“US subprime auto bears will have their day-Aggressive expansion of the market in recent years will create more winners than losers” from the Financial Times
April 27, 2018
In December 2015 Ben Weinger started betting on a fall in the shares of Credit Acceptance Corp, a Detroit-based supplier of car loans to people who might struggle to pay them back. Then, the price of the shares was about $220. Now it is around $330.
For two years in a row the bet has been among the worst performing of Mr Weinger’s New York hedge fund, 3-Sigma Value. Last year the fund handed investors a “piddly” return of 0.2 per cent, net of fees.
“We are not market timers,” Mr Weinger wrote in a slightly mournful year-end letter to investors.
Being bearish on subprime auto has not been easy. Total loans across the industry have soared since a trough in 2010, up more than 70 per cent to $1.22tn, as lenders doubled down on exposure to a sector that came through the 2008/09 financial crisis in relatively good shape. That gave a big boost to the bottom end, where millions of consumers struggling under low and irregular incomes have needed wheels to get around, and where yield-starved debt investors have been very keen to put up the money.
New lenders piled in, many of them backed by private equity firms such as Blackstone, Perella Weinberg and Lee Equity Partners. In the first few years after the crisis the top three issuers of securities backed by subprime auto loans (ABS) accounted for about 90 per cent of the total, according to Standard & Poor’s. By 2014 that share had dropped to about two-thirds and it has stayed there ever since.
Many of the newcomers reached out to riskier borrowers, cranking up loan-to-value ratios and debt-to-income ratios, as they tried to build a business. Some lenders stretched out the terms of the loans, too, moving from the standard 60-month contract to 72 or even 84. (That increases their exposure to falling used-car prices, if the borrower defaults and the lender has to repossess an older, shabbier model.)
One of the hairier ABS deals came from Honor Finance of Evanston, Illinois, which is majority- owned by CIVC Partners, a Chicago-based private
equity firm. In its debut $100m offer in December 2016, two-thirds of the borrowers had scores below 550 on the commonly used FICO scale, which normally means “very bad” credit in need of urgent repair. One quarter of the borrowers had no FICO score at all. “At Honor Finance,” the slogan runs, “you are more than a scorecard.”
The heightened competition made it tough going, even for the biggest players such as Santander Consumer, the Dallas-based specialist that accounted for a third of the subprime ABS market last year. Total volumes so far this year are $7.9bn, on course to beat 2017’s record haul of $25.4bn.
“You’d rather compete against someone trying to be profitable, rather than getting to market share,” said Brian Foran, analyst at Autonomous Research in New York.
But now a shake-out could be coming. Recent weeks have seen a succession of smaller outfits pulling down the shutters, hurt by a combination of higher losses on loans, and rising interest rates, which pushes up the cost of funding.
Casualties include Pelican Auto Finance, which shut up shop last month. Perella Weinberg, meanwhile, has seen higher-than-expected defaults at one of its fund investments, Flagship Credit Acceptance, which is based next door to Pelican in Chadds Ford, Pennsylvania. An initial public offering of Flagship, originally slated for 2015, does not appear imminent.
Perella and Flexpoint Ford, which backed Pelican, both declined to comment.
More of the fringe players are likely to beat a retreat, says Chris Gillock, managing director of Colonnade, a Chicago-based investment bank.
“Everybody was storming the gates trying to acquire enough assets to bust through the break-even point, so they all booked a bunch of crap deals. And if that’s all you had in your portfolio, that’s a problem. You can’t sweat through it.”
Santander could be beginning to see the benefits of the pullback: this week shares in the company leapt about one-fifth after it said first-quarter originations rose 18 per cent from a year earlier to $6.3bn.
As for Mr Weinger of 3-Sigma, he is still shorting Credit Acceptance, the fourth-biggest subprime ABS issuer this year, based on a mix of what he describes as thin disclosures, weird accounting and sub-par corporate governance. Credit Acceptance did not immediately comment.
“All we know is that if we stay disciplined to our market agnostic process and intellectually honest in its application then we will outperform over the course of a cycle,” he wrote in his year-end letter.
By: Ben McLannahan