto abs deals are priced at libor + 20. That means that the investor is willing to accept libor (essentially risk free rate) and 30 basis points on top of that. Is this a high return? Sure, if you compare it to prime auto loans that are priced libor + 20 but not compared to other securitized products. For instance, the senior tranche on collateralized loan obligations are being priced at libor + 160 on new deals.
Overall, this article is especially poorly written in that it does little other than stoke the flames of hatred against wall street. The writer claims that people are being exploited but then profiles an unemployed woman who cosigned a $30k loan on a car for her teenage daughter. The dealership almost certainly should not have lent her the money but the owners of these securities will pay the price, at least the equity tranche that absorbs all the initial losses. After not paying for a while, the car will probably be repossessed and resold.
The reason there is such appetite for these products is because of the low interest rate environment. Investment managers are desperate to earn a slightly higher return that the risk free rate. This is driving demand which explains why you saw the issuance of subprime abs explode over the last year and spreads tighten (spreads have widened later in the year though). Credit standards have probably degraded to try and meet the demand of abs securities, but that's inevitable.
At the end of the day, the investors will pay the price. There could be another financial crisis and a massive bailout at the tax payer expense but I doubt this is the product to cause panic. Unless the default rate on auto loans reaches 30-40% a year and the market for used cars drops a similar amount. I think the value of an auto is a lot more objective than that of a home.
I think it's interesting how high interest rate risky loans can be considered as sleazy while giving opportunities to the less fortunate is considered an admirable goal. These two are two sides of the same coin. Would it be better that people with less than perfect credit or generally considered higher risk not get any loans? Or the risk of those loans be picked up by tax-payers?
This part terrifies me. Not because of auto loans, but as returns remain low (and in my opinion, structural changes have occurred that will keep rates low in perpetuity), investment money will continue to look for higher returns with no moral qualms. Like farm land:
http://www.forbes.com/sites/joshuarogers/2014/09/23/dirt-che...
Its easy to look past subprime auto lending and payday loan lenders, but what happens when natural resources necessary for survival (food and water in this case) are sold to the highest bidder?
I loved the (very defensive) Bloomberg headline yesterday: Owners of Negative Yielding Sovereign Bonds Say They're No Fools [0]
The idea is that every country is trying to devalue their currency in order to help exports and domestic producers stay competitive. The countries are newly emboldened by the fact that rates have been very low for very long without much inflation. But economics never works exactly like its described in textbooks. I fear that if this all explodes we could have high inflation with a stagnant economy with no magic levers to pull to address both problems. In that case, it will be about survival.
[0] http://www.bloomberg.com/news/print/2015-01-26/owners-of-neg...
I'm glad I'm not the only one who thinks about this.
We already have low (consistently below target) inflation and stagnation.
The idea that we are going to get to a place with high inflation without climbing out of stagnation on some level must be explained, and it would be interesting to see how this would happen in your view.
If economics never functions like it does in the textbooks, then is macroeconomics a random activity? Yet it is predictable to the point where you expect runaway inflation?
I don't believe the macro economy is random. But I don't believe it can be understood to any certainty worthy of the quantitative methods ascribed to it by modern economists. If you look at empirical evidence (regression) for what most consider economic truths, you'll see a shockingly low R^2.
That being said, I think some economic truths can be discovered through logic. For instance, all else being equal, an increase in money supply will result in higher prices. As Milton Friedman said: "Inflation is always and everywhere a monetary phenomenon in the sense that it is and can be produced only by a more rapid increase in the quantity of money than in output".
I can't think of an example of destructive inflation without the increase of money supply by a central authority. So certainly there must be some link. So maybe we can say inflation is (almost) always associated with an increase in money supply but an increase in money supply is not always followed by inflation.
I don't know why it hasn't happened in this case.
So you can look back at a 5-7 year period in the 1970s and say 'look, that's where inflation occurred'. But living through a seven year period feels like a long time.
The final point is that inflation statistics are calculated in different ways now. If you look at inflation measures not linked to a 'basket of goods' type measure, there is plenty to see. The breakouts in collectible markets in the last year or two certainly point to strong inflation.
But on the whole the government response is not as stupid as it was in the 1970s, when they did things like put in price controls and things like that. There was a big deflationary hole to fill in first.
I don't think we are anywhere near out of the woods yet.
Anyway, if you're interested in structured products, I would just google '[structured product] primer'. There are a lot of great primers publicly available. Most are really old (2006 - present) but don't let that put you off. All the fundamentals are the same and they're definitely worth a read. Some are more relevant since they're still being structured. Examples include ABS (which include prime and subprime auto) and CLOs (collateralized loans). Others (like non-agency, subprime, most CDOs) are not. This [1] book was also helpful and more in-depth than most primers.
Feel free to pm me for more info.
[0] https://www.abalert.com/subscriber/subscribe_now.pl [1] http://www.wiley.com/WileyCDA/WileyTitle/productCd-111800674...
The attachment point is the % of cumulative losses after which a given tranche starts suffering losses of principal. So for example:
L+20 with a 20% attachment point against historical max losses in the asset class over all credit cycles of 1% is a lot better on a risk adjusted basis than L+200 with a 40% attachment point against historical max loss experience of 15%.
Without talking about historical loss experience we can't really guesstimate the margin of safety here nor say that a given tranche is or isn't good value.
Another possibly interesting nitpick: LIBOR isn't risk-free. It's an interbank rate so it is the short-term yields paid by highly rated financial institutions. Risk free means backed by an entity that can print money, like the Fed. That's why the LIBOR-Fed Funds basis exists.
Also, re: "I think it's interesting how high interest rate risky loans can be considered as sleazy while giving opportunities to the less fortunate is considered an admirable goal." check out the book _Scarcity_ by Mullanaithan and Shafir, which has a super interesting take on this question!
Attachment and detachment point are definitely very important. I found a random fed document from 2012 that suggests similar attachment/detachment points for AAA prime vs subprime abs securities (~79% attachment). I haven't looked at it too closely though and I could be missing something. I know spreads are a lot tighter since 2012 and credit quality of underlying loans may have worsened with lower standards. On the other hand, people are a lot better off now that in 2012 (i.e. stock market, housing market, etc).
Will check out Scarcity. Thanks for the recommendation!
[1] http://www.federalreserve.gov/SECRS/2012/May/20120523/R-1401...
Some people might get burnt, but it's not going to crater the economy.
Subprime has become a dirty word by association, but it really just does mean lending at a higher rate to people not as credit worthy. Which is a huge chunk of the market.
At 18 and making around $35k pre-tax I already had close to $30k in debt and the scary thing is that that situation lead to me getting bombarded with mail offers for more credit cards (including many different Bank of America cards) that I was supposedly pre-approved for. Now that I keep very little debt, besides my mortgage my 2 open cards have a balance of $0 on them 6 days out of 7, I get basically no offers. Education would go a long way to preventing what happened to me from happening to others but I can't help but suspect a healthy dose of tighter regulations, or restrictions, or ... something, should be put into place too.
I now know I was a stupid kid who made stupid mistakes. I've also learned from them. But I was also someone in one of the few industries that's still growing and was able to recover fairly easily and never really felt any pain from it. The average person isn't that fortunate.
That's where most of this lies. If you look at sleazy and then try to find the sleaze, more often than not they're rather separated from the reality of the harm they're actually doing.
Fast forward to today where I found long ago (~10 years ago) that getting serious about personal finance is a valuable thing. To my folks I might as well be speaking a different language, but I haven't paid a cent of interest in nearly a decade, and have maxed my tax-advantaged retirement accounts for the past 8 years.
On the credit itself while at first I was cautious and against the idea of debt, the moment there's any cashflow issue, bam. I'm rather embarrassed, but without discipline it's easy to get lost. And every time I'd hit the limit, the limit would go higher. WF started off at $3k, and moved to $20k with zero explicit requests from me. If you're living month to month (US health insurance was $1600/mo), a single bump can easily permanently put you on credit. And, WF never approved me for a line if credit or a normal loan, so getting refinanced at a decent rate was more difficult than it should have been. They also wouldn't split the card off so I could just pay down part.
In the end, it was my fault for being easily wooed and lacking self discipline. But they make it easy enough to step into and harder to step out.
In my case credit was certainly not discussed with the family, or amongst friends (most of who reacted the same way I did to their first card), or in school. I've had a job since I was 16 so I understood the value of money but I didn't understand the value of debt until I already had it.
I remember the feeling of being young and constantly stuck for cash to do anything. It's frustrating so I can understand how cards provide a temporary reprieve. Just don't get them is the only solution.
Personally i have 0 amount of debt. No car payments, nor house payments. This has allowed me to move jobs if i was not happy, even without something concrete. Also a startup.
I look at my peers, who were in a similar position as me. Some who have taken on home loans etc. they end up with the 'golden cuffs'.
Though you could argue i have no assets to show. Other than a varied work experience, and ability to move into many different roles.
Do people really not remember 2008? Jesus. The problem of course is that a conflagration in one sector of the financial markets all too easily spreads to others (remember when it was just subprime mortgages that were in trouble? then when it was just mortgages? then when HOLY SHIT THE APOCALYPSE IS EXTREMELY NIGH, SELL EVERYTHING AND BUY SPAM/AMMO?), e.g. through highly leveraged and interwoven networks of derivatives. If (when) this goes tits up I hope there are enough risk analysts being listened to at the Too Big To Fail orgs that counter-party/swap risks are minimized to just the direct players in this market.
Google 'moral hazard' for a more detailed explanation.
I took out a loan on a car, with a 27%+ interest rate. I grew up in a poor family and I didn't really know any better at the time. That is, I knew, but I had not yet developed the /discretion/ to act on that knowledge with sound judgement. So, I signed for the car.
Approx 2.5 years later I defaulted on the car. Truly, 100% my fault, of course. 3 years later I finally paid off the car, but that's only after I got a decent few gigs developing mobile apps. So, for a lot of my life I worked way more than I should have just to pay the upkeep on this car, because full coverage insurance is pretty high when you're young. Fast forward a few years and I haven't missed a payment in 3 years and I have an amex. So yeah, I learned from some mistakes. But did it have to be that way? Do I want it to be that way for future generations? No, that's what HUMAN PROGRESS is for.
I'm in the Army now. There's a law that protects servicemembers. Pretty much whatever debts you have when you join the military must have interest reduced to 6% or less. Also, if you look at a lot of state laws, the limit on interest rates before the loans are considered usury is around 6%... This is because of the general attitude amongst people that servicemembers should be treated well. Geez, wouldn't it be nice if everyone was exploited less?
It's a pretty safe bet to say that, anyone loaning someone money at an interest rate above 20% is basically robbing that person blind.
To posit that the other party is morally responsible for his own choices, and not the lender, is certainly correct. Caveat emptor is very common knowledge by now. The real question though is: is it for the greater good that we do this? Does offering predatory loans to inexperienced buyers who have not yet developed a strong enough will or learned enough about personal finance serve a higher purpose, beyond making oneself rich? Is making oneself rich, the ultimate goal in life, or is there something more important than that?
Sure, it's the buyers fault for purchasing. That doesn't make you a good person if you're that predatory lender, or the guy who invested in those bonds. It makes you someone who willfully exploited another human being's ignorance or inexperience for their own personal gain. Which in my book, makes you a pretty despicable person.
So I don't think we should take away the freedom of buyers to choose what they want. I think we should take away the freedom of sellers to behave in ways that is obviously not conducive to human progress and prosperity.
However, let's look at the bigger picture to see if we can spot any unintended consequences of the policy you hint at.
Interest is the price of money. Quite literally, it is the price that a person pays for buying access to a commodity called money now, rather than some time in the future. It is the price that another person is paid for selling access to their commodity called money.
What you're essentially advocating is price intervention in a market. You're essentially advocating that the supplier of this commodity should give their commodity away at a lower price than the natural price arrived at by the market.
The control of prices in just about any commodity is generally a precursor to a complete disappearance of that commodity on the market. Price controls on food are the best way to ensure food will stop being produced, leading to empty supermarket shelves, famines, riots, etc. Soviet Russia had a tight hand on prices during the 20s and 30s, which resulted in mass famines killing millions of people. A similar story is now unfolding itself in Venezuela. Whether you approve of the moral outlook or not isn't the point, it is a mistake to let a moral outlook, any moral outlook, dictate the price of a commodity.
Price isn't just what you pay for something, it is a signal to the market of the relative scarcity of that product, and the necessity for the producers in the market to make more of it. That signal is essential for efficient markets, i.e. for markets to supply what we all demand. Think of the aggregate of all prices in the markets for all commodities as the neural signals that are fired off through your brain to enable it to function. Of course, that information is spread out over millions of market participants, but it is in aggregate much more accurate than any small committee dictating prices could ever model, whether they have the right moral reasons to do so or not.
When interest rates jump from, say, 2% to 4%, in terms of cashflow this means a doubling of expenditure on a regular basis. If your mortgage was X per month, it'll now be 2X per month, which will immediately affect the expenses you have for other goods, such as food, utility bills, etc. If your business loan repayment was Y per month, it'll now mean 2Y per month, meaning you may not be profitable anymore and go out of business.
The mistake you're making is thinking money is a thing that exists separately from real things, a unit of account and medium of exchange.
Money is a product in itself, that enables humans to go forward and back in time (through loans and savings) in order to plan the storage and use of the wealth they've created or are yet to create. Without this function, no wealth is created but the tiniest subsistence-level kind.
So, determining its price makes all the difference between an economy that operates at subsistence-level, or one that actually functions.
If you remove the market for 20% loans, then those people will not get finance for anything, ever.
A 20% interest rate merely reflects the reality of lending to people like your younger self. They have a habit of defaulting. So to recover the money, a higher rate needs to be charged. Thus the amount of defaults can be higher and a return can still be made.
While you may think'banning' high interest rates will lead to better outcomes, it most certainly will not. See drugs, prostitution, gambling, etc. prohibition on any activity forces the activity underground, and then when you default, it's not a black mark on your credit but a black eye or worse.
What does need to happen is that credit understanding happens in school, and that every single credit product comes with a simple worksheet to clearly spell out the cost of the interest over time, and the final payback amount.
Yes, lending, even at higher rates, is a net good for society. It allows people to achieve things they currently do not have the money for. For every kid who defaults there is a family who buys a car, gets to work and builds up their credit score. A 20% rate actually says that the default rate is not too bad, overall.
It would for a standard loan, but auto loans are backed by the asset. At 20% it doesn't take long before interest catches up with depreciation and after that it's all profit - given the loan rates a good credit score can get you these days, ~15% above normal rates.
The return on the performing loans has to make up for the non-performing loans and the costs of administration and recovery of bad debts. That is how a loan portfolio works.
I'm not defending the shady practices of predatory lending - but the action taken really has to be on the educational side for the buyer. The rates merely reflect the market conditions at the time, and are the wrong thing to focus on. There should be entire semester of schooling dedicated to understanding credit, seeing as it is something that nearly every school leaver faces sooner or later.
Money lending and overconsumption are as old as time itself - what is really needed is for people to develop the internal dialog of 'i can't afford that, forget it'
Good. Aid for the poor should be aid, not debt.
You know what there should be? More BUSES. Oh man, what an idea. Lets build more public transportation! No, that's not profitable. Never mind, lets exploit people instead, because it's good for them.
We have all sorts of predictive analytics and common sense that makes it pretty trivial to figure out that the 19 year old with no income can't afford 72 months of payments on the shiny new BMW.
But who gives a shit? The buyer is ignorant. The salesman gets paid to move the car, the bank charging usurious rates makes a profit for the few months the buyer pays, and the repo-man with the license plate tracking recovers the asset.
This is a problem, because none of these parties has any expectation that the counter party can fulfill the contract. That's a moral hazard, and arguably fraud. (Actually, if you are a private individual, it is fraud in most states! If you're a federally chartered bank, no problem) That's why before banking became a national industry we have usury laws. It's unfortunate that we have loopholes allowing states like South Dakota and Nevada to neutralize these laws.
Perhaps a middle ground could be requiring people taking out these kinds of loans to receive two hours instruction on the side effects of taking out these loans and delivered by a consumer advocacy group --but without advocacy bias. Let them make their decision at the end of the day and put a three day waiting period in there.
And it isn't a tool for the poor, it's a funnel, draining wealth from people who don't have much to begin with.
You'll only get into trouble if you fundamentally misestimate the default probabilities. This is true for any debt instrument, however, prime or subprime, fancy or vanilla.
Then what caused the 2008 crash?
Securitization didn't fix this risk, nor was it meant to. Regulators allowed banks to satisfy capitalization requirements with senior tranches of other banks, but not with the senior tranches of their own portfolios. This isn't necessarily a terrible idea - it reduces local mispricing risk (i.e., one bank's underwriters suck), just not global mispricing risk (everyone sucks in the same way).
I'm curious whether companies like Affirm will figure out ways to improve upon this.
If you have poor credit, you likely will end up at a sleazy dealership that overcharges you on the price and you end up with the 20% interest rate to take care of the risk.
The value of that risk reduction is relatively insignificant to the lender, but some offer services like that (car buying services) to help attract desirable borrowers.
What?! 23.74%? That's nearly as bad as credit card debt. And for an auto loan?
It's one thing to pay higher interest rate for credit risk, but totally another to not understand basic financials - if you already have bad credit, you want to build up your finances, not dig a deeper hole by purchasing things you cannot afford, at interest rates you cannot afford.
A good case to improve financial literacy amongst the masses?
I think this is equivalent to money-lenders in India fleecing poor, illiterate farmers who don't even understand the interest rate they are paying.
"I bought into an investment backed by a loan to some poor people to get cars ... boy did I get taken for a ride!" :)