So the mainstream media has finally caught on. Just about every day, we read an article warning of the dangerous bubble in U.S. auto debt. That debt now totals a record $1.36 trillion according to the Federal Reserve Bank of New York. A recent Bloomberg article pointed out that’s about $6,100 of debt for every licensed driver. Terms like “securitizations” or “asset backed securities” (or “ABSs”) are critical to understanding auto finance. These financial instruments have been used to fuel excessive lender leverage. In the wake of the financial crisis, you may have heard about mortgage originators setting up bad subprime loans, and then offloading much of the risk of homeowners defaulting on their mortgages. These lenders did this by “securitizing” most of the loans. That is, packaging them into mortgage-backed securities (“MBSs”), which they sold to investors. The exact same tool exists in auto loans, except the securities are called auto ABSs. Nationwide, the ABS market is a fraction of what the MBS market was in 2007. But it’s a massive problem for certain individual players that could be wiped out by excessive reliance on ABSs. ABSs work like this: Lenders package thousands of individual auto loans (worth hundreds of millions – and sometimes billions – of dollars) into these debt securities, which are sold to investors in small pieces. The auto loans serve as collateral for the debt. To entice investors, lenders add significant amounts of “credit protection” or “credit enhancement” to the ABSs. This can take the form of extra cash
put into escrow and additional auto loans to serve as collateral for the debt to cover any potential credit losses. Most auto lenders use ABSs as their main source of capital. Not only do these ABSs allow them to offload the risk of their loans, but selling the securities injects their coffers with cash, allowing them to make more loans. They provide instant cash – or “liquidity”, in industry parlance – while moving the credit risk from the lenders onto investors. In today’s low-yield world, institutional investors like pension funds, bond mutual funds, and even some insurance companies are happy to scoop up these ABSs that pay interest rates ranging from 0.4% to 5.0%, depending on the level of risk. But, when this demand dries up... the business model of many lenders is in peril. If you’re just now picking up on the trends of the auto sales and lending industry... the graphic on the following page provides a simple view of the various factors in play. We call it the “auto-lending death spiral.” As you can see, the death spiral starts when management needs revenue growth and dips a little lower in the credit spectrum (Box 1 and 2) to attract new customers. Many of these new, lower-quality customers are going to need more “creative” loan terms in order to make their payments. So lenders may extend the terms of the loans and accept lower down payments than usual. Lenders also rely more on leasing to help lower monthly payments for buyers. They can offer lower payments because the residual values – the estimated value of the cars at the end of the leases – are set far too high (Box 3).
64 January 2018
Made with FlippingBook - professional solution for displaying marketing and sales documents online