Please shoot me down, if you can

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Jul 16, 2010 9:42 am

I am carefully looking into investing/buying non-prime automobile notes. They are currently yielding between 15%-24% annually with an average of 3 1/2 year maturities. The Lost Decade, where the stock market and now the real estate market have produced nearly zero returns and other fixed income alternative are at historic lows, I am looking for an alternative. 

For the first time in US history, people are defaulting on home loans instead of credit cards and credit cards before car loans (nobody wants to have to walk to work, school or the grocery store).  Moreover it was recently announced that over 43 million Americans have FICO scores below 599. At the worst part of the current recession, defaults never went above 10%. 

In addition to a rigorous underwriting process (no liar loans here), GPS systems are installed on all vehicles that are financed. This safeguards the collateral and reduces asset recovery to about 48 hours (rather than a lengthy and costly foreclosure in the case of a mortgage loan). In addition, the vehicles must carry insurance and have an overlay of Gap Insurance paid for by the borrower. 

Barring a full scale depression, I think this investment holds some merit. Thoughts? 

Jul 16, 2010 12:30 pm

Ok, I'm just going to pretend you're serious, and not the guy trying to wholesale these.

A 30% loan default with 50% recapture brings the rate down to pretty much zero.

Jul 16, 2010 12:43 pm

BF, where did you get the 30%-50% figures? This may be a decent investment with speculative money. My one concern is, if we really go into "depression" category, what will the default rate grow to and will that kill the value of the underlying asset? I would think these notes would be more secure in a flat or slight economy. Depression means deflation.

Jul 16, 2010 12:50 pm

Do you mean from places like BuyCarNotes.com? 

All I can say is that you and your clients have some big ones to take the risk on buying car notes from the folks that buy cars at the buy here/pay here car lots. 

In theory it sounds fantastic.  How can you argue with almost 20% returns?  That's what my clients thought about GMAC Smartnotes at 7.5%.  That one turned out great! 

I would assume you're not putting much more than 2-3% of a clients agressive money into something like this.  Right? 

Just a quick story.  A client of mine used to own one of those car lots.  He said he sold the same car on average about 4 times.  People would buy it (rarely for cash), they'd drive it for a while, stop making payments, and he'd go get it.  He said he charged over 20% in interest on those cars.  He sold the lot after his stomach just couldn't handle doing that to people anymore. 

If you can get past that with your clients, it might actually work out for you.  Question - how do the clients sell the notes if they need to get to cash quickly?  How is it priced?   

Jul 16, 2010 1:00 pm

[quote=navet]

BF, where did you get the 30%-50% figures? This may be a decent investment with speculative money. My one concern is, if we really go into "depression" category, what will the default rate grow to and will that kill the value of the underlying asset? I would think these notes would be more secure in a flat or slight economy. Depression means deflation.

[/quote]

The key to longevity in this biz is knowing how not to blow yourself up. I have nothing on my record, and I keep it that way... A little bit of bad, can go a long way in killing yourself. In spring of 2007 for example.... Every financial institution was at the window trying to issue bonds and preferreds. The terms were lucrative, rates high, the ratings even AAA. I could have made 2-3pts selling the stuff, and it would have been easy. Instead, I bought only GE and FNM and FRE bonds, NOT the preferreds. We sold off every financial holding we could. I remember a FNM preferred that was AAA and had a 7.5 coupon, and that sucker defaulted before the first interest payment was EVER MADE.... I was paying attention, worked at a bank that was issuing AWFUL loans, and avoided the mess, meanwhile my colleagues thought I was being tin foil hatted. Avoiding the financial melt down saved my career, and in the years ahead will have made all the difference.

Jul 16, 2010 5:19 pm

Shoot you down?  How about with a bazooka!  Don't lead your clients into this mess or you will probably regret it.

Jul 17, 2010 1:52 am

[quote=BigFirepower]

[quote=navet]

BF, where did you get the 30%-50% figures? This may be a decent investment with speculative money. My one concern is, if we really go into "depression" category, what will the default rate grow to and will that kill the value of the underlying asset? I would think these notes would be more secure in a flat or slight economy. Depression means deflation.

[/quote]

The key to longevity in this biz is knowing how not to blow yourself up. I have nothing on my record, and I keep it that way... A little bit of bad, can go a long way in killing yourself. In spring of 2007 for example.... Every financial institution was at the window trying to issue bonds and preferreds. The terms were lucrative, rates high, the ratings even AAA. I could have made 2-3pts selling the stuff, and it would have been easy. Instead, I bought only GE and FNM and FRE bonds, NOT the preferreds. We sold off every financial holding we could. I remember a FNM preferred that was AAA and had a 7.5 coupon, and that sucker defaulted before the first interest payment was EVER MADE.... I was paying attention, worked at a bank that was issuing AWFUL loans, and avoided the mess, meanwhile my colleagues thought I was being tin foil hatted. Avoiding the financial melt down saved my career, and in the years ahead will have made all the difference.

[/quote]

Shut up

Jul 17, 2010 10:36 am

[quote=BigFirepower] Ok, I'm just going to pretend you're serious, and not the guy trying to wholesale these. A 30% loan default with 50% recapture brings the rate down to pretty much zero. [/quote]

No, I'm not here to sell you anything. Just curious to see how others think through this situation (devil's advocate). You are assuming an Armageddon scenario? Maybe the thing to do is to buy a container or two of bicycles as a hedge?  

Jul 17, 2010 10:45 am

[quote=Spaceman Spiff] A client of mine used to own one of those car lots.  He said he sold the same car on average about 4 times.  People would buy it (rarely for cash), they'd drive it for a while, stop making payments, and he'd go get it.  He said he charged over 20% in interest on those cars.  He sold the lot after his stomach just couldn't handle doing that to people anymore. If you can get past that with your clients, it might actually work out for you.  Question - how do the clients sell the notes if they need to get to cash quickly?  How is it priced?  [/quote]

Oh, so someone who sat on the "opposite" side of your desk was in the business? Interesting.... 

Thanks for the questions. The paper trades much like other fixed-income instruments, as a discount to face value. The auto finance market is very large, behind the mortgage market.  Most banks have desks that trade this stuff. They also package the stuff and issue securities exactly like the mortgage market does. 

Jul 17, 2010 11:44 am

[quote=I am legend] Shoot you down?  How about with a bazooka!  Don't lead your clients into this mess or you will probably regret it. [/quote]

Thanks for the advice. Has anybody read the new financial reform bill? I found that auto dealers are now stronger in Washington than Wall Street: 

"There are close to eight hundred and fifty billion dollars’ worth of auto loans outstanding in the U.S.—about as much as our total credit-card debt—and car dealers broker about eighty per cent of them. Since the central task of the new consumer financial-protection agency is to oversee the market for consumer credit, which has become something of a cesspool in recent years, it would have been natural for car dealers to fall under its jurisdiction. Instead, the dealers won a special exemption: the new consumer financial protection agency can’t touch them." 

Jul 24, 2010 8:07 pm

There is certainly a market for distressed debt of all kinds. Subprime mortgage didn't go kaput because of the default rates. It went kaput because of the interest rates. If you don't price the risk appropriately then it doesn't matter if they default. The risk is mispriced. Firms like NLY do this with Mortgages all the time.

The real question is what is the price of these notes? What type of risk premium are you getting compared to the expected default rates? What is the potential loss if the default rates are 150% of your expectations?

Jul 28, 2010 8:49 pm

I am sourcing them at a 30% discount. The yield is really over 34%. Imagine someone buys a $10,000 vehicle with a 20% down payment. I am buying an $8,000 note, due in 4 years for $5,600. 

Default rates are around 10%, even during the worst of the past recession. 150% more is what, around 25% defaults? That's pretty heavy but my math is around 25.50% (34%-25%) assuming you can't recover one penny from the repossessed vehicle. Am I missing something? 

Aug 7, 2010 1:18 pm

So the yield is 34% by buying them at a 30% discount. Using your example of a 4 year note. You are buying the note with a 4 year maturity at 30% discount to par so the coupon payment is somewhere in the range of 19.5%. I don't know if there is a portion of the money that is prepaid in the monthly payment or if it's a balloon/bond type issue where it's paid back at par. Just for the sake of simplicity I'll say you are buying a typical bond type repayment schedule (i.e. interest only until maturity).

If you buy say 10 notes of 10,000 each (100k face value) for 70k and experience 10% default rates you will have earned 90k worth of maturity values + 19% of 90k for 4 years. So you'll receive 70k in payments and 90k back in 4 years. Your 70k turned into 160k. You have made an average return of 22.5k per year. 22.5/70 = 32% (approximately).

Assuming a 30% default rate you will generate 70k worth of maturity values + 19% of 70k for 4 years. So you'll receive 53k + 70k on your original investment of 70k. Your profit will be (53/70) / 4 per year. 13.25% per year. That's not a bad return but the question is what is the likelyhood of greater than 30% default rates? What about slow payments? 13.25 is nice but is it worth your expected risk?

What are the underwriting standards for these loans? How can you personally assertain the risk parameters?

These are all questions you'll have to ask.

Aug 7, 2010 1:22 pm

Also, what size of pools are you buying? A 30% default rate on 1 loan means that your expected return is either 0% default or 100% default. So you're return will be 30% or 0% and no where in between. If you buy 1000 notes you'll be in much better shape to get the expected default rates you calculate.