There have been increasing reports of problems emerging in the auto finance industry. The economics of owning a car are very much against the owner given the decline in value after the car leaves the lot.
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If you ask me, the only way for the existing economics to be justified is if every owner uses their car until it has no residual value. Now if that were the case, more car owners would be driving to work and navigating the streets every day in old, worn down jalopies. Instead most car owners love to reward themselves with something bright, shiny and new.
On the topic of car ownership, the subprime finance auto space in particular has received a lot of attention. What I find interesting are the analogs between subprime mortgage and subprime auto. Subprime auto was kick-started after the 2008 crisis because it performed well relative to what expectations were before the crisis. You may need a car to have a job but you do not need a house – you can always rent if, say, housing prices are high due to an inventory shortage.
Subprime auto was an early recipient of post-crisis financial institution-oriented private equity and warehouse securitization money, and it was one of the earlier asset classes within the ABS world to start back up again post-crisis. Wholesale funding and securitization were all predicated on the perceived outperformance that occurred through the crisis.
The real, fundamental risk surrounding subprime auto revolves around the value chain. More specifically, alignment within the value chain. The notion of financial incentive alignment was originally drilled into my head by an early investing mentor of mine. The importance of alignment may seem obvious, but it never stops being neglected. For example, very few providers of financing are also retail distributers of vehicles. “Car dealer A” sells a trade-in to “used car dealer B” for $3,000 via an auction house. “Used car dealer B” then marks it up to $10,000, gives a new buyer an $8,000, 20% APR loan (net of a $2,000 down payment) and then sells the loan at a 25% discount to an auto financier.
So, we have a borrower who wants compulsively to get into the biggest car possible, an originating auto dealer with negative basis in the trade from day one, a hungry wholesale and securitization market that is not going to wear any risk, and an overabundance of private equity firms pressing for origination to drive equity valuation. How can this be? Why is this something that only stops when there is a blow-up?
The answer is that the hunger for yield has made buyers of the paper relatively less picky about loan quality. Just like in mortgages during the crisis, in subprime auto you have a disconnected financing and origination chain with terrible incentive alignment in subprime auto. The underlying credit deterioration has been totally disregarded.
What does all of this mean for our business? In the below prime markets where volumes were not as large, where there were non-economic drivers keeping these loans out of bank wholesale funding and securitization, ironically water found its level. You can go into deeper subprime categories, appropriately price the obligation, and if you are a wholesale funder, force the retail originator of the loan to be aligned. As a result, at the time that they take on the obligation, they are still owners of the risk, and they actually care about loan quality. It performs well, particularly relative to the LTV they can create and the APR that they are able to charge because the pricing of the loan is not a beneficiary of the misaligned originate-to-securitize craze. We are involved in this lending already.
Other near-term opportunities in this value chain include purchasing this loan collateral at substantial discounts, which we have begun to do. We are also positioning ourselves to purchase auto deficiencies arising from subprime auto foreclosures, for which we have already organized a joint venture. Auto deficiencies are the charged-off residuals after people’s cars are repossessed and sold. If their car is repossessed, and it is sold for less than what was owed, the remainder is a personal obligation of the borrower. Debt buyers will purchase the loan for a few cents and resolve it.
We are always seeking to understand the full value chain for all types of collateral, find and pinpoint which components are cheap and dear, and set ourselves up to capitalize on these situations on behalf of our investors.
Dan Zwirn – Arena Investors – Capitalize for Kids
