What happens when you get an Auto Loan

"TheElephant" (426cubicinches) 02/18/2015 at 16:37 • Filed to: None

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There's been a spate of articles recently about the recent spike in auto loans, specifically "non-prime" loans. It's all a bit confusing. I mean, sub-prime is bad, right? That crashed the economy once after a couple people stopped paying for mortgages?

Kind of, but not really.

See - the Fed created the problem by keeping rates low. Pension funds and bond investors, which like the safety of Fed Government Debt, also need to earn some yield to continue to grow. With Treasuries paying so little, they look to the Asset Backed Security (ABS) market.

Why? Because losses are theoretically limited by the asset supporting the loan - i.e. your fuckin' car. Don't pay your loan? That's fine; they'll take the car, sell it and then put the proceeds towards the loan making sure the ABS market gets made whole.

So, whether you like it or not, you are part of a big, vicious, ABS circle.

Let's look at what happens when you take a loan with, say, Chrysler Capital (or Ford, or VW or GMAC, etc, etc, etc):

Step 1: You walk into a dealership

You find a car, you get a price and then you ask about that 4.5% for 60 months you saw advertised during Conan last night. After two hours of your time and a $250 "doc" or "origination" fee, you are driving home in your sweet, sweet Hellcat.

You get home, enroll in SpeedPay so you don't have to remember to write a check every month and then start doing burnouts. But the fun is just beginning at the banks.

Step 2: A bank buys the loan

Technically, the dealer was the originator and owner of your loan. But within a very short period of time, Chrysler Capital purchases the loan from the dealer. Sometimes dealers make money here (read: they usually make money here) - maybe Chrysler Capital pays 101% of the borrowed amount; maybe they don't require that origination fee to be passed along.

This creates liquidity - the dealer now has another $50k in cash available so he can go make another new loan. But Chrysler, which just reimbursed the dealer, needs more cash to buy more loans. So, after they have a whole bunch of them - like 150,000+ accounts - they call up Goldman and say "hey, let's issue some debt."

Step 3: an Asset Backed Security is born

After Chrysler Capital has a whole bunch of loans - let's say $50M, or about 1,000 Hellcat loans - they need to turn those loans into cash. They can't wait six years for $50M to trickle in, or sales volume would fall off.

So, they securitize via an ABS. $50M of loans that pay 4.5% coupons over 60 months generate about $1,000,000 per month.

Remember those Pension funds? They would like to earn more than 1% on their money, so they buy some ABS at a 3% coupon. Chrysler Capital pays about $750k per month on the $40M of debt it issues (the other $10M of loans is called "overcollateralization" and is essentially a buffer to keep losses from reducing the Pension Funds interest in the secured assets).

Step 4: Profit

So, now Chrysler has $40M of cash to go make more loans. And they are earning about $250k per month (the difference between customer payments and what they pay the pension fund). That's about $15M over the 5 year term of the ABS.

In total, Chrysler got $55M in cash for the $50M in loans they made.

But wait, there's more. Remember that $10M of overcollateralization? Chrysler gets that back, too. Let's assume that 100 Hellcat owners default (a 10% loss rate). That would come off the OC, reducing it from $10M to $5M.

And Chrysler would earn interest on that $5M over the life of the loan - at 4.5%, thats about an extra $1M in interest. That brings Chryslers $5M profit to $11M!

So, here's the final tally: $50M in loans generate - drum roll please - $61M in cash - or about a 4% return. And the best part - from Chrysler's perspective - is that they get their whole $50M nut back within the first 90 days, and only have exposure to loss on 20% of the portfolio.

Viola.

Welcome to Finance, bitch.

Edit to add: If a company like Chrysler Capital can turn the same $50M every three months, they basically earn 12% on that money. TWELVE PERCENT! The joys of annualization...

Sam > TheElephant 02/18/2015 at 16:42

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I'm considering getting a car loan soon. I'm thinking that I'm going to try and pay 50%+ down and finance the rest, to keep my payments low.

Party-vi > TheElephant 02/18/2015 at 16:42

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Me, after reading this.

Jordaneer, The Mountaineer Man > TheElephant 02/18/2015 at 16:42

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Step 1: buy car in cash,

Step 2: PROFIT!!!

P.S. Great article, I need to be a money lender!!!

TheElephant > Sam 02/18/2015 at 16:44

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Nothing wrong with a little debt. I have notes on all my cars, but none of them exceed 60% of purchase price...

Sam > TheElephant 02/18/2015 at 16:46

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Now I'm going to have to find a bank that'll finance a 19 year old with very little credit, who wants to buy a Viper.

BrianGriffin thinks “reliable” is just a state of mind > Sam 02/18/2015 at 16:46

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Depends on what interest rate you get, really. 0% is almost free money.

TheElephant > Sam 02/18/2015 at 16:48

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If your shopping new, use one of the captive financing arms - they all securitize so they generally have less stringent requirements compared to a bank.

Tapas > TheElephant 02/18/2015 at 16:48

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So....what does a company like Goldman get on buying the debts? And where does it get profit from this transaction?

Its taking on someone's debt by paying 80% in cash and the rest of it in installments with interest?

Sam > TheElephant 02/18/2015 at 16:49

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So like, BMW Financial and such?

BrianGriffin thinks “reliable” is just a state of mind > Jordaneer, The Mountaineer Man 02/18/2015 at 16:49

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Here's the rub, though: the dealer knows that they're going to get paid $X for every loan they write (1%, or the $200 doc fee, or whatever), so they tend to be more willing to work with you on the price of the car if they know you're going to be taking some financing through them.

Whatever you do, don't ever tell a dealer you're going to pay in cash. I've had more than one indirectly ask me to leave after that.

TheElephant > Tapas 02/18/2015 at 16:50

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Goldman makes money placing the debt and underwriting it.

See, there might be 20 pension funds that want a piece of the $50M. So Goldman gets a fee from each fund for splitting up the debt and making sure they don't "oversell".

Then they also charge the issuer for their time related to writing the docs and reviewing the numbers. That's usually 0.5 to 1% of total transaction.

In this example, Goldman would probably pocket about $1.5 to 2M for 10-15 days of work.

TheElephant > Sam 02/18/2015 at 16:51

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Exactly. Porsche Financial is actually one of the biggest movers in the ABS market. Porsche Leases make buku bucks when securitized. That's how I got my start.

Tapas > TheElephant 02/18/2015 at 17:01

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So they re-set the debt to people who want to make percentage of the interest (that is to be made on recovering the debt from the loan-taker) - And they have a processing fee they make on that?

Jordaneer, The Mountaineer Man > BrianGriffin thinks “reliable” is just a state of mind 02/18/2015 at 17:08

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I didn't know that, I've always thought it would be the opposite, that they would be more willing to work with you if you bought it in cash, because then they will get their money immediately.

TheElephant > Tapas 02/18/2015 at 17:24

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Basically.

The juice is in the spread, so to speak.

TheElephant > Party-vi 02/18/2015 at 17:28

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I like this gif too much

jariten1781 > Jordaneer, The Mountaineer Man 02/18/2015 at 17:33

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Lower end used car dealerships who back their own loans will prefer cash. Any other dealership will prefer you finance. You're very likely to get screamed at (not really, but they will get pissed enough to do so) if you try to pay with a credit card at any dealer.

E. Julius > TheElephant 02/18/2015 at 17:42

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I mean, sub-prime is bad, right? That crashed the economy once after a couple people stopped paying for mortgages?

Do people/did people create the types of instruments that played such a huge role in the financial crisis using auto loan backed securities? My understanding was that the subprime loans themselves were only one part of the problem. The diffusion of risk created by CDOs and the inflation of balance sheets caused by CDSs and synthetic derivatives, combined with overeager ratings agencies and a speculative bubble, allowed the subprime loans to wreak as much havoc as they did. Like I said, I don't know if this is happening these days, but if it is they might still be considered a bit scary to some. At the very least it would have provided like 6 more steps to your article that would've been pretty entertaining.

Disclaimer: I'm not in finance, this is just based on my own personal research. Feel free to correct me if I'm wrong.

TheElephant > E. Julius 02/18/2015 at 18:28

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So, the problem with subprime mortgages was caused by something called "tranching".

Tranching is the act of flowing dollars down a waterfall while flowing losses up the structure. Think about it this way: the $50M of Hellcat loans might be broken out as $20M of "A" tranche, $20M of "B" tranche and $10M of "C" tranche.

The "C" tranche would absorb 100% of all losses, up to $10M. Then the B tranche absorbs the next $20M and - if the losses exceed 60% - the A tranche starts getting hit.

While at the same time, the dollars go to reduce the A Tranche balance first, then B, then C.

This means the A tranche balance is decreasing at a really fast rate relative to potential future losses, increasing its creditworthiness.

The problem with MBS (the mortgage securities) was that the "C" tranche might have only been a couple hundred grand and was quickly exhausted.

Basically: piss poor planning creates problem; market shifts magnify weakness; you lose your house.

E. Julius > TheElephant 02/18/2015 at 19:39

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I don't think the problem was with the tranching itself. That allows investors to decide how much risk they choose to bear and what types of yields they can expect. With a simple structure like this, your large institutional investors would mostly put their money in the senior tranches (as an alternative to low yield treasury bonds like you mention in your second paragraph), while more adventurous investors would take on the junior tranches hoping for the higher yields. If it stopped there, with MBSs, the damage from the subprime crisis probably would have been contained to boutique investment banks, hedge funds, and small dips on the quarterly statements of the big banks and pension funds.

The issue is when the yields from these lower tranches are combined into a collateralized debt obligation, of which the senior tranches were still rated as AAA despite being composed entirely of subprime assets. When this occurs, large institutional investors looking for steady yields invest in these as an asset they believe to be safe (as it's rated AAA). This exposes sectors of the financial market which previously carried low risk to what is actually just a conglomeration of high risk assets, mistakenly believed to be safe under the false assumption that the default rate on the underlying assets couldn't be high enough to substantially affect the yield of the senior tranches of the CDO.

On top of that, big banks like Lehman Brothers used Credit Default Swaps to generate additional cash flows from people taking positions on the CDOs, and collateralized the yields from these CDSs into synthetic CDOs. This creates even more highly rated assets that are effectively backed junked, tricking huge numbers of investors into exposing themselves to classes of assets normally considered far too risky for most investment strategies. These large investors include major banks, thus introducing systemic risk. Since these synthetic CDOs aren't tied to any actual physical assets, multiple synthetic CDOs can be created from one pool of assets, which results in the huge multiplicative effect when the subprime loan payments stopped coming in.

This is why subprime mortgages became a nuclear bomb, not the practice of separating asset backed securities into tranches.

My original question was asking if these types of practices involving ludicrous ratings and synthetic derivatives extended to securities backed by car loans back in the days before the crisis, and if this is still occurring today.

TheElephant > E. Julius 02/18/2015 at 19:45

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I do not work with any exotic derivatives. And since the Auto ABS market is under $200B, I would venture a guess no one else does.

I take a bit of issue with your analysis - I think the real issue was that the banks retained the shitty lower tranches (because of the high yield, as you point out) and did not adequately allow for cyclical losses. So once they started going sour, the banks needed more cash to meet capital requirements so they issued more securities and retained more lower tranches to help the securities sell, thereby creating a positive feedback loop.

At the end of the day, the story is the same: bears make money, bulls make money, pigs get slaughtered.

And, for the record, I was on Acela from DC to NYC on 10/8/2008. I remember a stock broker actually weeping at 3:45 as the market neared close. Full-on global recession set in, for me, on this day.

E. Julius > TheElephant 02/18/2015 at 20:10

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I suppose in a way the two analyses aren't irreconcilable. The banks, Lehman in particular, maintained huge investments in the low rated tranches in CDOs, like you said. This obviously meant that when the market began to slow down they sold more and more securities, once again like you said. The use of synthetic derivatives dramatically expanded the reach of any negative movements though. I can't find the specific chart I'm thinking of, but in 2008 the global OTC derivatives market was something like $~600 trillion, which was like 10 times global GDP. This obviously meant that when the underlying assets went bad, a lot of people lost a lot more money than they otherwise would have.

Of course, the underlying causes of the crisis are still being debated to this day, so I guess we can't say for sure. Like you said, end of the day it's the same story. Crazy to hear your story about the stockbroker though. Those were some difficult times, although I was an all but oblivious sophomore in high school at the time. Fucked up how much the world was collapsing around all of us at the time and I barely noticed : /

Thanks for your original post by the way, I quite enjoyed it.

Highlander-Datsuns are Forever > TheElephant 02/18/2015 at 21:36

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This should go on the front page, good stuff!

It also seems like the asset as a vehicle is much easier to repo and recoup than a house. The thing that bothers me is folks are signing up for 72 and 84 month loans on a car that they might only want for 4-5 years. They will be digging themselves a hole of debt that will be very difficult to get out of and don't realize they should live within their means and buy a $10,000 2008 Camary instead of that shinny $37,000 ford F-150.