What Happens to the Folks Who Don’t Win in ‘The Transition’?
An alarm sounded…
It was different from the last one.
“Live hit!” the driver gasped.
He sped around the corner and killed the headlights.
“Stay here. I’ll be right back.” He grabbed a small flashlight and stepped out of the car.
I reached over and locked the doors. It was a bad neighborhood. And it was late at night.
The driver returned with a grin and pumped his fist. “Yes!… We’ve been looking for that one for six months!”
Last year on a Sunday evening, I spent four hours riding shotgun with a repo man in Baltimore, Maryland. “Bruce,” the driver, is a grizzled veteran of the repo business. He’s seen it all… and been shot at, beaten up, clubbed, and called every name you can imagine. He’s also been stabbed twice – both times by women.
You may have seen one of the reality TV shows about vehicle repossession. But the company I visited is more than two muscle heads in a tow truck… With about 100 employees, it’s one of the 10 largest repo operations in the country.
The owner – “Jack” – agreed to provide us unfettered behind-the-scenes access to his business… as long as we keep him anonymous. (Neither Bruce nor Jack are their real names.) The reasons for Jack’s caution are obvious. These folks keep a low profile. You won’t see the company’s name on the side of its vehicles. Drivers spend all night in many of the worst neighborhoods… And they aren’t very popular.
Despite the industry’s gruff reputation, Jack’s company uses state-of-the-art technology to track down deadbeat borrowers for its clients – usually banks and other auto lenders.
In the recovery industry, Bruce is known as a “spotter.” He drives a car outfitted with four cameras, two in the front and two in the back. These cameras are continuously and automatically snapping pictures of license plates as he combs the streets all night until dawn.
The technology logs and stores the photos along with the time and location. When a lender needs a car back, it simply provides the license plate number to the company. Bruce cross-references it to his database to see if he’s ever snapped that plate. If the owner is anywhere in Baltimore… chances are Bruce has a good idea where to look for it.
No matter where you live, chances are someone has photos of your car. If you default on your loan, they know where to find you.
See, Bruce alone averages close to 200,000 photographs per month. And Jack’s company has 49 other camera-equipped spotter cars across several states. Of course, every major player in the repo business now uses the same automated rapid-photo technology that Jack does (although Jack proudly reports that he was the first adopter). The point is, no matter where you live, chances are someone has photos of your car. If you default on your loan, they know where to find you.
If you find this creepy, you’re not alone. I asked Bruce to enter my license plate into his system. He instantly pulled up listings for each of the five times he’s photographed my truck. We had never met, but Bruce already knew where I drive, where I work, and most importantly, where I sleep.
Last year, I spent a few hours helping Bruce find the cars the banks had requested that day. Armed with dozens of photos of the deadbeat borrowers’ plates, Bruce found four “hits” in four hours. When he finds a car, he dispatches one of Jack’s tow trucks to repossess it.
But our “live hit” was a little different. A live hit is when, by chance, Bruce happens to snap a photo of a wanted plate that he wasn’t specifically looking for that night. This is extremely unusual – a rare bonus. That’s why Bruce was so excited. This particular Texas plate had “gone cold.” Everyone had stopped looking for it.
Emotions run high when folks realize they are losing their car. That’s why repo men like Jack and Bruce – and Bruce’s designated tow-truck driver – sometimes wear bulletproof vests and work mostly at night. That’s when delinquent borrowers tend to be at home – and in bed.
Jack and Bruce’s business plays a key role in a story my colleagues and I have been following for more than three years now – the looming bust in subprime auto lending.
You’ve likely heard a lot recently about the subprime auto crash. It’s suddenly the fashionable thing to talk about on Wall Street and in the mainstream financial press. Banks are slowly starting to admit that they’ve overextended credit to certain auto consumers. Bond-rating agencies and Wall Street analysts are reporting on who has the ugliest loan book. And credit agencies are publishing horrifying stats on the types of people who routinely get 20% financing on cars they can’t afford.
But these statistics are always backward-looking. They tell you what was happening in the auto market three months ago. If you want to find out what’s happening in auto finance right now, you’ve got to buckle up and ride along with guys like Bruce and Jack.
The banks and lenders try to convince Wall Street “it’s all under control”…
But we’ve established relationships with a handful of the repo industry’s biggest players. And Jack and Bruce tell a different story: The repo business is booming… which means things are even worse than we thought for irresponsible lenders – who will soon face their reckoning.
Hello Wall Street, Welcome to the Party!
Longtime Stansberry’s Investment Advisory subscribers know my collegues and I were among the first to sound the alarm on the looming problems in auto debt… specifically subprime auto debt. One of our first major auto-loan-bubble warnings came in our March 2014 issue. We’ve repeatedly sounded the alarm since that issue.
We pointed out that much of the boom in the auto industry following the last financial crisis was fueled by the expansion of cheap credit to subprime borrowers. Subprime borrowers are the riskiest, least creditworthy borrowers. They have the lowest credit scores, usually defined as less than 620.
When we first began writing about the problems in auto lending, the experts scoffed. In 2015, for example, the economists at consumer-credit behemoth Equifax published a bold commentary that flew in the face of our thesis: “The Subprime Auto Bubble Is Fiction, Not Fact.”
In February 2015, Melinda Zabritski, director of automotive finance for data aggregator Experian, reassured market followers:
Whenever there is an uptick in the number of loans to sub-prime and deep-sub-prime customers, there is the potential for a “sky is falling” type of reaction. The reality is we are looking at a remarkably stable automotive-loan market, in part because consumers are continuing to stay on top of their payments.
Experian does a fantastic job tracking what’s happening in auto finance. Experian statistics are one of our favorite research tools. The interesting thing is, the Experian data that accompanied Zabritski’s “remarkably stable” commentary were indeed bleak. “Deep Subprime” was the fastest-growing loan category, by a wide margin. Average terms were extending. The amounts due on monthly payments were up – even for the riskiest buyers. And payments had started to slip…
In September 2015, as Experian and Equifax were reassuring the masses, we warned of “the subprime auto collapse of 2016.”
Well… the numbers from 2016 made it clear… Delinquencies and defaults are up. Used-car prices are down.
The latest data in 2017 were even worse. Delinquencies and defaults are rising to levels not seen since the last financial crisis. New-car sales are down.
And suddenly the “sky is falling” type reaction seems a lot more realistic. Wall Street firms such as Morgan Stanley and Bank of America have recently issued warnings on auto trends. As have the Federal Reserve, debt-rating agency Fitch, and federal regulators at the Office of the Comptroller of the Currency. Steve Eisman – the investor who famously shorted the mortgage industry in the book and movie The Big Short – even warned about subprime auto debt in a Bloomberg interview. The mainstream media – including Forbes, Fortune, and Business Insider – have dutifully repeated these reports.
So the mainstream media has finally caught on. Just about every day, we read an article warning of the dangerous bubble in U.S. auto debt. That debt now totals a record $1.36 trillion according to the Federal Reserve Bank of New York. A recent Bloomberg article pointed out that’s about $6,100 of debt for every licensed driver.
Terms like “securitizations” or “asset backed securities” (or “ABSs”) are critical to understanding auto finance. These financial instruments have been used to fuel excessive lender leverage.
In the wake of the financial crisis, you may have heard about mortgage originators setting up bad subprime loans, and then offloading much of the risk of homeowners defaulting on their mortgages. These lenders did this by “securitizing” most of the loans. That is, packaging them into mortgage-backed securities (“MBSs”), which they sold to investors.
The exact same tool exists in auto loans, except the securities are called auto ABSs. Nationwide, the ABS market is a fraction of what the MBS market was in 2007. But it’s a massive problem for certain individual players that could be wiped out by excessive reliance on ABSs.
ABSs work like this: Lenders package thousands of individual auto loans (worth hundreds of millions – and sometimes billions – of dollars) into these debt securities, which are sold to investors in small pieces. The auto loans serve as collateral for the debt. To entice investors, lenders add significant amounts of “credit protection” or “credit enhancement” to the ABSs. This can take the form of extra cash put into escrow and additional auto loans to serve as collateral for the debt to cover any potential credit losses.
Most auto lenders use ABSs as their main source of capital. Not only do these ABSs allow them to offload the risk of their loans, but selling the securities injects their coffers with cash, allowing them to make more loans. They provide instant cash – or “liquidity”, in industry parlance – while moving the credit risk from the lenders onto investors.
In today’s low-yield world, institutional investors like pension funds, bond mutual funds, and even some insurance companies are happy to scoop up these ABSs that pay interest rates ranging from 0.4% to 5.0%, depending on the level of risk. But, when this demand dries up… the business model of many lenders is in peril.
If you’re just now picking up on the trends of the auto sales and lending industry… the graphic below provides a simple view of the various factors in play. We call it the “auto-lending death spiral.”
As you can see, the death spiral starts when management needs revenue growth and dips a little lower in the credit spectrum (Box 1 and 2) to attract new customers. Many of these new, lower-quality customers are going to need more “creative” loan terms in order to make their payments. So lenders may extend the terms of the loans and accept lower down payments than usual. Lenders also rely more on leasing to help lower monthly payments for buyers. They can offer lower payments because the residual values – the estimated value of the cars at the end of the leases – are set far too high (Box 3).
Some of these unqualified borrowers will inevitably stop paying and eventually default (Box 4), leading to more repossessions (Box 5). Repossessed cars end up at used-car auctions. The increased use of leasing also floods the used-car market as cars roll off their leases after two or three years. This puts downward pressure on used-car prices – the lifeblood of the entire auto market (Box 6).
Since used cars are collateral for many ABSs, a falling market for used cars weakens investor demand for the securities, making it necessary for auto lenders to seek other sources of financing (Boxes 7 and 8).
To lure investors back to the ABS and funding markets, lenders need to show Wall Street healthy growth numbers. So auto lenders start the spiral all over again… going back to Box 1 and seeking even lower-quality borrowers…
These spirals will typically repeat several times before the whole charade breaks down, with the data getting uglier and uglier with each go-round.
For example, since we began following this market in 2013, the longest-term length of these loans (Box 3) has gradually stretched from 60 months (2013) to 84 months (2015) to 96 months (2016).
But when the death spiral finally breaks, the entire auto-lending market will collapse… and take the auto manufacturers and new-car dealers down with it…
The toll this takes on individuals is harsh. More and more will find themselves suffocating from overwhelming auto-loan debt… with their cars worth far less than they paid. And that’s just one branch of the massive debt problem in America.
For many, there will be no escape.
Most people with a 401(k) or brokerage account will see huge losses. And it could result in the biggest shift in America… affecting both you and your money. To learn more, including the most important step you can take to protect yourself, click here to get my colleague Porter Stansberry’s new book The American Jubilee.
Bill Shaw travels the globe searching for the best investment ideas in the commodities and natural resource space… As editor of two natural resource focused newsletters, Commodity Supercycles and Stansberry Gold & Silver Investor, he focuses on oil & gas, base and precious metals, agriculture equities, and gold bullion.
Bill has also spent more than a decade in various land development management roles for residential homebuilders – obtaining permits and designing and constructing new communities – and has managed a $100 million portfolio of land assets.