These PE Firms Are About To Get Crushed By Their Subprime Auto Bets

In the aftermath of the "great recession," private equity firms placed massive bets on subprime auto finance companies with the typical "thesis" going something like this: "well, people have to get to work don"t they?"...genius, if we understand it correctly.

Of course, the "thesis" seemed to be confirmed when auto securitizations performed relatively well throughout the financial crisis, amid a sea of mortgage bonds getting wiped out, and private equity titans were off to the races with wall street titans from Perella Weinberg to Blackstone and KKR scooping stakes in small niche lenders.

Unfortunately, as Bloomberg points out today, the $3 billion bet on subprime auto lenders hasn"t played out precisely to plan as the "well, people have to get to work" thesis has proved to be somewhat less than full proof.

A Perella Weinberg Partners fund has been sitting on an IPO of Flagship Credit Acceptance for two years as bad loan write-offs push it into the red. Blackstone Group LP has struggled to make Exeter Finance profitable, despite sinking almost a half-billion dollars into the lender since 2011 and shaking up the C-suite multiple times. And Wall Street bankers in private say others would love to cash out too, but there’s currently no market for such exits.

 

Since the turn of the decade, buyout firms, hedge funds and other private investors have staked at least $3 billion on non-bank auto lenders, according to Colonnade. Among PE firms, everyone from Blackstone and KKR & Co. to Lee Equity Partners, Altamont Capital and CIVC Partners waded in.

 

Many targeted smaller finance companies that often catered to the least creditworthy borrowers with nowhere else to turn. Overall, subprime car loans -- those extended to people with credit scores of 620 or lower -- have increased 72 percent since 2011. Last year, about 20 percent of all new car loans went to subprime borrowers.

 

“The PE guys sailed into this thing with stars in their eyes. Some of the businesses have done fine and some haven’t,” said Chris Gillock, managing director at Colonnade Advisors, a boutique investment bank. But right now, “it’s about as out-of-favor a sector as I can think of.”

Of course, the turnaround strategy was "simple." Given that subrpime auto collateral held up well during the great recession, private equity investors figured they were sitting on rock solid collateral that would holdup under even the most egregious loosening of underwriting standards.  Therefore, given that there was "no downside", lenders wholeheartedly embraced deteriorating underwriting standards, like stretching out terms so borrowers could "afford" cars they couldn"t really afford, as a way to grow their loans books. 

Alas, it didn"t work out as planned as subprime delinquencies are suddenly soaring and used car prices are tanking...making profits somewhat elusive.

Take Exeter. The company, which is licensed in all 50 states and works with roughly 10,000 dealerships, hasn’t been profitable since 2011, when Blackstone took a majority stake, an S&P Global Ratings report in September showed. That’s after the PE firm invested $472 million to help Exeter expand and cycled through three CEOs at the lender.

 

On a pretax basis, Exeter turned a profit in 2016 and 2017, according to Matthew Anderson, a spokesman at Blackstone. He added the New York-based firm hasn’t tried to sell the lender.

 

Blackstone may look to unload Exeter later next year, said a person familiar with the matter, who asked not to be identified because it’s private.

 

Bad loans remain an issue. This year, a rash of delinquencies in two bonds stuffed with loans that Exeter made in 2015 caused the securities to dip into their extra collateral to keep investors whole.

 

Another example is Flagship, which Perella Weinberg bought in 2010. (Innovatus Capital Partners, which manages the lender on behalf of Perella Weinberg, was formed by former Perella Weinberg managers last year after they split from the firm.)

As it turns out, the "well, people have to get to work" thesis only works to the extent that auto manufacturers maintain some level of discipline and refrain from exploiting their captive finance companies to flood the market with new supply...a move which will eventually lead to crashing used car prices and massive subprime securitization losses.

Unfortunately, as we pointed out last month, a review of the latest Fed data on auto loans underwritten by "Banks and Credit Unions" compared to those loans provided by "Auto Finance" companies prove that the nightmare scenario is playing out for subprime lenders...

First, taking a look at auto loans provided by traditional banks and credit unions, one can see some marginal deterioration in subprime auto loans.  That said, the deterioration is certainly nothing substantial with 90-day delinquencies pretty much in line with 2004/2005 levels and no where near the rates experienced in 2008/2009.

 

 

But, a drastically different picture emerges when looking at just the auto loans originated by America"s auto finance captives.  To our great "shock", auto OEMs in the U.S. seem to have been much more "flexible" on underwriting standards over the past couple of years resulting in delinquency rates that nearly rival those last experienced at the height of the great recession.

 

Of course, we"re sure that GM Financial and Ford Motor Credit just got unlucky with their deteriorating credit portfolios...certainly they would never knowingly attempt to game their own short-term financial success by putting millions of Americans into cars they can"t possibly afford, right?

Exposing Who's Behind Surging Subprime Delinquencies (Hint: Rhymes With 'Perennials')

For months now we"ve been writing about the mysteriously rising subprime delinquencies afflicting auto ABS structures despite repeated confirmations from the Fed and equity markets that "everything is awesome" (see "Auto Bubble Burst Begins As Subprime Delinquencies Soar To 2009 Levels" and "Signs Of An Auto Bubble: Soaring Delinquencies In These 266 Subprime ABS Deals Can"t Be Good" for a couple of recent examples).  Shockingly, as confirmed by the chart below from UBS strategist Matthew Mish, 2016 vintage subprime auto ABS structures are even underperforming 2007/2008 vintage securitizations.

Now, Mish is back with more survey data explaining the who/what/when/where/why"s of spiking loan delinquencies. 

Ironically, survey results suggest that households making over $100,000 per year are 2.5x more likely to default on loan payments over the next 12 months than those making under $40,000...because making more money just means you can afford more debt, right?

First, the survey evidence suggests the rise in consumer default perceptions has occurred primarily in the middle and upper household incomes cohort. And those consumers concerned with missing a payment are highest in the upper income category (household incomes of $100k+). In particular, the most elevated readings occur at the lower ends of the middle and higher income categories (i.e., 50-74k and 100-149k, respectively.

Of course, the most "shocking" results of the survey suggest that our precious snowflake millennials are over 5x more likely to default than folks aged 45 and above.  That said, we suspect that many of those defaults may come from student loan debt...which is totally bogus because higher education should be "totes free", right?

In another shocking discovery, people with the most debt were also found to be most at risk of default...who knew?

Oddly, however, households who reported being able to cover their monthly expenses were more at risk of default than households burning through cash each month...sounds like these folks have picked up some valuable lessons from Tesla on how to burn through cash without defaulting...

Finally, this last chart was intended to shed light on why certain households are more likely to default but, in the end, the "no specific reason" category dominated responses leading UBS to conclude that people are just far more comfortable defaulting on debt, in general, in the post-crisis era.

This mosaic seems quite consistent with the reported concerns earlier around limited positive cash flow (income vs expenses) and the broader reality that real median wage growth has been largely non-existent in recent years (and for several decades) despite rising debt levels. However, the most commonly cited reason continues to be "no specific reason". While difficult to prove decisively other survey results on the millennial generation specifically seem to be consistent with the thesis that US consumer willingness to default (or the lack of stigma associated with bankruptcy) may have increased further in the post-crisis era.

To summarize the UBS survey results, increasing delinquencies are being driven by millennials who graduated college with massive student debt balances, but were making decent money so they levered up even more to buy a house (or 2), a couple of cars and a timeshare.  That said, now that the earnings growth they expected has failed to materialize, their sense of entitlement has taken over and they"ve decided to socialize their debt burdens while completely ignoring the stigmas associated with such actions.

Where Are America's Subprime Borrowers Located

The St. Louis Fed"s FRED Blog has released an interested piece showing the geographical distribution of America"s subprime borrowers.

As author Maximiliano Dvorkin writes, most economists agree the financial sector and high levels of household debt played an important role in the last recession. But since 2008, the levels of both household debt relative to income and debt service payments relative to income have fallen. The reasons for the fall appear driven by a lower demand for credit by borrowers or stricter lending requirements by lenders. Nonetheless, an important implication of lower levels of debt and lower debt payments is an improvement in borrowers’ credit scores, as these factors would translate into less debt and fewer missed payments, which have an important weight in how these scores are computed.

The two graphs show the percentage of the population with a credit score below 660 in each U.S. county in 2009 and 2016. A person with a score below 660 will have a harder time securing credit from a lender and may have to pay a higher interest rate if a loan is secured, then again as reported earlier today, adjustments to how the FICO score is being calculated will provide an artificial boost to some 12 million Americans in the coming months.

Comparing 2009 and 2016, we see that the percentage of the population with a subprime credit score has decreased, consistent with some of the recent changes described above.

2009

2016

In addition, the graphs show that counties in the south and southeast have a larger-than-average concentration of subprime population. That said, the graphs clear do not account for impaired student loans which do not for the most part affect FICO scores, and which at $1.4 trillion, have become by far the biggest burden on the US consumer, and whose adverse impact the government has been actively coverng up. A recent breakdown of average student debt per borrower by state from the Dallas Fed shows a rather different distribution. One wonders what the above maps would look like if they incorporated the amount of delinquent student debt as well.

Auto Lending Update - Someone Please Explain How This Is Not A Bubble

Experian recently released their Q4 2016 Automotive Finance Market update which includes a lot of statistics that seem to confirm our frequently documented concerns about the sustainability of the current level of annual auto sales (see here, here and here for our recent notes on the topic).

First, there is the staggering growth of auto loans outstanding.  It should be readily apparent to almost anyone that a 21% expansion in credit issuance over the course of just two years likely implies there has been at least some degradation in underwriting standards.

But you don"t have to speculate as Experian lays out the facts...and, sure enough, the outstanding loan balances of "Deep Subprime" borrowers have increased by double the amount of any other bucket, other than the plain "Subprime" folks, of course.

Of course, an impaired credit profile has, in no way, hampered America"s entitled consumers" demand for driving around in style as average subprime loan balances actually exceed "Super Prime."

But don"t worry, those subprime borrowers can "afford" those loans because they simply offset higher interest costs with stretched out terms...

...which keeps there average monthly payments low.

But, despite all the financial engineering, a look at 60-day auto delinquencies around the country may imply that the auto party is slowly coming to an end.

But sure, auto sales should be perfectly sustainable around 18mm per year...