Author Topic: LEAP Puts on Sub Prime Auto Lenders  (Read 5781 times)

Wfearful_Bgreedy

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LEAP Puts on Sub Prime Auto Lenders
« on: March 18, 2018, 04:24:10 PM »
I was curious about purchasing Put LEAPs in publicly traded sub-prime auto lenders like Credit Acceptance Corp and Santander Consumer USA,  CACC and SC respectively. Iím usually too early and I donít claim to be able to time the market, thatís why long term expiration puts are the only instrument I would consider and it would be a tiny portion of my portfolio. It would be too expensive to short outright so LEAPs look better. My only concern is that there is not a specific event or date driven thesis which would make the payout more rewarding and make volatility not follow a normal distribution like a court ruling on a specific date. I have a couple main reasons:

- Defaults are increasing
https://www.bloomberg.com/amp/news/articles/2018-02-02/never-mind-defaults-debt-backed-by-subprime-auto-loans-is-hot
Both SC and CACC are increasing their provisioning for these defaults and analysts asked why they were provisioning at a higher tick without a clear answer.

- The used auto index is decreasing
http://www.nada.com/b2b/NADAOutlook/Guidelines.aspx
This matters a lot because folks purchasing a new car depend on the trade in value of their used car. If they canít trade in for value then new car dealers get desperate and offer more discounts which pushes down used car value more. When subprime lenders repossess autos they depend on the value of those vehicles to make themselves whole and if you look at CACCís portfolio from 2015 to today based on their 10K they are owning more and more of these loans outright rather than handing off the risk to the dealer due to competitive pressure. When borrowers finish their lease and the remaining payments are more than the market value of their vehicle they will return the car leading to more used cars on the market. https://www.kbb.com/car-news/all-the-latest/this-week-in-car-buying-inventories-grow-used-cars-flood-market/2100004210/amp/

- Interest rates are increasing
If the spread between the Fed rate and high interest sub prime auto bonds decrease then lenders will have to increase interest rates to entice bond purchasers or take a margin hit.

- The quality of new dealers is likely decreasing
If you look at Credit Acceptance 10K they are increasing dealership footprint but are seeing some market saturation. I believe there are 35000 used car dealerships in the US and they are in 9000. So what you see is that their per dealer deals are decreasing per year. Also if you see the analyst questions from their last quarterly it appears that their new dealers are not meeting the minimum 100 deal quota in order to gain access to up front lending. I am speculating that it is their new dealers responsible for the downtrend in loan rates and that they are pushing into new territory where subprime isnít as viable in the hopes for the same growth. Companies like CACC have had amazing compounding growth but I think maintaining that growth will be very difficult given their size now. You can see the analysts inquiring about new dealer performance and a non-answer on page 4.
https://seekingalpha.com/article/4141501-credit-acceptances-cacc-ceo-brett-roberts-q4-2017-results-earnings-call-transcript?page=4

- Business Model Shift
I applaud Credit Acceptance in their early days for crafting a business model that shared the underwriting risk with the dealers. In their original business model the dealers would get an up-front loan from Credit Acceptance that was short of the full purchase price. The dealer would then recoup the difference over time as the loan continued to perform. This would incentivize dealers to practice good underwriting. Now however for the past few years CA has shifted from sharing the risk to owning more of the loans, see the chart on percentage growth from "Dealer" loans to "Purchased" loans.
https://globenewswire.com/news-release/2018/01/30/1314630/0/en/Credit-Acceptance-Announces-Fourth-Quarter-and-Full-Year-2017-Earnings.html
I imagine this is because dealers would rather take more upfront and use that to cycle through more inventory rather than wait a few years to collect payments. This is a misalignment of incentives and risk where dealers are offloading the default risk to the lender without any fear of losing their source of cash because they have multiple online options to choose from.

- Unemployment at all time low
How can defaults be increasing when unemployment in the US is at an all time low. Imagine if that unemployment regressed to the mean. Since there is so much competition now between subprime lenders and dealers have the pick of the litter often the fastest pre-approval wins. So the lenders are incentivized to decrease underwriting standards and beat out the next lender. The question is who is the fastest and worst underwriter? I donít think I know that answer yet, I think historically Credit Acceptance has been more prudent and outlived the competition but the business model is changing.

- Loan duration is increasing
The average duration of these auto loans are at all time highs of 65 months and max of 85 to 94 months. If used car prices continue to decrease then these vehicles are more likely to be underwater compared to a scenario where they had been on a traditional payment term. I am curious as to the correlation between longer loan periods in a downward vehicle price environment and defaults. My hypothesis is that if the vehicle is underwater and I can no longer make payments then I will just let the lender repossess the vehicle.

- What are consumers actually buying?
Right now the market leader in the US is without a doubt luxury SUVs and pickup trucks.
https://mobile.nytimes.com/2018/02/15/automobiles/wheels/luxury-trucks-suv.html?referer=https://www.google.com/
These are vehicles with higher maintenance and gas costs. Pick any street in your area and count how many lifted trucks or SUVs with a new dealer tag on the plate that werenít there a few months ago. Iím not sure your neighbor will keep that Ford Raptor if times get tough.

My calculations in excel were showing me a 1.6X Payoff for Santander Consumer USA using a two year out of the money strike price 40 percent lower than market. I would hope for at least a 2X payout, this was one of the rules Cornwall Capital had for investing. CACC used to be run by owner operators who have a lot of experience surviving multiple up and down environments, however their founder has since sold a lot of his shares and their business model is shifting from sharing the risk to owning the risk.
https://www.bloomberg.com/news/articles/2017-05-04/as-inventor-of-subprime-car-loans-exits-critics-smell-a-lemon
Santander might be a better opportunity though they aren't as richly priced for growth.

In summary I think this market has enjoyed a lot of tailwinds for the past 8 years and people made a lot of money in this industry. I think there are a lot of headwinds ahead while these companies are being priced for perfection. Because the duration of auto loans continues to increase out to 65 months or greater in an environment where the used price index is decreasing provides heightened odds of borrowers being caught in a down job market with a luxury vehicle that is underwater. While lenders are incentivized to increase loan duration to make monthly payments more palatable today they are relying on the resale value of those vehicles in the event of default in the future.
« Last Edit: March 18, 2018, 08:57:23 PM by Wfearful_Bgreedy »


DRValue

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Re: LEAP Puts on Sub Prime Auto Lenders
« Reply #1 on: March 19, 2018, 03:59:35 AM »
Great write up!

Very interested in this. The model seems to be make the loan and securitize it which makes shorting Santander consumer a bit less attractive.  I'm trying to find auto loan lenders or investors that keep the loans on the books but Google finance is gone and I'm struggling.
Also I can't find a sub prime auto loan index.

With sub prime mortgages though the trigger was teaser rates ending and higher rates kicking in. What do you think the trigger will be here?

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DRValue

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Re: LEAP Puts on Sub Prime Auto Lenders
« Reply #2 on: March 19, 2018, 06:03:04 AM »
Just reading the CACC AR. They are clearly going after growth through the purchase program where the dealer has less skin in the game. Couple that with a lender who lends with no questions asked to poor to no credit borrowers and you have a recipe for disaster. I can't see a dealer turning down a sale here.
Losses all depends on what they charge for the loans and the softening of the resale market value.
More to do but if I can work out a catalyst there could be something here.
Thanks for sharing.
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jmp8822

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Re: LEAP Puts on Sub Prime Auto Lenders
« Reply #3 on: March 19, 2018, 08:02:33 AM »
I don't see any LEAPS listed for CACC.

Wfearful_Bgreedy

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Re: LEAP Puts on Sub Prime Auto Lenders
« Reply #4 on: March 19, 2018, 10:32:01 AM »
This is probably my own naÔvetť on LEAPs I saw options on CACC that go out to the end of 2018 and considered those leaps. SC on the other hand has options two years out.

Cigarbutt

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Re: LEAP Puts on Sub Prime Auto Lenders
« Reply #5 on: March 19, 2018, 01:14:11 PM »
Wfearful_Bgreedy,

-I like your post too and agree with the potential.
-Cycles are cycles and subprime auto lending appears to form a top.
-However, as with all these opportunities, timing is an important factor.

So, even if I like your thesis, here are three moderating factors.

1-Resilience of the subprime auto lending market

I have done some work to compare the ę state Ľ of the auto subprime market before the 2007-9 episode to now (interest rates, credit score, lending origination by credit tier, LTV to loan, term length, delinquency rates). IMO, auto finance lenders are only in a slightly worse position (I think banks exposed to this segment are, in fact, in a better position).  The auto finance lenders have a relatively larger piece of the subprime pie but I think that the creditworthiness of customers is comparable. Also, the auto finance companies ratio of subprime debt over total outstanding auto debt is actually lower. This is a cyclical business and CACC has had its share of problems (more familiar with CACC than SC) but it has been around for a long time. Even if the the terms of loans have gotten longer, those loans do season fairly rapidly.  If you are quasi-autistic , you may want to look at the link below (slightly outdated but relevant). The link also shows that going through the Great Recession (certainly a significant real life stress test), not a single securitization issue was downgraded (at least by S&P). Despite the severity of the recession, the auto ABS market rebounded quite nicely after a relatively short period. The US Treasury came to the rescue of GMAC but my understanding is that the rescue was more directed to GM, the manufacturer itself. It may take more than a usual credit cycle adjustment to really hurt the underlying business.

https://www.capitaliq.com/CIQDotNet/CreditResearch/RenderArticle.aspx?articleId=1817685&SctArtId=420028&from=CM&nsl_code=LIME&sourceObjectId=10010733&sourceRevId=1&fee_ind=N&exp_date=20270320-23:12:27

2-Relative advantage to CACC and SC if/when the auto credit cycle turns

I see that many newer and smaller players have appeared on the scene and these entrants likely have been/are using loosened standards and those players may absorb first a significant portion of the losses if credit dries up as larger players such as CACC and SC suffer relatively less, use their relative scale and maintain access to credit.

3-The auto subprime financing market, by itself, is not large enough to precipitate its own demise.

If you can identify a catalyst, it would be then reasonable to run various time-weighted scenarios. What was interesting with the subprime mortgage segment leading to 2007 was that the worsening lending standards were way more significant than what is happening now in the auto subprime market and formed a large enough market to trigger a wholesale liquidity crisis in the mortgage prime segment, then in the general economy triggering a recession and then sustaining the self-fulfilling prophecy of a massive decline in the mortgage subprime segment that started the whole thing. I donít think that the auto subprime segment is large enough to cause that type of vicious circle. There are plenty of potential catalysts in our markets now but, for your thesis to play out, you have to rely on a large increase in interest rates or a recession in order to make a large profit. A simple cyclical adjustment would do the trick to some degree but IMO expected profits would be less with names like CACC or SC compared to weaker players and timing remains an issue.

Thanks for sharing. Will follow.
« Last Edit: March 19, 2018, 01:42:57 PM by Cigarbutt »

DRValue

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Re: LEAP Puts on Sub Prime Auto Lenders
« Reply #6 on: March 19, 2018, 02:18:27 PM »
Cigarbutt

I'm close to the same conclusion. It feels like there's something here but trying to find it is difficult.

For instance I've read that some of these loans have an interest rate as high as 25% and charge offs happen in the first 120 days. But then the car is sold at auction and losses made up.
One reason that high interest rates have been charged is to protect investors buying the abs (according to an analyst) so I don't think securities demand will fall to business failing levels as defaults may rise but that wouldn't mean huge abs losses. Same goes for loans on the balance sheet.

Might be worth checking the capital structure and maturity schedule of some of these businesses to predict some pinch points.  I think cacc has issued equity and sold some bonds recently will have to check.

Worst case I see is that this is the top of the cycle and mortgage rates are rising
which together bring elevated losses and lower loan demand that'll hurt top and bottom lines.

There doesn't seem to be a catalyst that will crater the abs and cripple the businesses that we need for the short, like a funding term mis-match or variable rate change.

Autos as a whole may soften. Karmax (KMX) may get interesting, but that'll take an extreme scenario. Anything with low operating leverage in a down market might be interesting.

Going to keep an eye on kmx cacc and sc but dont think this will be for me.
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Cigarbutt

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Re: LEAP Puts on Sub Prime Auto Lenders
« Reply #7 on: March 20, 2018, 04:50:53 AM »
Follow-up
The link provided above may no longer be available or may have an availability time-dependent feature for access.

Here's a more generic access to the research with more recent data.

https://www.spratings.com/ca_AD/structured-finance?catSelected=88212

---)Subprime auto loan tracker, 2017 review...14/03/18

https://www.spratings.com/ca_AD/structured-finance?p_p_id=122_INSTANCE_w5mTyRwrkVAV&p_p_lifecycle=0&p_p_state=normal&p_p_mode=view&p_p_col_id=column-1&p_p_col_count=2&p_r_p_564233524_resetCur=true&p_r_p_564233524_categoryId=88211,88212,88228,88240,88319,88340,88352,88359


---)Subprime auto loan tracker, January 2018...19/03/18
« Last Edit: March 20, 2018, 04:52:26 AM by Cigarbutt »

Cigarbutt

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Re: LEAP Puts on Sub Prime Auto Lenders
« Reply #8 on: March 23, 2018, 08:22:44 AM »
I had put this topic aside but came across:
https://www.plainsite.org/realitycheck/creditacceptance.html

I spent some time on the three part series.
They explore many valid points but:
-Don't know anything about the author/group making the research/report, what is the intent, the motives?
-The auto subprime leasing industry is messy and a relatively easy target.
-The muckracking style is hard to differentiate from true investigative work

Any thoughts?

LongHaul

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Re: LEAP Puts on Sub Prime Auto Lenders
« Reply #9 on: March 25, 2018, 11:17:09 AM »
I am interested in how this plays out.  It smells (and I have heard) auto lenders are going into deep subprime territory and pushing out the Buy Here Pay Here operators.  So if the easy lending reverses then a huge chunk of consumers can't buy cars.  Rough guess ~90% of Carmax buyers finance (includes Non KMX finance guess). 

So if financing suddenly becomes tight for subprime and near subprime that eliminates a big chunk of demand and buyers.  Then used vehicle prices fall and lenders lose more.   Typical credit cycle. 

See used vehicle price chart
https://publish.manheim.com/en/services/consulting/used-vehicle-value-index.html

Could mean that prices tank and stay lower than normal. 

I think this cycle has happened a bunch of times as the new subprime autolenders learn about credit risk and get wiped out.   Not an easy industry dealing with a lot of yoyos who you are loaning cars to.

Thoughts on how this plays out?
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