Thursday, July 24, 2014

Credit Acceptance and subprime auto lending

Credit Acceptance (CACC) is a subprime auto lender. Glenn Chan has written a series of posts in which he describes CACC's business model and how it has produced strong historical returns, calling it a wonderful business. He writes that CACC is good at underwriting and debt collection and has developed mutually beneficial partnerships with car dealers.

Chan is an astute investor - his articles about mining are essential reading for anyone who invests in that sector-- but I think that CACC is a bad investment for several reasons.


Business quality

CACC is a successful lender, but high-quality lenders differ from the typical high-quality business in a couple of important ways:
• Loans are essentially a commodity, and underwriting them has few barriers to entry. During a boom, it's easy for new companies to flood into the financial sector and depress margins, even if those companies can't match the high-quality lenders' returns over a full economic cycle.
• Even if a lender is structurally more efficient than its competitors, loan losses can still sink it. This happened to Golden West during the housing bubble, and it was far from being the bubble's most aggressive lender. Lenders face existential risks that the typical high-quality business doesn't face. (Edit: mitigating this, much of CACC's debt is non-recourse).


Macro issues

Although lower-income Americans' wages have stagnated or fallen since 2007, subprime auto loan volumes are close to reaching their 2006-07 peak. According to the CFO of America's Car-Mart, another subprime auto lender, "We believe that our customers have never been more stressed financially and, at the same time, have never been presented with more aggressive financing options for their vehicles."

This may be suppressing CACC's loan losses: if subprime borrowers can easily get a car loan despite being financially stressed, then many of CACC's borrowers who would normally default can find other, more aggressive lenders to refinance them.

Glenn Chan points out that the documentation for subprime loans is very stringent, as opposed to low-doc loans that were common during the housing bubble. I don't find this reassuring because 1) the housing bubble was so excessive that auto lending doesn't have to reach the same extremes to be a problem, and 2) subprime auto loans have their own dangers. They're typically issued at LTVs above 100%, in many cases above 120%, even though cars depreciate quickly. The high LTVs let lenders get around usury laws and trick borrowers into paying higher effective interest rates, but they also lead to huge losses on the loans that go bad.

Eric Falkenstein, in his application of Batesian mimicry to the business cycle, argues that investors always fight the last war: if a certain class of securities does well during a bust, this convinces investors that the securities are intrinsically low-risk or high-quality, which paves the way for a bubble to develop.

I think this has occurred with subprime auto loans. Used car prices were very strong during 2009, thanks in part to Cash for Clunkers, and the Fed's efforts to stimulate lending were particularly effective with auto loans since they have relatively short terms. These things kept loan losses relatively low, and that's given investors a false sense of security regarding how bad they'll get during the next downturn.


Valuation and margins

If CACC meets analysts' estimates, it will earn a ROE of 40% this year with relatively low leverage. This really isn't sustainable. Would-be competitors may not be able to match this ROE, but they don't need to match it to earn high returns.

CACC trades at 4x TBV. This also isn't sustainable IMO. Not a lot has to go wrong for the multiple to fall, and CACC is buying back stock, which is a waste of money at that valuation.

5 comments:

  1. Thoughts on CRMT?

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  2. Thanks a lot for the post!

    I think that a loan with a high LTV has better risk/reward than a low LTV. In that sense it is less risky. If you are a lender that gives the dealer money for the entire loan, then a high LTV is risky. (So these lenders have stipulations against high LTV.) If the lender is like Credit Acceptance or Westlake, then the lender gives an advance for only part of the loan. That's not so problematic.

    2- It's not really losses on the loans that are a problem. It's what happens when lenders *underestimate* their losses. Because it's incredibly difficult to predict loan losses, underestimations are bound to happen.

    Intense price competition can lead to Credit Acceptance experiencing adverse selection.

    3- Loans with longer terms would be a sign of potentially dangerous lending. These loans are more affordable initially and will show lower delinquency initially. But they have a higher chance of resulting in losses because there is more time for the car to depreciate, need an expensive repair, or for the borrower to lose his/her job.

    But this is too obvious. There are lots of different ways to lend poorly in the subprime space. Problems might happen when subprime lenders try to expand into the deep subprime space (or from prime to subprime)... and learn lessons the hard way.

    5- I don't believe it's easy for deep subprime borrowers to effectively refinance. Only DriveTime offers that (DTChamp), but I think they know what they're doing.

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  3. I'm long CACC. Not totally convinced yet so only a modest position. Always appreciate contrary views. A few thoughts
    1. CACC sweeps all the money until it's advance is paid off. In other words, the dealer is in the first loss position. That is, until dealers start to pool loans after reaching 100 and receive accelerated holdback. I feel like a lot has to go wrong for CACC to lose principal. Reductions in the collection rate of course result in income reductions, but that is different than losing capital.
    2. I don't think comparisons to sub prime housing super appropriate. (A) For starters, what were so many people with sub prime credit even doing buying a house? The dollar amount in question are quite different (B) Auto lenders have large coupons to recoup their capital. This was not the case in housing. (C) More generally than sub prime housing, people were treating their houses as piggy banks which added much leverage the system; as stated in the article: cars depreciate, making this not really possible, (D) Cars can be repossessed very quickly relative to housing.
    3. There are two sides to the Manheim "coin". While falling car values hurt recovery rates, they help underwriting because the cars become more affordable. The SC CEO recently commented on this, and considered these offsetting effects basically a wash.
    4. CACC has exhibited strong discipline, walking away from business without a margin of safety. Witness the dealer attrition they experience and infrequent pricing changes.
    5. Regarding the "last battle" thought, it's not very clear to me who is really fighting the last battle. Those calling subprime another bubble or those who see structural differences.

    One thing I plan to ask CACC about is why their average loan size is significantly larger than those of competitors. My guess is that the difference is due to ancillary products. So the question becomes, why do they feel comfortable financing these costs when others do not.

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  4. Thanks for all the comments. I'll try to post a reply later this weekend.

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