Wfearful_Bgreedy Posted March 18, 2018 Share Posted March 18, 2018 I was curious about purchasing Put LEAPs in publicly traded sub-prime auto lenders like Credit Acceptance Corp and Santander Consumer USA, CACC and SC respectively. I’m usually too early and I don’t claim to be able to time the market, that’s why long term expiration puts are the only instrument I would consider and it would be a tiny portion of my portfolio. It would be too expensive to short outright so LEAPs look better. My only concern is that there is not a specific event or date driven thesis which would make the payout more rewarding and make volatility not follow a normal distribution like a court ruling on a specific date. I have a couple main reasons: - Defaults are increasing https://www.bloomberg.com/amp/news/articles/2018-02-02/never-mind-defaults-debt-backed-by-subprime-auto-loans-is-hot Both SC and CACC are increasing their provisioning for these defaults and analysts asked why they were provisioning at a higher tick without a clear answer. - The used auto index is decreasing http://www.nada.com/b2b/NADAOutlook/Guidelines.aspx This matters a lot because folks purchasing a new car depend on the trade in value of their used car. If they can’t trade in for value then new car dealers get desperate and offer more discounts which pushes down used car value more. When subprime lenders repossess autos they depend on the value of those vehicles to make themselves whole and if you look at CACC’s portfolio from 2015 to today based on their 10K they are owning more and more of these loans outright rather than handing off the risk to the dealer due to competitive pressure. When borrowers finish their lease and the remaining payments are more than the market value of their vehicle they will return the car leading to more used cars on the market. https://www.kbb.com/car-news/all-the-latest/this-week-in-car-buying-inventories-grow-used-cars-flood-market/2100004210/amp/ - Interest rates are increasing If the spread between the Fed rate and high interest sub prime auto bonds decrease then lenders will have to increase interest rates to entice bond purchasers or take a margin hit. - The quality of new dealers is likely decreasing If you look at Credit Acceptance 10K they are increasing dealership footprint but are seeing some market saturation. I believe there are 35000 used car dealerships in the US and they are in 9000. So what you see is that their per dealer deals are decreasing per year. Also if you see the analyst questions from their last quarterly it appears that their new dealers are not meeting the minimum 100 deal quota in order to gain access to up front lending. I am speculating that it is their new dealers responsible for the downtrend in loan rates and that they are pushing into new territory where subprime isn’t as viable in the hopes for the same growth. Companies like CACC have had amazing compounding growth but I think maintaining that growth will be very difficult given their size now. You can see the analysts inquiring about new dealer performance and a non-answer on page 4. https://seekingalpha.com/article/4141501-credit-acceptances-cacc-ceo-brett-roberts-q4-2017-results-earnings-call-transcript?page=4 - Business Model Shift I applaud Credit Acceptance in their early days for crafting a business model that shared the underwriting risk with the dealers. In their original business model the dealers would get an up-front loan from Credit Acceptance that was short of the full purchase price. The dealer would then recoup the difference over time as the loan continued to perform. This would incentivize dealers to practice good underwriting. Now however for the past few years CA has shifted from sharing the risk to owning more of the loans, see the chart on percentage growth from "Dealer" loans to "Purchased" loans. https://globenewswire.com/news-release/2018/01/30/1314630/0/en/Credit-Acceptance-Announces-Fourth-Quarter-and-Full-Year-2017-Earnings.html I imagine this is because dealers would rather take more upfront and use that to cycle through more inventory rather than wait a few years to collect payments. This is a misalignment of incentives and risk where dealers are offloading the default risk to the lender without any fear of losing their source of cash because they have multiple online options to choose from. - Unemployment at all time low How can defaults be increasing when unemployment in the US is at an all time low. Imagine if that unemployment regressed to the mean. Since there is so much competition now between subprime lenders and dealers have the pick of the litter often the fastest pre-approval wins. So the lenders are incentivized to decrease underwriting standards and beat out the next lender. The question is who is the fastest and worst underwriter? I don’t think I know that answer yet, I think historically Credit Acceptance has been more prudent and outlived the competition but the business model is changing. - Loan duration is increasing The average duration of these auto loans are at all time highs of 65 months and max of 85 to 94 months. If used car prices continue to decrease then these vehicles are more likely to be underwater compared to a scenario where they had been on a traditional payment term. I am curious as to the correlation between longer loan periods in a downward vehicle price environment and defaults. My hypothesis is that if the vehicle is underwater and I can no longer make payments then I will just let the lender repossess the vehicle. - What are consumers actually buying? Right now the market leader in the US is without a doubt luxury SUVs and pickup trucks. https://mobile.nytimes.com/2018/02/15/automobiles/wheels/luxury-trucks-suv.html?referer=https://www.google.com/ These are vehicles with higher maintenance and gas costs. Pick any street in your area and count how many lifted trucks or SUVs with a new dealer tag on the plate that weren’t there a few months ago. I’m not sure your neighbor will keep that Ford Raptor if times get tough. My calculations in excel were showing me a 1.6X Payoff for Santander Consumer USA using a two year out of the money strike price 40 percent lower than market. I would hope for at least a 2X payout, this was one of the rules Cornwall Capital had for investing. CACC used to be run by owner operators who have a lot of experience surviving multiple up and down environments, however their founder has since sold a lot of his shares and their business model is shifting from sharing the risk to owning the risk. https://www.bloomberg.com/news/articles/2017-05-04/as-inventor-of-subprime-car-loans-exits-critics-smell-a-lemon Santander might be a better opportunity though they aren't as richly priced for growth. In summary I think this market has enjoyed a lot of tailwinds for the past 8 years and people made a lot of money in this industry. I think there are a lot of headwinds ahead while these companies are being priced for perfection. Because the duration of auto loans continues to increase out to 65 months or greater in an environment where the used price index is decreasing provides heightened odds of borrowers being caught in a down job market with a luxury vehicle that is underwater. While lenders are incentivized to increase loan duration to make monthly payments more palatable today they are relying on the resale value of those vehicles in the event of default in the future. Link to comment Share on other sites More sharing options...
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