Brad Lamensdorf and Two Rivers Analytics amazonaws com
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Brad Lamensdorf and Two Rivers Analytics NOVEMBER 2014
Auto Finance: Another Subprime bubble? It is past Halloween, yet we still see the ghosts of subprime stalking unsuspecting investors again. Is the auto finance market a replay of the home loan subprime bubble on a smaller scale? We see a buildup of credit risk from rapidly escalating lower quality loan exposure, coupled with artificially high auto and related sales enabled by easy credit. The first signs of deterioration have appeared: delinquencies and repossessions are increasing already. Some of the companies we see as most exposed are Santander Consumer US (SC), TCF Financial Corporation (TCB), LKQ Corp. (LKQ), Carmax (KMX), Lithia Motors (LAD), and similar financing driven discretionary companies such as Harley Davidson (HOG) and Winnebago (WGO). These and other names will be highlighted further in this piece and in a subsequent article.
Deteriorating auto loan credit quality The data points to a buildup of risk in auto finance. Auto loan volumes have spiked, the proportion of subprime loans has increased, loan terms are lengthening and there has been an increase in loan to values. These factors all point to a buildup of risks. While the timing of the credit tipping point is uncertain, recent damage in subprime for furniture and durables reminds us that these bubbles are not sustainable forever. CONNs, a leading furniture and appliance retailer, lost 31% of its value on September 3rd when it revealed a decline in the credit quality of its lending programs. This decline not only resulted in credit losses, but it also called into question the company’s growth prospects. Easy credit was being used to pull sales forward.
Loan volumes are growing fast Vehicle sales are skyrocketing. FRED data shows that vehicle sales have recovered to their prerecession levels, if not to their absolute peaks. Most of these sales involve financing. Unsurprisingly auto loan balances have recovered their peaks as well, setting a new record at $900bn. This record exceeds the 2005-2006 peak by about 10%.
1 B R A D L A M E N S D O R F A N D T W O R I V E R S A N A LY T I C S
BRAD LAMENSDORF AND TWO RIVERS ANALYTICS
NOVEMBER 2014
In the rush to lend, banks have lowered their standards. Credit quality has been deteriorating. We see this through the quality of the borrower pool, the loan-tovalue (LTV) ratios made, and the average life of the loans. Of greatest concern is the deteriorating quality of the borrowers being granted auto financing. Less qualified, lower credit score borrowers are finding willing lenders more and more easily. Source: Federal Reserve Bank of New York and Two Rivers Analytics.
Data from the NY Federal Reserve Bank shows that the value of subprime loans has doubled since the recession’s trough. See the black line in this chart for evidence.
A different cut of the data shows that the share of financing represented by subprime loans is rising. Equifax shows that subprime has risen to approximately a third of auto loan originations.
2 B R A D L A M E N S D O R F A N D T W O R I V E R S A N A LY T I C S
BRAD LAMENSDORF AND TWO RIVERS ANALYTICS
NOVEMBER 2014
Experian’s data highlights that deep subprime loans are growing the fastest of the various quality categories. Deep-subprime loans increased 13% in Q2 2014. These are the worst of the worst.
In addition, the amount lenders are willing to lend against new and used cars is increasing. With rising LTVs the borrower has less “skin in the game” and the lender faces a more difficult time recovering should they need to repossess the car. This chart shows that all lender categories have increased their loan to value ratios. Note that each type of lenders’ loans average more than 100% of the value of the car.
As the term of auto loans increases the borrowers can generally borrow more money for a given monthly payment, and the risk to the lender increases because the amortization is slower. According to Experian the average length of subprime was 71.2 months in the second quarter, up from 70 months a year earlier.
3 B R A D L A M E N S D O R F A N D T W O R I V E R S A N A LY T I C S
BRAD LAMENSDORF AND TWO RIVERS ANALYTICS
NOVEMBER 2014
The market for securitized auto loans is hot as well. Barclays reports that $80 bn of new subprime auto loans have been bought by investors desperately seeking yield while the Fed keeps treasury yields near zero. This much liquidity always creates speculative excess, which is reminiscent of home loans in 2006 and the internet bubble of 1999.
Riskier loans are being made, but is quality deteriorating? S&P thinks so:
“In our opinion, we’re at a turning point with respect to subprime auto loan performance, similar to where we were in 2006…competition has intensified…The increased competition has led to lengthening loan terms and rising loan-to-value ratios, both of which generally result in higher losses. Though many lenders have told us that their performance in recent years had exceeded their own expectations, we are now hearing that they expect losses to trend upward” - Standard & Poors Subprime Auto Performance: The Best Is Behind Us, Feb 26, 2014 Signs that auto loan portfolios were deteriorating could be seen by late 2013. The TransUnion credit reporting agency revealed that the rate of auto loans late by 60 or more days had risen to 0.95% from 0.87% earlier. Losses, in turn, have risen as the following S&P chart shows. Another credit agency, Experian, startled investors when they reported that repossessions by finance companies had doubled to 2.75% in the second quarter, from 1.13% last year. In fact, finance companies show the highest recent auto loan portfolio growth rates, at a time when subprime lending rose the most. Naturally, they are the ones seeing the largest increases in default rates.
4 B R A D L A M E N S D O R F A N D T W O R I V E R S A N A LY T I C S
BRAD LAMENSDORF AND TWO RIVERS ANALYTICS
NOVEMBER 2014
How deep is the rot? We have also begun to see anecdotal evidence of fraudulent loan origination. Several states have launched investigations into cases of outright fraud. Dealers have been found to have falsified employment data, income verification data and other information used to grant financing to unqualified buyers. These loans are then being repackaged and sold.
Why does this matter? On September 3rd, when Conns Inc. announced the deterioration of its customer financing portfolio - mostly subprime customers - its stock dropped 31%. Not only had credit losses impacted earnings directly by producing write-offs and loss accruals, but it began to dawn on investors that Conns had driven sales with cheap credit. Once the cheap credit was no longer sustainable, Conns became a much less attractive investment. Conns reported that “delinquency unexpectedly deteriorated across all credit quality levels, customer groups, product categories, geographic regions and years of origination.” Their portfolio showed some of the same trends we now see in auto loans. There was a crowding out of prime lenders by subprime lender share (in this case, towards Conn’s own financing programs), falling FICO scores and increasing delinquencies in the portfolio. It is likely that the same consumer using credit for the purchase of their household durables is using the more aggressive auto finance programs. Is it that difficult to imagine that the same consumers could do similar damage to auto lenders?
How do you play this trend? There are several ways to play the consumer/subprime credit deterioration theme. The most direct way is to sell short shares of the lenders most exposed to subprime auto loans. Another way is to sell short shares in businesses benefitting from auto sales, namely dealerships and auto manufacturers. There are also similarly situated companies that sell a more discretionary product than automobiles and are as exposed to lower quality credit consumers. These could include manufacturers and retailers of recreational vehicles such as snowmobiles, RV’s and motorcycles. To the extent that purchases are driven by subprime borrowers, these companies will feel the impact if subprime vehicle loans turn down. In terms of “pure play” subprime exposure, finance companies seem to come closest. They have the highest proportion of subprime and fast growing subprime shares.
5 B R A D L A M E N S D O R F A N D T W O R I V E R S A N A LY T I C S
BRAD LAMENSDORF AND TWO RIVERS ANALYTICS
NOVEMBER 2014
It will help to focus on those lenders whose market shares rose the most during the recent period of subprime expansion. These lenders are likely to have put on a lot of exposure quickly during a period of aggressive credit deterioration.
6 B R A D L A M E N S D O R F A N D T W O R I V E R S A N A LY T I C S
Brad Lamensdorf and Two Rivers Analytics NOVEMBER 2014
Auto Finance: Another Subprime bubble? It is past Halloween, yet we still see the ghosts of subprime stalking unsuspecting investors again. Is the auto finance market a replay of the home loan subprime bubble on a smaller scale? We see a buildup of credit risk from rapidly escalating lower quality loan exposure, coupled with artificially high auto and related sales enabled by easy credit. The first signs of deterioration have appeared: delinquencies and repossessions are increasing already. Some of the companies we see as most exposed are Santander Consumer US (SC), TCF Financial Corporation (TCB), LKQ Corp. (LKQ), Carmax (KMX), Lithia Motors (LAD), and similar financing driven discretionary companies such as Harley Davidson (HOG) and Winnebago (WGO). These and other names will be highlighted further in this piece and in a subsequent article.
Deteriorating auto loan credit quality The data points to a buildup of risk in auto finance. Auto loan volumes have spiked, the proportion of subprime loans has increased, loan terms are lengthening and there has been an increase in loan to values. These factors all point to a buildup of risks. While the timing of the credit tipping point is uncertain, recent damage in subprime for furniture and durables reminds us that these bubbles are not sustainable forever. CONNs, a leading furniture and appliance retailer, lost 31% of its value on September 3rd when it revealed a decline in the credit quality of its lending programs. This decline not only resulted in credit losses, but it also called into question the company’s growth prospects. Easy credit was being used to pull sales forward.
Loan volumes are growing fast Vehicle sales are skyrocketing. FRED data shows that vehicle sales have recovered to their prerecession levels, if not to their absolute peaks. Most of these sales involve financing. Unsurprisingly auto loan balances have recovered their peaks as well, setting a new record at $900bn. This record exceeds the 2005-2006 peak by about 10%.
1 B R A D L A M E N S D O R F A N D T W O R I V E R S A N A LY T I C S
BRAD LAMENSDORF AND TWO RIVERS ANALYTICS
NOVEMBER 2014
In the rush to lend, banks have lowered their standards. Credit quality has been deteriorating. We see this through the quality of the borrower pool, the loan-tovalue (LTV) ratios made, and the average life of the loans. Of greatest concern is the deteriorating quality of the borrowers being granted auto financing. Less qualified, lower credit score borrowers are finding willing lenders more and more easily. Source: Federal Reserve Bank of New York and Two Rivers Analytics.
Data from the NY Federal Reserve Bank shows that the value of subprime loans has doubled since the recession’s trough. See the black line in this chart for evidence.
A different cut of the data shows that the share of financing represented by subprime loans is rising. Equifax shows that subprime has risen to approximately a third of auto loan originations.
2 B R A D L A M E N S D O R F A N D T W O R I V E R S A N A LY T I C S
BRAD LAMENSDORF AND TWO RIVERS ANALYTICS
NOVEMBER 2014
Experian’s data highlights that deep subprime loans are growing the fastest of the various quality categories. Deep-subprime loans increased 13% in Q2 2014. These are the worst of the worst.
In addition, the amount lenders are willing to lend against new and used cars is increasing. With rising LTVs the borrower has less “skin in the game” and the lender faces a more difficult time recovering should they need to repossess the car. This chart shows that all lender categories have increased their loan to value ratios. Note that each type of lenders’ loans average more than 100% of the value of the car.
As the term of auto loans increases the borrowers can generally borrow more money for a given monthly payment, and the risk to the lender increases because the amortization is slower. According to Experian the average length of subprime was 71.2 months in the second quarter, up from 70 months a year earlier.
3 B R A D L A M E N S D O R F A N D T W O R I V E R S A N A LY T I C S
BRAD LAMENSDORF AND TWO RIVERS ANALYTICS
NOVEMBER 2014
The market for securitized auto loans is hot as well. Barclays reports that $80 bn of new subprime auto loans have been bought by investors desperately seeking yield while the Fed keeps treasury yields near zero. This much liquidity always creates speculative excess, which is reminiscent of home loans in 2006 and the internet bubble of 1999.
Riskier loans are being made, but is quality deteriorating? S&P thinks so:
“In our opinion, we’re at a turning point with respect to subprime auto loan performance, similar to where we were in 2006…competition has intensified…The increased competition has led to lengthening loan terms and rising loan-to-value ratios, both of which generally result in higher losses. Though many lenders have told us that their performance in recent years had exceeded their own expectations, we are now hearing that they expect losses to trend upward” - Standard & Poors Subprime Auto Performance: The Best Is Behind Us, Feb 26, 2014 Signs that auto loan portfolios were deteriorating could be seen by late 2013. The TransUnion credit reporting agency revealed that the rate of auto loans late by 60 or more days had risen to 0.95% from 0.87% earlier. Losses, in turn, have risen as the following S&P chart shows. Another credit agency, Experian, startled investors when they reported that repossessions by finance companies had doubled to 2.75% in the second quarter, from 1.13% last year. In fact, finance companies show the highest recent auto loan portfolio growth rates, at a time when subprime lending rose the most. Naturally, they are the ones seeing the largest increases in default rates.
4 B R A D L A M E N S D O R F A N D T W O R I V E R S A N A LY T I C S
BRAD LAMENSDORF AND TWO RIVERS ANALYTICS
NOVEMBER 2014
How deep is the rot? We have also begun to see anecdotal evidence of fraudulent loan origination. Several states have launched investigations into cases of outright fraud. Dealers have been found to have falsified employment data, income verification data and other information used to grant financing to unqualified buyers. These loans are then being repackaged and sold.
Why does this matter? On September 3rd, when Conns Inc. announced the deterioration of its customer financing portfolio - mostly subprime customers - its stock dropped 31%. Not only had credit losses impacted earnings directly by producing write-offs and loss accruals, but it began to dawn on investors that Conns had driven sales with cheap credit. Once the cheap credit was no longer sustainable, Conns became a much less attractive investment. Conns reported that “delinquency unexpectedly deteriorated across all credit quality levels, customer groups, product categories, geographic regions and years of origination.” Their portfolio showed some of the same trends we now see in auto loans. There was a crowding out of prime lenders by subprime lender share (in this case, towards Conn’s own financing programs), falling FICO scores and increasing delinquencies in the portfolio. It is likely that the same consumer using credit for the purchase of their household durables is using the more aggressive auto finance programs. Is it that difficult to imagine that the same consumers could do similar damage to auto lenders?
How do you play this trend? There are several ways to play the consumer/subprime credit deterioration theme. The most direct way is to sell short shares of the lenders most exposed to subprime auto loans. Another way is to sell short shares in businesses benefitting from auto sales, namely dealerships and auto manufacturers. There are also similarly situated companies that sell a more discretionary product than automobiles and are as exposed to lower quality credit consumers. These could include manufacturers and retailers of recreational vehicles such as snowmobiles, RV’s and motorcycles. To the extent that purchases are driven by subprime borrowers, these companies will feel the impact if subprime vehicle loans turn down. In terms of “pure play” subprime exposure, finance companies seem to come closest. They have the highest proportion of subprime and fast growing subprime shares.
5 B R A D L A M E N S D O R F A N D T W O R I V E R S A N A LY T I C S
BRAD LAMENSDORF AND TWO RIVERS ANALYTICS
NOVEMBER 2014
It will help to focus on those lenders whose market shares rose the most during the recent period of subprime expansion. These lenders are likely to have put on a lot of exposure quickly during a period of aggressive credit deterioration.
6 B R A D L A M E N S D O R F A N D T W O R I V E R S A N A LY T I C S
