“A thought crossed his mind: How do you make poor people feel wealthy when wages are stagnant? You give them cheap loans.”
― Michael Lewis: The Big Short
If you have seen the recent movie or read the book entitled “The Big Short” by Michael Lewis, you have a very real picture of the gravity of the last U.S. financial crisis in housing.
Many of you don’t need the movie or book to understand the damage the housing crisis did to the economy and everyday people. It just wasn’t the risk taking house flippers or folks who bit off more than they can chew who suffered from the crisis. It was nearly everyone who owned real estate.
What the majority of investors didn’t get prior to Michael Lewis popularizing history is the fact that a small group of savvy traders made an absolute fortune by correctly predicting and shorting the financial crisis. In other words, everyone’s loss was this small group’s massive gain.
Imagine being on the short side of the big crash!
You likely believe that it’s too late to profit from any potential financial crisis in the United States. That Janet Yellen and the Federal Reserve have everything under control now and that its near impossible to such a scenario to ever happen again.
Well, when markets become bubbles and the bubble bursts even the Federal Reserve can be powerless to intercede.
Right now there are significant signs that another bubble is brewing in the U.S. financial system.
The good news is that it’s not too late to create your very own Big Short.
While it’s not time right now to jump on the short train, we have identified three stocks that will likely make fantastically lucrative shorts once this next financial bubble bursts.
If you haven’t guessed it, I am talking about the subprime auto loan bubble. Some of you may have direct experience with the world of sub-prime auto loan debt, others, I am certain have read or heard about this vexing issue. The similarities of the pending sub-prime auto loan crisis to the housing crisis are uncanny.
Pre- 2007, almost anyone could obtain a mortgage for housing. There are verified stories of day laborers earning $14,000 per year obtaining a mortgage to buy a $740,000 home. Stories like this abound during the era of the so-called liar and NINJA loans. NINJA stood for no income, no job, no assets. Basically, if you were able to breathe, some mortgage company would give you a loan.
Right now, auto lenders are making a tremendous number of subprime loans. According to the Center for Responsible Lending outstanding auto loan balances reached a record-breaking $870 billion in the third quarter of this 2014, an increase of 9.9% and 24.5% over the same periods in 2013 and 2012, respectively. As of the end of the third quarter of 2014, loans to consumers with below prime credit comprised 38.7% of open accounts, totaling over $336 billion. Also, according to the Federal Reserve, “The dollar value of originations to people with credit scores below 660 has roughly doubled since 2009, while originations for the other credit score groups increased by only about half.” Likewise, subprime auto loan securitization issuances stood at $13.7 billion in 2013, more than 12 times the issuances in 2009.
In addition, repossession rates are skyrocketing. The Center reports that in every quarter since 3Q 2013, repossession rates have been significantly higher than the same quarter in the previous year. Most alarming, the 2Q 2014 repossession rate was 70% higher than 2Q 2013. This increase is also evidenced in the auto loan asset backed securities (ABS) market. Both delinquency and net loss rates have increased from their post-recession lows in 2011, and are projected to continue that trajectory in the near future.
The icing on the cake that puts fear into everyone who truly understands what is going on is the fact that Loan to Value ratios and loan time frames are rapidly increasing.
It is now common place for lenders to allow car dealers to offer loans that exceed the value of the car. The reason for this is that LTV ratios above 100% create greater profits for the dealer. The dealer can now roll very profitable items such as extended warranties and credit insurance into the deal.
Worse yet is the fact that high LTV ratios permit dealers to finance “negative equity”. Negative equity is the money still owed when a trade-in vehicle is worth less than the outstanding balance of the loan on the trade-in. This enables the auto dealer to sell more cars but at the same time pushes consumers deeper into debt. Many of these sub-prime borrowers are just one pay check away from defaulting and the higher the debt the deeper the problem.
Add longer terms to the mix and it paints a very frightening picture.
Lenders are extending loan terms to as long as 96 months. Longer loan terms result in the borrower owing more than the car is worth for the bulk of the loan term. The Office of the Comptroller of the Currency (OCC), reported “The average loss per vehicle has risen substantially in the past two years, an indication of how longer terms and higher LTVs can increase exposure.”
Now that we understand the gravity of the situation, how can this knowledge be used to create another Big Short?
We have identified three companies that will suffer greatly once the sub-prime auto loan bubble bursts. Here they are in order of significance in the sub-prime auto loan sector.
- Santander Consumer (NYSE:SC)
This Spanish bank is the leader in the subprime auto sector. It’s wholly owned Chrysler Financial is notorious for being extremely aggressive when it comes to loan approval. 98% of Santander’s consumer lending is targeted at auto buyers. Out of this 98%, about one half is provided to buyers with credit scores below 640, therefore subprime.
Most damning of all for Santander is the fact that the SEC, the New York Department of Financial Services and the Consumer Finance Protection Bureau are all digging into the company’s lending policies. These agencies are very suspicious of Santander’s practices and if something significant is found, look out below!
- Ally Financial (NYSE:ALLY)
This rebranded GMAC has been ramping up its exposure to sub-prime auto loans. CEO Jeffrey Brown told Reuters that the company, the largest U.S. auto lender, is ramping up its risk-taking even as some government officials grow increasingly concerned about the area. Ally is one of several auto lenders that have received subpoenas in recent months from the U.S. Department of Justice over subprime lending practices, an area that prosecutors are examining for fraud and other abuses using lessons they learned from crisis-era cases.
Unlike other lenders, Ally had been prohibited from using deposits at its bank to fund subprime auto loans because it was still under partial government ownership. But after fully repaying taxpayers in December, Ally can now make the loans through its bank, cutting its funding costs by around 45 percent, Brown said.
3. Wells Fargo (NYSE:WFC)
Wells Fargo recently opened around 60 new branches in the United States targeting the auto lending business.
The company lent over $30 billion to auto buyers last year. Intelligently, WFC has stated that it will cap its sub-prime auto at 10% of its auto portfolio.
However, at the same time, the company’s auto loan portfolio is expanding significantly while it is cutting back on its mortgage holdings.
If you own any of these three subprime stocks, seriously consider selling them now. Huge profits are possible on the short side for traders who can time their entries into the shorts.