by John Rubino
The longer an expansion lasts, the crappier its paper becomes.
That may seem like a baseless assertion, but it’s actually just simple math. Early in recoveries, borrowers and lenders are both shell-shocked by the just-ended recession, so only high-quality deals get done. But as time passes, all the good borrowers get their loans and if banks want to keep the deals flowing, lower-quality borrowers must be found and financed. Eventually the deals become shockingly speculative and start blowing up en masse, bringing on the next downturn.
For a more sophisticated explanation of this process, see the work of the late/great Hyman Minsky, as described here:
Hyman Minsky has become famous in the aftermath of the financial crisis for his characterization of the three phases of markets – hedge finance, where the borrower can repay interest and principal out of cash flows; speculative finance, where cash flows can repay interest but not principal, and therefore need to roll over any financing; and Ponzi finance, where cash flows cannot pay either principal or interest and therefore must either borrow more or sell assets to support those costs.
The Minsky moment in a crisis is when Ponzi finance becomes the most common. My colleague John Rooney aptly compares these to a fully amortizing mortgage, an interest only mortgage, and a negative amortization mortgage – images from the housing collapse, which was the most recent Minsky moment.
Where are we in this cycle? Based on the following, it’s Ponzi time:
Car finance companies have pushed into fresh territory this year by selling Single B rated debt backed by loans made to sub-prime borrowers.
Selling Double B bonds was a bold trade not so long ago but as demand has grown for riskier assets, auto sellers are now able to sell further down the capital structure.
“It would appear that investors have grown comfortable with this collateral,” S&P auto ABS analyst Amy Martin told IFR.
“But some investors who are buying this class stand to lose principal if losses are just mildly higher than expected.”
American Credit Acceptance, First Investors, Foursight Capital, United Auto Credit and Westlake have each sold Single B bonds this year, according to Intex data.
By migrating to Single B from Double B, investors can pick up a bit of the spread that has vanished from less risky classes.
Last summer Double B spreads sank to a post-crisis low of around 300bp. But by last month, Westlake had cleared its Double B notes at 205bp, according to IFR data.
Its Single Bs fetched 325bp to yield 6.1%.
“It will be one area to watch,” a senior ABS banker told IFR this week. “We used to say that the Double B window was not always open. Now multiple companies are selling Single Bs.”
Already – with the economy growing nicely and interest rates still historically low – subprime auto loan defaults are trending upward, and are now above their Great Recession levels. So it’s reasonable to assume that when the next recession hits, hundreds of thousands of Americans who bought cars they couldn’t afford with money they didn’t have will find those never-ending payment terms more than they can handle. The sector will become a high-profile casualty and today’s “comfortable” investors will be a lot less so.
As Always, Pensioners Are the Real Victims
Speculation on this scale (dressed up as conservative fixed-income portfolio management) is only possible in an environment of excessively easy money. When governments force interest rates down to unnaturally-low levels in order to manage their own excessive debts, they force conservative investors like pension funds and retirees to reach for yield via equities and junk bonds.
This adds a couple of years to the expansion but at the cost of catastrophic losses for people who don’t deserve it and can’t afford it.