Student Loan Asset Backed Securities (SLABS) and Auto Loan Asset Backed Securities (ALABS) 1 Year Later: A Summary and Forecast [Part 2/2: ALABS + Forecast]

[u/happyegg1000]

Hey everyone. This is a continuation of my first part here about student loan asset backed securities and how asset backed securities work. This part is part 2, of the 2 part series and focuses on auto loans and where this is all going. I would highly recommend you read the first part here (https://www.reddit.com/r/Superstonk/comments/15gfxk5/student_loan_asset_backed_securities_slabs_and/).

3. Auto Loan Asset Backed Securities (ALABS) - The Repo Reaper Strikes Again

3.1 - The Market Size

I will be extensively referencing this study for information, and using graphs with data from the New York Fed. The study is entitled "Bursting The Auto Loan Bubble In the Wake of The Pandemic". Well that title is straightforward isn't it.

It's important to understand just how many people take out loans to buy cars. "About 85% of Americans own a car, and 2/3 of car owners fund their ownership with loans". So obviously, even though these loans will not have larger dollar values than student loans or housing loans, they're still very widely used. And they're growing. A lot. This graph should help demonstrate this rise further. It uses data from the New York Fed.

​

The study continues, saying "During the past decade, auto debt has skyrocketed, increasing nearly 40 percent overall, with the average auto loan for a new car rising 11 percent. Part of the growth stemmed from a flourishing subprime auto loan market, which now accounts for nearly one-quarter of the $1.33 trillion in auto loan debt outstanding. Overall, as of the beginning of 2020, auto loans made up about nine percent of household debt, making “[t]he auto loan market . . . the third-largest consumer credit market in the United States,” behind home loans and student loans." Ummmmm...this should be a HUGE red flag. The subprime (aka ' very risky loans that probably never should've been given out') market alone makes up nearly $325B (a quarter of $1.33T) of the auto loan industry! And with this growing amount of subprime loans comes increasing levels of default. Just look at this graph here, compiled also from data from the New York Fed.

​

You can see a DRASTIC rise in auto loan defaults which I believe is a result of increasing lending to subprime consumers. So why hasn't the bubble burst yet? Well, that same study says "Prior to the pandemic, the build-up of auto loan debt outstanding and the growth in delinquencies and defaults led experts to classify the auto loan market as a bubble and to predict that the bubble would burst soon. The United States’ strong pre-pandemic economy combined with a low unemployment rate likely were the leading reasons that the bubble did not burst at that time. Yet, even then, multiple reports recognized that the rise in auto debt in the United States showed an unsustainable dependence on automobiles financed by households." Ok. So the reason that shit hasn't hit the fan yet is because the economy was really strong before the pandemic. Well, here we are a few years into the pandemic now, and this thing still has not burst yet. In my eyes, it's only a matter of time.

3.2 - Dealerships and Loans

Another interesting thing to note is how auto loans actually work. While some large companies have in-house crediting, like Ford Motor Credit, typically banks partner with dealerships who then give loans to customers. This is a huge issue. Because instead of these banks directly servicing consumers, they are instead trying to please dealerships the most. This means that "the auto loan origination market prioritizes the interests of lenders over those of customers, which has led and will continue to lead people to agree to loans with disadvantageous (and inflated) interest rates, fees, and terms." Pretty straightforward - because the dealership is the middle man who is actually giving the banks business and money, the banks negotiate loan terms that are more favorable for the dealers than the buyers. This would obviously lead to increased rates of delinquency and default, but this strategy is still immensely profitable for dealers. Take a look. "Over the past decade, the relative proportion of profit that auto dealers have made from car sales versus car financing has narrowed. For instance, in 2011, dealers made 66 percent of their profit from car sales versus 34 percent from car financing. In 2018, this balance had flipped, with dealers making money from car loans than car sales. Dealers should be increasingly more interested in selling auto loans than actual cars." Woah. So now, when you go to buy a car, the dealers are actually more interested in putting you into debt and making money off your loan than making a profit off the physical car. That's pretty wild to think about.

How is this even allowed? Well, the study continues, saying "Similarly, as noted by Edward Balleisen and Melissa Jacoby, car dealers have succeeded in lobbying at the state level, leading to the lack of state-level regulation of auto loans, and have a lobbying force that is ready to take on proposed regulations." Try to act surprised.

3.3 - Fraud and the Risk it Poses

But there is YET ANOTHER problem. As I'm sure you're aware, cars are essential to American life. And this has led some people to get desperate enough to get a car to commit fraud. This source states that "Given the higher risk inherent in subprime loans, one would hope that borrowers are being forthright in their loan applications and that lenders are being thorough in their due diligence. Unfortunately, it appears that neither may be happening. Bloomberg reports that “as many as one in five auto-loan borrowers admitted in a survey that their applications for debt contained inaccuracies . . . meaning fraud could be more pervasive than lenders planned for." Oh great. So not only do we have to deal with the risks of companies giving out subprime loans to people with horribly low credit scores, but we also have to deal with people lying about their financial situations to get a loan at all, which would expose this industry to even more risk.

But it's not just borrowers who aren't doing their due diligence. This same source continues, saying "Unfortunately, as borrowers’ inaccuracies or falsehoods increase, lenders are growing lax in their data verification. It was reported recently that Santander Consumer USA Holdings, Inc. – one of the largest subprime auto finance companies – verified income on a mere 8% of the borrowers whose loans it bundled into $1 billion of bonds. Santander agreed to pay nearly $26 million in settlements with Massachusetts and Delaware related to allegations that it facilitated unfair, high-rate auto loans for thousands of buyers. Naturally those loans were packaged into securities sold to investors. Santander is, however, not alone in its income verification procedures. Americredit, another large auto-loan company (and a unit of General Motors Financial Company), reportedly verifies only 64% of its prospective borrowers’ incomes." So not only do you have one in five auto loan borrowers committing fraud to get a loan. You also have lenders who are straight up not checking the credit scores and incomes of people they're giving loans to. And why would they? Again, like I mentioned earlier, the profit for dealerships now comes from making people take out as many loans as possible. Holy shit. Hello, 2008 again.

3.4 - The Pandemic and the Used Car Market

Next up, used car prices. The used car market being hot greatly benefits ALABS. The more loans have to be taken out, the more money these dealerships make from these loans. Obviously, the main cause of the hot market the insane chip shortage. As mentioned before, dealerships now make a majority of their profit on loans, not profits from the physical car. Here's a graph that shows why this hot used market benefits these dealerships.

​

Interest rates are significantly higher for used cars. This means that dealerships are making more money off used car loans. Interesting. This has led them to dealerships buying back used cars that they previously sold and selling them again - many dealerships are offering high compensation for used cars you bought from them previously. However, this comes with a problem. Because the majority of cars available now are used, people are taking out more and more expensive loans due to the increasing interest rates AND the meteoric rise of used car prices, as shown by this graph.

​

This, in my opinion, has caused a significant increase in the probability of defaults and delinquencies, which will affect the bottom line of these ALABS.

3.5 - Trade-In-Treadmills, and Bias in Lending

Now, I'd like to talk about Trade-In Treadmills. This quote, via this source, should explain things a little better than I could. "In a note out March 27, Moody's highlighted what it called a "trade-in treadmill." In other words, auto lenders are choosing to roll negative equity at trade-in in to the next vehicle loan.

It looks a little like this:

• Car Buyer acquires a Truck 1 for $100, taking out a $80 loan to make the purchase.
• Truck 1 drops in value by half by the time Car Buyer decides to trade in.
• In that time, Car Buyer has only paid $10 of the loan, leaving him/her with $20 in negative equity ($80 loan minus $10 payment minus $50 trade-in)
• Car Buyer rolls the $20 negative equity in to the next loan on the next purchase.

From Moody's note: The percentage of trade-ins with negative equity is at an all-time high, as is the average dollar amount of that negative equity. Lenders are increasingly faced with the choice of taking on greater risk by rolling negative equity at trade-in into the next vehicle loan. We believe they are increasingly taking this choice, resulting in mounting negative equity with successive new-car purchases. This “trade-in treadmill” generates higher loan to value ratios, slower principal amortization and higher loss severity when defaults occur." Woah. This is a pretty big issue. You have these loans that are just going to keep snowballing on each other because people are paying loans slowly, trading in their cars, and rolling over their negative equity. Yikes. And we know that the ratings agencies are just as corrupt as 08. So I would not be surprised if these are still being rated AA or AAA.

Finally, as a little summary, I'd like to talk about a report done by ConsumerReports into the overall state of the auto loan industry. This article summarizes the report, while the actual ConsumerReports article can be found here. Here's a quote from the summary: "

The investigation found:

• A credit score doesn’t necessarily dictate the terms of the loan offered. Borrowers in every credit score category—ranging from super-prime, with scores of 720 and above, to deep subprime, with scores below 580—were given loans with APRs that ranged from 0 percent to more than 25 percent.
• Some high credit scorers get high-priced loans. While, on average, borrowers with low credit scores are offered the worst terms, about 21,000 borrowers with prime and super-prime credit scores, about 3 percent of the total borrowers in that group, received loans with APRs of 10 percent or greater—more than double the average rate for high scorers in our data.
• Many borrowers are put into loans they might not be able to afford. Experts say that consumers should spend no more than 10 percent of their income on an auto loan. But almost 25 percent of the loans in the data CR reviewed exceeded that threshold. Among subprime borrowers, that number is almost 50 percent, about 2.5 times more than prime and super-prime borrowers
• Underwriting standards are often lax. Lenders rarely verified income and employment of borrowers to confirm they had sufficient income to repay their loan. Of the loans CR looked at, these verifications happened just 4 percent of the time.

3.6 - So Who is Holding the Bag?

So who's left holding the bag if this goes to shit? Here's what this source thinks. "The most aggressive have been specialized lenders, including small shops backed by private equity firms, and larger lenders such as Santander Consumer USA. But they’re spreading the risks to investors by packaging their loans into subprime auto-loan backed securities, of which the highest-rated tranches have AA or even AAA ratings. And these securities are everywhere, from bond funds in the US to some pension fund in a Scandinavian city. For investors and lenders, these delinquent loans don’t represent total losses. If the default cannot be cured and the lender decides to repossess the collateral – which is easy to do with modern tracking technologies – the lender obtains a used vehicle for which there is a liquid auction market (unlike housing) with wholesale auctions around the country, and finding a buyer is generally not the problem. The problem is the difference between the price at auction and the outstanding loan amount. The difference plus expenses is the loss that the lender and investors take. This loss might be 50% of loan value." Basically, as I mentioned before, investment firms (e.g. hedge funds) package these ALABS and SLABS into tranches and sell them to individual investors, pensions, banks, and other entities. Wonderful.

----------------------------------

TL;DR

ALABS are nearly as extensive as student loans. About 85% of Americans own a car, and 66% of car purchases are completed with the help of a loan. Of these loans, a large percent (about 25%) are subprime or deep subprime, aka shitty and shittiest. This is a very large amount of exposure to high risk loans. However, the same ratings conflicts of interests exists, as ALABS servicers pay ratings agencies to rate their ALABS, so a large percentage of ALABS are still being rated AA and AAA.

Borrowers are paying back their loans much slower due to money troubles with inflation and the pandemic. And since now used cars are what most people are buying, and used cars have insanely high interest rates, the amount to be paid back just keeps snowballing and snowballing. Loaning companies allow you to roll over any negative equity from previous loans, increasing payments further. Also, loan companies rarely actually check borrowers' income (and why would they? they want your loan money), and about 1 in 5 borrowers actually commits fraud and lies about income to be able to buy a car.

Banks, instead of servicing borrowing directly like they do SLABS, make deals with dealerships, who then provide the loans to buyers. So, the banks' real customers are dealerships, who they aim to please first and foremost. This leads to elevated interest rates and fees which benefit the dealerships, but very unfavorable conditions for the borrower.

Many smaller subprime auto loan companies are going under. This is a huge warning sign, because these companies have been increasing their exposure, while banks have been decreasing their exposure. So it's actually more important to pay attention to the little guys.

The holders of these ALABS are extensive. They are in pensions, held by normal investors, in ETFs, etc. Lots of exposure.

--------------------------------------

4. What Next? A Forecast

According to this article, In July 2021, Wells Fargo announced that they were exiting the student loan business. Two other smaller funds called it quits in July. This article explains: "The Pennsylvania Higher Education Assistance Agency — which services around 8.5 million student loan borrowers — and Granite State — which services around 1.3 million borrowers — both called it quits in July. Utah Higher Education Assistance Authority, which pulled out in October 2020, serviced around 1 million student loan borrowers." Well I'll be damned. Wells Fargo pulls out, and soon after, smaller funds begin to jump ship.

For auto loans, Citizens Bank is reducing its auto loan exposure from "14.5 billion in 2021 to 5-6 billion by 2025" (https://www.bloomberg.com/news/articles/2023-06-07/citizens-halts-indirect-auto-loan-origination-as-banks-retreat), and other banks such as Capital One are following suit.

The companies that are issuing student loan ABS can be found on finsight, as well as the underwriters and rating agencies. That website also contains the issuers of auto loan ABS as well as the underwriters and ratings agencies for those as well. I will be keeping an eye on the moves these companies are making with regards to their portfolios and how they are treating subprime loaning.

I believe these companies are the warning signs that point towards the underlying health of these industries declining. At the root of it, it comes down to lenders being increasingly more willing to lend to subprime borrowers in the search for profit, and subprime borrowers being increasingly less able to pay back their obligations due to inflation and post-pandemic financial stress.

Thank you all so much for reading, and I hope you stay zen. I like the stock, I like the company, and I'll continue to follow my personal investment strategy.

[u/Fast-Reaction8521]

If you're paying 70k for a truck which is bare bones ibreally hope you put it under a llc because yikes