
Investment Riches Built on Subprime Auto Loans to Poor - yablak
http://dealbook.nytimes.com/2015/01/26/investment-riches-built-on-auto-loans-to-poor/
======
bko
> The investors can earn relatively high returns on securities that the rating
> agencies have deemed low-risk.

Last time I checked, the most senior (AAA) tranches of subprime auto abs deals
are priced at libor + 20. That means that the investor is willing to accept
libor (essentially risk free rate) and 30 basis points on top of that. Is this
a high return? Sure, if you compare it to prime auto loans that are priced
libor + 20 but not compared to other securitized products. For instance, the
senior tranche on collateralized loan obligations are being priced at libor +
160 on new deals.

Overall, this article is especially poorly written in that it does little
other than stoke the flames of hatred against wall street. The writer claims
that people are being exploited but then profiles an unemployed woman who
cosigned a $30k loan on a car for her teenage daughter. The dealership almost
certainly should not have lent her the money but the owners of these
securities will pay the price, at least the equity tranche that absorbs all
the initial losses. After not paying for a while, the car will probably be
repossessed and resold.

The reason there is such appetite for these products is because of the low
interest rate environment. Investment managers are desperate to earn a
slightly higher return that the risk free rate. This is driving demand which
explains why you saw the issuance of subprime abs explode over the last year
and spreads tighten (spreads have widened later in the year though). Credit
standards have probably degraded to try and meet the demand of abs securities,
but that's inevitable.

At the end of the day, the investors will pay the price. There could be
another financial crisis and a massive bailout at the tax payer expense but I
doubt this is the product to cause panic. Unless the default rate on auto
loans reaches 30-40% a year and the market for used cars drops a similar
amount. I think the value of an auto is a lot more objective than that of a
home.

I think it's interesting how high interest rate risky loans can be considered
as sleazy while giving opportunities to the less fortunate is considered an
admirable goal. These two are two sides of the same coin. Would it be better
that people with less than perfect credit or generally considered higher risk
not get any loans? Or the risk of those loans be picked up by tax-payers?

~~~
joncooper
Comparing the LIBOR spread isn't enough to compare senior subprime tranches to
senior prime tranches. Among other things, the attachment point matters a very
a great deal.

The attachment point is the % of cumulative losses after which a given tranche
starts suffering losses of principal. So for example:

L+20 with a 20% attachment point against historical max losses in the asset
class over all credit cycles of 1% is a lot better on a risk adjusted basis
than L+200 with a 40% attachment point against historical max loss experience
of 15%.

Without talking about historical loss experience we can't really guesstimate
the margin of safety here nor say that a given tranche is or isn't good value.

Another possibly interesting nitpick: LIBOR isn't risk-free. It's an interbank
rate so it is the short-term yields paid by highly rated financial
institutions. Risk free means backed by an entity that can print money, like
the Fed. That's why the LIBOR-Fed Funds basis exists.

Also, re: "I think it's interesting how high interest rate risky loans can be
considered as sleazy while giving opportunities to the less fortunate is
considered an admirable goal." check out the book _Scarcity_ by Mullanaithan
and Shafir, which has a super interesting take on this question!

~~~
bko
Completely agree with everything you said. I was only calling libor risk-free
as it is what would be substituted for the risk free rate used in finance
textbooks. Technically it's not risk-free but serves as a base return to
benchmark off of. Also, most of these bonds pay coupons linked to libor.

Attachment and detachment point are definitely very important. I found a
random fed document from 2012 that suggests similar attachment/detachment
points for AAA prime vs subprime abs securities (~79% attachment). I haven't
looked at it too closely though and I could be missing something. I know
spreads are a lot tighter since 2012 and credit quality of underlying loans
may have worsened with lower standards. On the other hand, people are a lot
better off now that in 2012 (i.e. stock market, housing market, etc).

Will check out Scarcity. Thanks for the recommendation!

[1]
[http://www.federalreserve.gov/SECRS/2012/May/20120523/R-1401...](http://www.federalreserve.gov/SECRS/2012/May/20120523/R-1401/R-1401_051812_107330_532952917460_1.pdf)

~~~
jsprogrammer
Current state of economic thinking: technically not risk-free, but we'll call
it that anyway...what could go wrong!?

~~~
joncooper
Well, if you're talking about LIBOR, the risk is that the AA bank to whom you
have counterparty risk will default within 3mo, so it's very, very, very low
risk.

------
icehawk219
The ease with which huge amounts of credit are given to people who clearly
shouldn't receive it is quite scary. When I was 18 I had a decent enough job
as a fledgling software developer making above average for my age but still
not great. My car broke down and I decided to get a new one and as a stupid 18
year old with access to some money and credit I of course set my eyes on a
nice shiny, new off the lot, convertible. $20k in debt later I drove off the
lot. And they were nice enough to throw in a brand new Bank of America credit
card with a $10k limit on it too! It of course didn't take long for me to
nearly max that out and end up with a crash course in credit that I wish I'd
had beaten into me years earlier or that I was smart enough to figure out
sooner.

At 18 and making around $35k pre-tax I already had close to $30k in debt and
the scary thing is that that situation lead to me getting bombarded with mail
offers for more credit cards (including many different Bank of America cards)
that I was supposedly pre-approved for. Now that I keep very little debt,
besides my mortgage my 2 open cards have a balance of $0 on them 6 days out of
7, I get basically no offers. Education would go a long way to preventing what
happened to me from happening to others but I can't help but suspect a healthy
dose of tighter regulations, or restrictions, or ... something, should be put
into place too.

I now know I was a stupid kid who made stupid mistakes. I've also learned from
them. But I was also someone in one of the few industries that's still growing
and was able to recover fairly easily and never really felt any pain from it.
The average person isn't that fortunate.

~~~
brc
I'm curious how you weren't more savvy with carloans and credit in general?
Was it never discussed by your family? Did you ignore advice? It always seems
completely obvious to me to steer clear of financing cars (never had a car
loan, ever) yet I see so many others dive right in and end up very poor as a
result.

~~~
icehawk219
It's easy to blame others but what it really does come down to is a lack of
appreciation for what debt really is and how it really works. It's very easy
to get approved for 3 credit cards each with a $5k limit and say to yourself
"I have $15k to spend on anything I want." For someone who has never had
access to a lot of money that's a very easy trap to fall into and it's pretty
much what happened to me. Sure I had a savings account that was respectable
for my age but that's not spending money you carry around in your wallet.

In my case credit was certainly not discussed with the family, or amongst
friends (most of who reacted the same way I did to their first card), or in
school. I've had a job since I was 16 so I understood the value of money but I
didn't understand the value of debt until I already had it.

~~~
brc
Thanks for the reply. It seems that credit cards are designed to tap into the
human desire to live in the moment. I guess if you had to actually go to a
loan shark and pick up a suitcase with $15k in it, and know that a goon was
going to turn up weekly looking for the interest, you'd be a bit more
circumspect about whose money it really is.

I remember the feeling of being young and constantly stuck for cash to do
anything. It's frustrating so I can understand how cards provide a temporary
reprieve. Just don't get them is the only solution.

------
ismail
I find debt to be interesting, I think having debt, affects your decision
making and your risk taking.

Personally i have 0 amount of debt. No car payments, nor house payments. This
has allowed me to move jobs if i was not happy, even without something
concrete. Also a startup.

I look at my peers, who were in a similar position as me. Some who have taken
on home loans etc. they end up with the 'golden cuffs'.

Though you could argue i have no assets to show. Other than a varied work
experience, and ability to move into many different roles.

~~~
bjelkeman-again
Best decision we ever made, do minimise or eliminate debt.

------
volkadav
"This package of loans returns N times the risk free rate of return but is
just as safe, according to ratings agencies!"

Do people really not remember 2008? Jesus. The problem of course is that a
conflagration in one sector of the financial markets all too easily spreads to
others (remember when it was just subprime mortgages that were in trouble?
then when it was just mortgages? then when HOLY SHIT THE APOCALYPSE IS
EXTREMELY NIGH, SELL EVERYTHING AND BUY SPAM/AMMO?), e.g. through highly
leveraged and interwoven networks of derivatives. If (when) this goes tits up
I hope there are enough risk analysts being listened to at the Too Big To Fail
orgs that counter-party/swap risks are minimized to just the direct players in
this market.

~~~
duncan_bayne
Sure they remember. They remember that the last time this happened, taxpayers
were fleeced to prop up the organisations and individuals who should have lost
everything.

Google 'moral hazard' for a more detailed explanation.

~~~
tzs
And they will do it again...one of the first things the new Congress did was
repeal Dodd-Frank provisions that required banks to do some of their
derivative trading in separate entities that were not FDIC insured.

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princeb
this is a good thing. all I see is that someone who would normally not have
the ability to drive a BMW be able to enjoy the use of one - however
temporarily. I do not believe I have the moral superiority nor the arrogance
to determine what constitutes a "responsible" decision for another person, or
make a value judgement for them without appreciation of their values, let
alone forcing them on such a path. here are two parties - one who needs a car
(and all the intangible satisfaction in excess of the basic utility that comes
with it), and another who is willing to take extra risk on their capital for a
bit more income. how presumptuous it is to stand between their relationship.

~~~
readme
Please allow me to share my experiences with you. When I was 18, I had not yet
capitalized on any of my talents, and I worked at a Starbucks.

I took out a loan on a car, with a 27%+ interest rate. I grew up in a poor
family and I didn't really know any better at the time. That is, I knew, but I
had not yet developed the /discretion/ to act on that knowledge with sound
judgement. So, I signed for the car.

Approx 2.5 years later I defaulted on the car. Truly, 100% my fault, of
course. 3 years later I finally paid off the car, but that's only after I got
a decent few gigs developing mobile apps. So, for a lot of my life I worked
way more than I should have just to pay the upkeep on this car, because full
coverage insurance is pretty high when you're young. Fast forward a few years
and I haven't missed a payment in 3 years and I have an amex. So yeah, I
learned from some mistakes. But did it have to be that way? Do I want it to be
that way for future generations? No, that's what HUMAN PROGRESS is for.

I'm in the Army now. There's a law that protects servicemembers. Pretty much
whatever debts you have when you join the military must have interest reduced
to 6% or less. Also, if you look at a lot of state laws, the limit on interest
rates before the loans are considered usury is around 6%... This is because of
the general attitude amongst people that servicemembers should be treated
well. Geez, wouldn't it be nice if everyone was exploited less?

It's a pretty safe bet to say that, anyone loaning someone money at an
interest rate above 20% is basically robbing that person blind.

To posit that the other party is morally responsible for his own choices, and
not the lender, is certainly correct. Caveat emptor is very common knowledge
by now. The real question though is: is it for the greater good that we do
this? Does offering predatory loans to inexperienced buyers who have not yet
developed a strong enough will or learned enough about personal finance serve
a higher purpose, beyond making oneself rich? Is making oneself rich, the
ultimate goal in life, or is there something more important than that?

Sure, it's the buyers fault for purchasing. That doesn't make you a good
person if you're that predatory lender, or the guy who invested in those
bonds. It makes you someone who willfully exploited another human being's
ignorance or inexperience for their own personal gain. Which in my book, makes
you a pretty despicable person.

So I don't think we should take away the freedom of buyers to choose what they
want. I think we should take away the freedom of sellers to behave in ways
that is obviously not conducive to human progress and prosperity.

~~~
brc
It sounds good in theory but you're still learning.

If you remove the market for 20% loans, then those people will not get finance
for anything, ever.

A 20% interest rate merely reflects the reality of lending to people like your
younger self. They have a habit of defaulting. So to recover the money, a
higher rate needs to be charged. Thus the amount of defaults can be higher and
a return can still be made.

While you may think'banning' high interest rates will lead to better outcomes,
it most certainly will not. See drugs, prostitution, gambling, etc.
prohibition on any activity forces the activity underground, and then when you
default, it's not a black mark on your credit but a black eye or worse.

What does need to happen is that credit understanding happens in school, and
that every single credit product comes with a simple worksheet to clearly
spell out the cost of the interest over time, and the final payback amount.

Yes, lending, even at higher rates, is a net good for society. It allows
people to achieve things they currently do not have the money for. For every
kid who defaults there is a family who buys a car, gets to work and builds up
their credit score. A 20% rate actually says that the default rate is not too
bad, overall.

~~~
thedufer
> A 20% rate actually says that the default rate is not too bad, overall.

It would for a standard loan, but auto loans are backed by the asset. At 20%
it doesn't take long before interest catches up with depreciation and after
that it's all profit - given the loan rates a good credit score can get you
these days, ~15% above normal rates.

~~~
brc
The asset behind the loan has little to do with the interest rate. That is a
function of default rates. There is an opportunity cost when a loan goes bad -
that money is earning zero percent - as well as the cost of foreclosure (repo
man and legal work) plus the recovery value of a vehicle (or property). People
who have defaulted on loans generally do not return the collateral in ready-
to-sell condition, and any sales must be done at wholesale level, whereas the
loan is generally for an inflated retail level.

The return on the performing loans has to make up for the non-performing loans
and the costs of administration and recovery of bad debts. That is how a loan
portfolio works.

I'm not defending the shady practices of predatory lending - but the action
taken really has to be on the educational side for the buyer. The rates merely
reflect the market conditions at the time, and are the wrong thing to focus
on. There should be entire semester of schooling dedicated to understanding
credit, seeing as it is something that nearly every school leaver faces sooner
or later.

Money lending and overconsumption are as old as time itself - what is really
needed is for people to develop the internal dialog of 'i can't afford that,
forget it'

------
grandalf
The way bankruptcy laws are, 20% is probably pretty reasonable considering
that the vehicle's value decreases pretty rapidly.

I'm curious whether companies like Affirm will figure out ways to improve upon
this.

~~~
cowsandmilk
If you have good credit, you can get rates under 2% on a new car and your
lender will negotiate a lower car price for you since that will lower their
risk.

If you have poor credit, you likely will end up at a sleazy dealership that
overcharges you on the price and you end up with the 20% interest rate to take
care of the risk.

~~~
stephenbez
How do you get a lender to negotiate a lower car price for you?

~~~
grandalf
To the extent that the collateral value of the purchased item impacts the
lender's overall risk, all lenders have an incentive to drive down the
purchase price to reduce risk (since this reduces the difference between the
loan amount and the collateral value).

The value of that risk reduction is relatively insignificant to the lender,
but some offer services like that (car buying services) to help attract
desirable borrowers.

------
shenoyroopesh
> Dane Carpe, of Creswell, Ore., lost his 2008 Dodge Charger when he could not
> repay the $17,116 he borrowed at a 23.74 percent interest rate. Credit Carl
> Kiilsgaard for The New York Times

What?! 23.74%? That's nearly as bad as credit card debt. And for an auto loan?

It's one thing to pay higher interest rate for credit risk, but totally
another to not understand basic financials - if you already have bad credit,
you want to build up your finances, not dig a deeper hole by purchasing things
you cannot afford, at interest rates you cannot afford.

A good case to improve financial literacy amongst the masses?

I think this is equivalent to money-lenders in India fleecing poor, illiterate
farmers who don't even understand the interest rate they are paying.

------
kazinator
I'm all for it. The winners here are the poor who get behind reasonable
wheels, so they can improve their lives. The losers are some greedy suckers
who believe in the future performance promises of some mutual fund.

"I bought into an investment backed by a loan to some poor people to get cars
... boy did I get taken for a ride!" :)

------
adamdeloach45
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------
adamdeloach45
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------
heck818
Why not? There are winners and losers in every game.

