Carmaggeddon? Toxic Bonds & ABS: Can't say I didn't Warn You (twice)

Before I start, I must credit Bloomberg's Danielle DiMartino Booth for coining the term "Carmaggeddon."

Ever see the same headline image before? For those followers who've been with me a while, you may notice - I took it from an article I wrote back in August 2015 (see here) in which I described how the magnificent growth in auto sales was fueled, at least in part, by relaxed lending standards. First, let's take a piece from that original post:

"Free money begets free lending. Free lending begets over-leverage. Over-leverage begets defaults. The length of time free money is available, and any incremental money put into supply (e.g. the stuff that came rolling off the Greenspan/Bernanke printing press), determines the amount of free lending and over-borrowing. The degree of over-borrowing relative to income begets the magnitude of defaults, and the magnitude of defaults begets the losses to a credit implosion."

As the major automakers sought to continue to meet sales growth targets, their financing arms (e.g. GM Financial in the case of General Motors (NYSE:GM), Mercedes Benz Financial Services as it relates to Daimler AG (FRA:DAI), and so on) seemed to be doing a lot of the legwork. On August 14, 2015, I noted that on the prior day, figures released by the Federal Reserve Bank (FRB) of New York showed that in the 2nd quarter of 2015, as auto-sales continued to rise in what may have appeared to others to be a "healthy auto market," outstanding auto loans surpassed the proverbial $1 trillion mark. In particular, I noted the basket of borrowers holding those loans looked very similar to the bucket of borrowers with adjustable rate mortgages (ARM) in the U.S. in 2006/07; we all know how that ended.

It amazes me how quickly we are to forget the recent past. We can blame the Availability Bias (a behavioral bias that leads us to remember only the things that have occurred in our recent past), but one would have thought that as lenders jumped aboard the auto-loan bus they would've recalled the relatively recent crisis (i.e. the 2008 meltdown) driven by lax lending to borrowers without the capacity to repay. Moreover, mutual fund managers, one would hope, would know better than to buy a bucket of crappy auto-loans in the form of collateralized loan obligations (CLOs), collateralized debt obligations (CDOs), or other securitized products - remembering that these were the toxic devices used by the major investment banks to offload bad mortgages to unsuspecting investors in the last crisis.

Today, car sales are at their lowest levels in over two years, and sub-prime delinquencies are nearing crisis-era highs. So-called "deep sub-prime" loans, or those granted only to borrowers with a clear inability to repay (sarcasm mine), represent a third of the total U.S. sub-prime car loan securitization market (compared to a tenth of the market in 2010). Loan terms have been extended as borrowers are stretched precariously thin in their attempts to match their paychecks with their payment capacity.

According to the FRB of NY, six million borrowers in the domestic auto-loan market have gone into technical default, and many more are expected to come.

Let's think about this theoretically, from a logical perspective. Credit does not create any incremental demand - it simply shifts demand from period to period - aggregate demand, or total demand in the long-run, does not change. Credit in ample supply can drive early purchases of items that would've otherwise been bought in later periods, but it comes at the cost of reduced demand (below the normal level) down the line. Credit is simply a mechanism that allows a borrower to consume more today than his income could otherwise support. In exchange, he must, at some point in the future, consume less than he earns as his debts are repaid (including interest). In other words, credit finances over-consumption today at the expense of future consumption.

Now let's apply this to the car market. If automakers sought to accelerate demand and pull revenues forward, relaxed lending standards is an obvious way to achieve this goal. But in the end, as we have learned - credit is only temporary. It simply shifts the timing of auto purchases; in the long-run, total demand does not change. Thus, lax lending today will result in higher near-term demand, but this comes at the expense of sales in future periods. Things get really ugly when lenders get greedy and make loans to individuals who lack the capacity-to-repay.

You see, if a bunch of auto-lenders extend credit at unusually low rates to creditworthy borrowers and further extend credit to a less creditworthy (or "sub-prime") crowd, things will seem great in the short-run: cars are rolling-off the lots, demand is rising and in-turn, prices and collateral values rise. As the value of collateral rises, lenders become even more relaxed. They begin to extend credit to a new class of borrowers, using optimistic assumptions in their lending formulas such as overly high residual and collateral values (for vehicles coming off lease or those that are repossessed and sold at auction). High collateral value assumptions make it seem logical to extend credit to a greater share of borrowers, despite their less-than-stellar credit. And thus the vicious feedback loop reinforces itself.

Those who might have otherwise waited to buy that new Cadillac are rushing to buy it now, after hearing about the new 0% down, 0.9% APR offered by the local dealer. But a few years down-the-line, creditworthy borrowers have relatively new vehicles, so they aren't out in the market buying cars. Extensive credit granted to those without the capacity repay leaves many strapped to make their monthly payments, and defaults begin to rise. As defaults rise, lenders adjust their calculations and tighten lending standards. Fewer individuals seek loans to buy new cars at it's now more costly to borrow. Lenders quickly find that as they seize collateral on defaulted loans, the reclaimed vehicles aren't worth nearly what they were at the height of the credit bubble (and hence their implied "collateral values" were wrong). Suddenly, supply of used and new vehicles gets far ahead of demand, precisely as new car sales dry up and prices collapse in the used market.

Of course, it can be expected then that today, with six million already in technical default on existing auto-loans and an expectation for "many more" to come, used car prices are crashing (and they are), devastating the collateral lenders can recoup at auction.

I'd be remiss if I didn't alert the potential victims here: many of you may think your 401(k) or other retirement accounts are invested in "safe" mutual funds, where the primary mandate is to invest in U.S. government- and agency-backed fixed income instruments (or even "high-grade" bonds), but I'd strongly recommend you review the latest annual reports for all fixed income mutual funds in which you are invested (annual reports can be found here by searching by fund name or ticker, within the Annual Report, zone in on the Schedule of Investments) - you may be shocked to find investments in things like "consumer credit card receivables" and "auto-loan Asset Backed Securities (ABS)."

Despite the obvious, precarious state of the U.S. auto market, investors in the auto-loan backed securitization market seem completely free of concern. If anything, pricing in the market for asset-backed securities supported by auto-loans appears to be expected to improve. According to Bloomberg, a year ago, buyers of the riskiest slices of auto ABS bonds were demanding yields that were 7.5% higher than comparable four-year maturity swaps (the fixed income instrument against which they're priced). But by the end of Q1 of this year, that 7.5% premium had been cut in half (in other words, investors are willing to buy the same, riskiest traunches of auto ABS for a premium of only 3.75% or so).

According to Bloomberg, auto dealers in the "deep" sub-prime space reinforce the pricing environment -- demand for loans from borrowers without the ability to repay naturally remains strong, and underwriting standards have not tightened in recent months despite the obvious deterioration in the sector. In fact, car loans led the rise in consumer credit in February. Excluding mortgages, household debt now standards at a fresh record of $3.3 trillion.

What gives? We will see as this plays out in the coming year, but I suspect the cycle is coming to a close -- and free or loosening credit, played to its logical endpoint, never ends well.

It's worthwhile to note that in 2011, the entire auto ABS index was concentrated among two big (highly exposed) lenders: Banco Santander (a personal favorite of mine when picking on exposed European financiers) and AmeriCredit, each of which made up ~45% of the index (collectively accounting for 90%). Today, their respective concentrations have dropped (though still strikingly high) to 28% and 25%, respectively. According to Well's Fargo's John McElravey, the gap has been filled by what he terms "non-benchmark issuers." Many of these so-called "non-benchmark" issuers are backed by private equity, a cause for concern among dealers. Will the money behind these lenders, who generally follow more loose underwriting standards, flee the market as quickly as they've jumped in? How would one "stress-test" a market that was virtually non-existent six years ago?

Debt has perpetuated the global markets at an unprecedented clip (and at an unprecedented scale). And while this, non-bank market of lenders to "deep" sub-prime borrowers in the auto sector did not exist prior to the last downturn, neither did the abundance of bad student loans, adding yet another layer of risk to households' future capacity to keep current on their debt-obligations. The ultimate tipping point, or the point at which an economy falls into recession, occurs when households' debt burdens (collectively) grow faster than household incomes. The capital markets have clearly placed the onus on the new administration and Congress to expedite deregulation and implement new legislation to catalyze short-term economic growth, with the Fed pulling back on its accommodative approach (at least for now). The current economic 'expansion,' the third-longest on record, may just be one accident away from a trip to the body shop.