We’ve been shouting from the rooftops about the dangers inherent in the subprime auto market for more than a year.
Auto debt in America has joined student loan debt in the trillion dollar bubble club and part of the reason why is that Wall Street is once again perpetuating the “originate to sell” model whereby lenders relax underwriting standards because they know they’ll be able to offload the credit risk.
Looser standards mean the eligible pool of borrowers expands, but it also means the loans being pooled and securitized by Wall Street are increasingly dubious. Data from Experian shows that terms for new and used car loans are beginning to border on the absurd, as the percentage of new vehicles with financing rose to 86.6% in Q3 (that’s up from 79.9% in 2010), the average amount financed climbed $1,137 from the same period a year ago, and the average loan term inched up to 67 months.
There’s also evidence - from the NY Fed - to suggest that a higher and higher percentage of auto loan originations are going to borrowers with lower credit scores. Here’s the chart (note the highlighted portion in the bottom right hand corner):
For those who might have missed it, the industry went full-retard in November when Skopos Financial - the king of unbelievably bad securitizations - sold a deal in which 14% of the loans "backing" $154 million in new ABS were made to borrowers with no credit score at all.
Given all of the above, you can see why some money managers would be interested in shorting that paper and according to Citi, quite a few hedge fund managers, inspired by "The Big Short" are inundating banks wil requests to bet agains the market. "We have received an explosion of calls from equity and hedge fund investors looking to short auto ABS," Citi's Mary Kane wrote in a note out last month.
For her part, Mary doesn't think it's a good idea. Here's why:
There are four principal reasons to NOT short auto ABS: 1) consistent and stable long-term performance through numerous cycles; 2) robust credit enhancement protecting principal at risk 3) auto loan growth historically in line while securitization rates remain low, 4) originate-to-sell practices are not and have never been prevalent. Data shows that auto loan growth is not out of line with historical growth and that auto loan financing is not excessively reliant on the ABS market. The auto ABS securitization rate varied from 15–28% from 2004–present. Currently at 16%, it shows that most US auto loans are held on lenders’ balance sheet.
Now first of all, Mary can say the originate to sell model isn't "prevalent" all she wants, but it's at 16% and at one point around 2010 was nearly a third of the market, so we're not entirely sure what counts as "prevalent", but it's definitely a big piece of the puzzle. Additionally, auto loan ABS supply rose by something like 25% in 2015 and the types of deals getting done clearly involve shoddy credits.
Of course you'd think that if this was such a "bad" idea, then Citi would gladly dream-up some bespoke deals, take the other side of the trade, and sit back as the premiums come in.
In any event, we suppose the point is this: just because the originate to sell model isn't as "prevalent" as it could be in some hypothetical world where the market is even riskier than it is now, doesn't mean that shorting specific issues isn't a good idea. Especially when the Skopos Financials and Santander Consumers of the world are selling deals that are obviously filled with junk. Unfortunately, there's no way to get synthetic exposure to the market and Kane is correct that shorting the cash bonds would likely turn into an expensive proposition.
Kane's conclusion: "It seems like too many people have seen the movie “The Big Short” and are starting to think the movie heroes’ short strategy would translate to the ABS market. By the way, the ABS conference did NOT take place at Caesar’s Palace that year as per the film, it was at The Venetian. So, it’s not wise to believe everything you see in a movie and hit films are not the best source for trade ideas."
Right. Movies "aren't the best source for trade ideas."
Neither are sellside desks.
Just ask a Goldman client.