The auto loan market is booming - total auto loans in the United States rose 50% from 2010 to December 2015.
But of the more than $1 trillion in auto loans outstanding, Experian estimates that between $205 billion and $388 billion are subprime loans, with 15% to 20% of those loans securitized.
We've been here before - though in much worse trouble - back in 2007.
Now, when you consider that U.S. subprime mortgages outstanding in 2007 were $1.3 trillion (based on Ben Bernanke's remarks from May 2007), and mortgage-backed securities and MBS derivatives based on those subprime loans outstanding probably totaled another $2 trillion to $4 trillion, subprime auto loans don't come close to the depth and breadth of subprime mortgages back in the day.
Still... when the subprime auto bubble pops, it's going to be messy - and smart traders are going to have the opportunity to profit... if they know where to look.
Today, I'm going to break down the growing subprime auto loan bubble, including how we got here and where I think we're headed.
Then, I'll show you how to profit...
The mortgage meltdown that triggered the Great Recession started with late payments, and right now subprime auto loans are starting to head down the same road.
According to Fitch Ratings, the 60-day delinquency rate (loans at least 60 days past due) on an index of securitized subprime auto loans hit 5.16% in April 2016. That's more than during the Great Recession and the highest level since 1996.
Net losses on securitized subprime auto loans were 7.5% in April, based on S&P data.
The market for subprime auto loans is big and getting bigger every day because more players are getting into the business.
Besides banks like Wells Fargo and Ally Financial that make subprime auto loans, small, rapidly growing non-bank lenders backed by hedge funds and private equity shops are popping up everywhere.
Companies that specialize in subprime lending like OneMain Holdings in Evansville, Ind., and Avant, a Chicago-based online lender who has generated $2.8 billion in unsecured personal loans since 2012 and jumped into the auto lending game, are all the rage.
Sheila Bair, the former head of the FDIC from 2006 to 2011, joined Avant's board on April 1, citing her long-held desire to make credit more widely available. But that, of course, is another story for another time.
The reason it's so easy and lucrative for so many upstarts to get into the business and grow is that most of the loans they make are being securitized and sold off to investors.
As proof of the rapid growth of the securitization of subprime auto loans, Exeter Finance, which securitizes loans and markets them and is now the third-largest issuer of subprime auto bonds, grew its portfolio from $150 million three years ago to over $2.8 billion today.
It's a profitable business all around... but it's not sustainable. That's thanks to increasingly questionable lending practices brought about by increased competition.
Lenders not only finance new and used cars, they finance everything from down-payments and warranties to undercoating. And believe it or not, they are now offering "cash out" refinancing.
That's right - subprime borrowers can refinance their already expensive auto loans and take cash out.
And because the game is so lucrative, increasing competition is lowering standards and making lenders stretch further and further out on the "bad borrowers" tree to find takers of their high-interest-rate loans.
You know this is going to end badly.
Lenders typically charge between 9% and 36% interest, with 9% being pretty rare.
For comparison purposes, the average 60-month new car loan to prime borrowers is 4.05%.
The average loan term on subprime auto loans is 72 months.
While longer terms make monthly payments smaller, there's a problem with depreciation of the underlying asset while the loan's outstanding.
It's just an accident waiting to happen...
As I said, subprime auto loans imploding won't have the same impact that subprime mortgages had on the global economy. So you don't have to worry about betting on the world tumbling into another Great Recession.
That said, there aren't a lot of ways to make money on rising defaults on subprime auto loans - as of right now, banks aren't lining up to take the other side of derivative short trades.
But there is one trade that makes a lot of sense right now and can make you some good money when the bubble finally bursts.
One of the biggest players in the subprime auto loan game is Santander Consumer USA Holdings Inc. (NYSE: SC), a unit of Banco Santander SA (NYSE: SAN), the giant Spanish bank.
SC is a stock you want to short.
They're already bleeding. SC twice delayed its 10-K filing for the fiscal year ending Dec. 31, 2015, because it was forced by securities regulators to restate three years' worth of earnings because they didn't properly account for "material weaknesses" in their loan book.
Presumably by accident, SC did not adequately provision for bad loans, which funnily enough, were worse than they knew. After adjusting "troubled debt restructurings," Santander Consumer's fourth-quarter 2015 profits were knocked all the way down to $12 million... from a previously trumpeted $67.7 million.
That's bad... but believe it or not, it gets even worse.
What I find really disturbing is that in spite of that "correction," when the company restated earnings for all of 2014 and all of 2015, profits were only adjusted down 5% each year.
Something's not right there.
And, as far as guidance, the company said in January that 2016 would be a tougher year on account of increasing competition.
Now I think you get it. This whole subprime auto merry-go-round is eventually going to throw a lot of riders off their painted ponies.
If you want to bet on the crash of the subprime auto loan game, I like shorting Santander Consumer USA Holdings at the market.
Short more if it gets to $13 and more if it gets to $14, where it could get to if all's right with the world.
I'd love to be averaging up on this short; there's a ton of resistance at $14, so if it gets there and the investing landscape isn't perfect, SC will falter. On its own it's going to falter. But in a world where markets lead stocks higher, it could get taken higher.
If the market falters because consumers falter and earnings continue to deteriorate, you'll wish you were short SC at an average price of $13, because it's going to test $8, and if it can't hold there, it's going to $4.
On the upside, if you're short at an average price of $13, cover 20% higher at $15.60.
If the stock gets there it will be a miracle.
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