14 months ago (almost to the day), Citi’s Mary Kane had some advice for clients.
See, some folks were starting to get the idea that maybe securitizing auto loans made to borrowers with no FICOs was a really bad idea – those borrowers having no credit score and all.
For those unaware that such things have been going on for years in the US auto market, here’s a look at a deal that got done in 2015 (the originator shall remain nameless but you can find it if you really want to):
Here’s what the above-mentioned Mary Kane said:
There are four principal reasons to NOT short auto ABS: 1) consistent and stable long-term performance through numerous cycles; 2) robust credit enhancement protecting principal at risk 3) auto loan growth historically in line while securitization rates remain low, 4) originate-to-sell practices are not and have never been prevalent. Data shows that auto loan growth is not out of line with historical growth and that auto loan financing is not excessively reliant on the ABS market. The auto ABS securitization rate varied from 15–28% from 2004–present. Currently at 16%, it shows that most US auto loans are held on lenders’ balance sheet.
We’re not going to get too deep into the specifics here, but it goes without saying that some of those assumptions were tested this week.
Here’s what else Mary said in the same note:
It seems like too many people have seen the movie “The Big Short” and are starting to think the movie heroes’ short strategy would translate to the ABS market. By the way, the ABS conference did NOT take place at Caesar’s Palace that year as per the film, it was at The Venetian. So, it’s not wise to believe everything you see in a movie and hit films are not the best source for trade ideas.
See how that works? Because the movie confused Caesar’s Palace with The Venetian, you shouldn’t short subprime auto. Makes sense, right?
Well, fast forward a year, and here’s what Mary said about the current state of this market:
Subprime Auto ABS at Peak Market Share The securitization market continues to finance numerous subprime auto finance companies and total outstanding subprime auto ABS amounted to $41 bb, which accounted for 29% of total outstanding retail auto ABS as of 31 Dec 2016 (Figure 8), setting a new record market share. We continue to think that the subprime auto space may undergo consolidation, as there are a large number of competitors. Moreover, some of the smaller companies rely heavily on the ABS market for financing, and this could be a risk if the market backs up. Heightened regulatory compliance costs have also materialized in the last couple of years, and the sector is the subject of close CFPB scrutiny.
Sounds a bit less optimistic, doesn’t it?
As it turns out, Jamie Dimon’s clients have been asking the same questions Citi’s clients were asking Mary Kane in early 2016. Consider the following from a JPM note dated Friday:
With disappointing March auto sales, falling used car values, rising subprime auto ABS delinquencies/losses grabbing headlines, we have seen a resurgence in calls from equity, macro strategy, and high yield corporate accounts looking to short subprime auto ABS. We saw a similar wave of short interest last February amidst the equity market sell-off. To date, we are not aware of any accounts following through to put a short position on subprime auto ABS. We do not recommend shorting auto ABS because such trades are not efficient in expressing negative views on the auto lending industry.
Hmmm. So why, one might fairly ask, is shorting auto ABS not an “efficient way” to express a negative view on… well, JPM doesn’t put it this way, but… on subprime auto ABS? Here’s the “answer”…
First and foremost, ABS has historically been a long only market. Unlike CMBX or corporates, there is no liquidity (or any trading that we are aware of), in baskets of ABS bonds or single-name CDS. Buying protection on a specific subprime auto ABS bond via a single-name CDS is a simple trade to put on. Given the heavy over subscription levels on recent auto ABS transactions, we would think that finding traditional ABS investors to take the other side (and sell protection) would be relatively easy and could be done inside of current cash levels. Current indicative BBB and BB subprime auto ABS spreads are at swaps +130bp and +275bp, respectively. CDS theoretically could be inside cash levels based purely on those new issue tranches being 3-6 times oversubscribed.
Putting on the trade is easy, but to make a profit on shorting ABS will be difficult. Based on current expectations for performance versus credit support protecting bondholders, we do not expect auto ABS bonds to suffer write-downs. As we highlighted last week, subprime auto ABS bonds are well built to withstand reasonable levels of stress for the ratings, even at the BB level. We note that there were no defaults of auto ABS even during the Great Recession, when auto sales plummeted to 10mn SAAR area and domestic automakers were on the edge of possible bankruptcy (among the many other woes across the financial system). Furthermore, the Great Recession experience has been incorporated into the stresses for auto ABS. Overall, fundamentals in subprime auto ABS are still solid given current expectations for economic growth, labor market conditions and auto lending trends relative to available credit enhancement and robust structures.
Those interested in shorting auto ABS have indicated to us that their time horizon is short and the bet is for spreads to widen (rather than default). The likelihood of spread widening event is much higher than the probability of default. Our expectation is that spreads have room to tighten further over the rest of the year based on ABS market fundamentals and technicals, but we have also recognized that ABS market is not immune to broad financial market volatility. However, over a short time horizon, even if spreads were to gap out, the paper gains on a short position would be very hard to monetize given the lack of liquidity (again, traditional ABS investors are long only).
To close out and monetize a short on a single auto ABS bond, a new counterparty, outside of traditional ABS investors, with an even more negative view on that bond would have to be found.We recognized that negative sentiment can feed on itself and perhaps sufficient short interest will turn into actual trades (liquidity still highly questionable), but we also believe that such a development would represent a disconnect of the CDS from actual credit fundamental trends on ABS. Unless fundamentals have change drastically in a short time frame, technical driven spread widening gains on a short position will be more of a market timing exercise than a credit view on the auto ABS being shorted.
For example, we note that the GFAST 15-1 class C originally rated BB L (DBRS)/BB (KBRA) was upgraded to BBB L/BBB- near the end of 2016 despite the originator Go Financial having already shuttered its doors (servicing was taken over by DriveTime). In addition, Fitch noted this week that the “ratings outlook for US auto ABS is positive and stable for prime and subprime, respectively… We expect to issue further upgrades in the remaining part of the year, although at a lower level and slower pace given declining asset performance and expectations of their loss rates remaining within our forecasts.” We showed last week that benchmark subordinate subprime auto ABS are routinely upgraded once 12-24 month seasoned, while lower tier names tend to see upgrades as well but with more seasoning. Auto ABS are structured to build credit enhancement (shoring up protection for bondholders) with stable to improving credit profile for outstanding bonds.
In conclusion, we recommend accounts not venture to short ABS. Fundamentally, ABS are secured by assets and will take losses only after unsecured bondholders and shareholders. From a practical execution point of view, corporate CDS and equity markets have active and liquid markets versus no current market for CDS on ABS. Cheaper, more liquid and more efficient shorts are available in corporate CDS than in ABS (Exhibit 1). For traditional ABS investors, we recommend maintaining course in auto ABS. Top tier names offer relative safe haven to ride out the negative auto headlines in the near term.
Ok, so those points are well taken but – and this is a big “but” – did you notice the inherent irony in that assessment? JPM says this:
… the Great Recession experience has been incorporated into the stresses for auto ABS
That’s all fine and good, but if all of the arguments outlined above (the bolded passages) sound a whole lot like the arguments Wall Street would have spit out a decade ago in an effort to discourage folks from shorting the housing market, that’s because they are the same arguments.
Finally, when you hear people like Mary Kane say things like “too many people have seen the movie ‘The Big Short’ and are starting to think the movie heroes’ short strategy would translate to the ABS market” and/or “it’s not wise to believe everything you see in a movie and hit films are not the best source for trade ideas,” do remember that one of the very same “heroes” from that very same movie, recently said he was worried about this very same subprime auto market.
Trade (or don’t) accordingly.