The coronavirus has driven the consumer spending and unemployment picture on its head. If the math for subprime auto loans did not work before, it surely will not work in coming months. Below is a 2018 newsletter that recounts some of the dynamics in subprime auto lending. In that newsletter, this quote was a stark predictor of what many now face: “In the future, the negative impacts will only get worse: when the economy turns down, the larger loan amounts and length will be devastating for many borrowers.”
As the economy worsens, the ultimate holders of these loans will face some challenging questions. For example, what is the true economic value of their investment now? And, for many that have stated goals in socially responsible investing (i.e., SRI or ESG investing), what does that really mean to them? Two important questions that many may find hard to answer.
October 2018 – M2X Capital LLC
A Surprising Enabler of the Cycle of Poverty: Socially Responsible Companies & Investors
“We have met the enemy and he is us.” – Walt Kelly, Cartoonist (1913 to 1973)
Dr. Martin Luther King once said, “Philanthropy is commendable, but it must not cause the philanthropist to overlook the circumstances of economic injustice which make philanthropy necessary.” In short, problems are systemic and, if you do not fix the underlying drivers, then your ultimate impact is likely to be superficial. If he were alive today, Dr. King might feel a sense of excitement about the push for companies and investors to be more socially responsible – a trend with potential for positive systemic impact. Unfortunately, he would be dismayed that some of these self-proclaimed socially responsible groups are not merely overlooking the “circumstances of economic injustice,” they are potentially financing the root drivers.
Most of us intuitively understand the cycle of poverty. Impoverished people lack resources which, in turn, puts them at a disadvantage in terms of their education, health and opportunity set. This leads to poor people staying poor from one generation to the next. Where do socially responsible groups come in? Are they directly stealing from the poor? No, in fact, it’s worse. They fund a business that generates outsized returns but is nearly certain to drive many of its poor customers even further in debt, all under the guise of helping. To be clear, there are many drivers of the cycle of poverty, here we will explore just one: predatory lending, especially as it relates to subprime auto financing. As the Banksy photo below shows, it can be dressed up to look like a decent man trying to help, but the reality is not so pretty (the man is feeding the dog a bone, but he has sawed off the dog’s leg).
A Short Primer on Subprime Auto Lending
Subprime auto lending addresses a real need in the market. Many poor people lack access to credit. They typically need credit to buy a car, which is often necessary for them to get and maintain a job. While many traditional lenders stay away (or say they do but really do not, as we will explain later), other financial groups have filled the gap. These groups will make a seemingly reasonable argument: given the poor credit of their customers, interest rates must be substantially higher (20% to 30%) to compensate for the risk.
While at face value the argument is logical, reality is not so simple. First, customers are often less educated, economically disadvantaged and have limited options. In short, they are vulnerable. And, unfortunately, there are always some unscrupulous people that will try to take advantage of people in such situations. This can be done in many ways: false advertising, confusing documentation, deceptive sales tactics and overly-aggressive collection tactics. Predatory lending is called that for a reason: someone is a predator, someone is hunted. This dynamic has been well-recognized by people over time, as shown by laws attempting to thwart bad lending behavior from Biblical times to the present day.
To be clear, not all subprime lenders are predatory. Like any other industry, there is a range of ethical behavior from those that are decent to those that are criminal. However, there are a lot of warning signs that the less decent seem to be more active than usual the past several years. This perhaps is an entirely predictable, unintended consequence of low interest rates. Lenders can lend at 20% to 30% interest rates (whatever the law will allow for that locality), yet their funding costs have gone down – the spread is as large as it may ever be. Even better, the current political environment is bent on de-regulation and Mick Mulvaney is head of the Consumer Financial Protection Board. It might be the best environment for subprime lenders ever. One strategy to make the most money in such an environment would be to get more people into even larger loans at any cost. Unfortunately, this appears to be exactly what is happening.
Consider the following points:
1. Volumes of Subprime Auto Loans are Booming, Lending Standards Are Often a Joke: One easy way to lend money is to give loans to whomever wants it. Literally anyone. As an example, Bloomberg reported in May of 2017 that, “Santander Consumer USA Holdings Inc., one of the biggest subprime auto finance companies, verified income on just 8 percent of borrowers whose loans it recently bundled into $1 billion of bonds, according to Moody’s Investors Service.” Their competitor, Credit Acceptance Corporation offers “100% guaranteed credit approval.”
Predictably, auto loan volumes are sharply increasing. Business Insider reported that of the $1.1 trillion in auto loans outstanding, about $280 billion were subprime.
2. Two Ways That Dealers Make Loans Even Larger: Often, subprime auto dealers add on two other extras. First, as the cars are often old, you get sold on a service contract. After all, you are financing a really old car over 5 years. Second, guaranteed auto protection, so-called GAP insurance, is sold as a way to cover the costs of a car destroyed in an accident. Given the desire to do more loans at higher amounts, this creates a clear incentive to add lots of these to the loan amount, whether they make sense or not. As the example below shows, many times they make little sense.
3. Huge Increases in Value and Length Per Loan Means the Math Does Not Work: One way to get people into larger and larger loans is to make the term longer. After all, most of us – even the well-educated – often only think about the monthly payment and not the amount being financed.
Case in point: Credit Acceptance, one of the biggest subprime lenders in the industry, had been lending at values of about $12,000 to $14,000 per car for ~36 months before 2008. In the past 10 years, that has exploded to an average loan of $20,000 for 55 months in 2017!
Unfortunately, many of these cars are old and will not last without lots of costly repairs. The math of old cars, at such high loan values and lengthy terms does not make sense for the borrower at all.
4. Predictably, Many People Can’t Pay: What happens when you get poor people into these types of loans? Not surprisingly, many customers end up defaulting or, in subprime-speak, they “quit.” To give you an idea, about 35% of all borrowers at Credit Acceptance quit, or cannot pay. That is a remarkable number.
5. But If So Many People Default, How Do the Lenders Make So Much Money? Up until now, this might seem like a bad business for the lender. You give money to anyone with a heartbeat and a lot default. You might be surprised that it turns out to be very lucrative: for example, Credit Acceptance Corporation has generated 35% ROEs over the past 10 years. That is over 2x the return on equity of the S&P 500.
At its surface, high industry returns with high default rates might seem perplexing. But as you dig deeper, you realize that the lack of initial vetting on the loans is more than made up by aggressive legal collection efforts on the back-end. For example, the research firm PlainSite did an exhaustive analysis of court cases related to Credit Acceptance Corporation. One finding: In Michigan’s 36thDistrict (i.e., Detroit), nearly 12% of ALL cases were related to this one company suing its customers to garnish wages and income tax refunds for years or decades into the future!
The Los Angeles Times uncovered another piece to the financial model. When someone defaults, you simply repossess that car and re-loan it to another person. They detailed one single car that was repossessed and loaned out to other owners 8 times in 3 years! Worse yet, the loan amounts were at 2x to 3x the Blue Book value of the car each time. The comedian, John Oliver, detailed this example in his program on auto lending and then researched that same car for an update. What did they find? That same car was again repossessed and resold two more times!
Could it get worse? Charles Juntikka, a bankruptcy lawyer, detailed why many lenders were so open to lending to recently bankrupt people in an interview with The New York Times. He said, “The reason people are targeted after bankruptcy is that….they know they can’t declare bankruptcy again for another 8 years.” A creative, but particularly devious, customer acquisition strategy indeed.
When you put it all together, you begin to understand how such high returns can be generated with such low lending standards and high default rates.
Customers Consistently Complain About the Business Practices
Perhaps not surprisingly, many customers do not seem to be big fans of these types of lenders. In fact, when you peruse the Consumer Affairs or Better Business Bureau reviews, many customers seem to hate them. Now, to be fair, some customers are clearly going to be at fault and even the best businesses get unfair complaints. However, reviewing complaints highlights several issues:
- Customers are often desperate with limited options
- Customers are often not well-educated and lack an understanding of the math of the loan
- Customers consistently complain it was not explained well and fees were hidden
- Lender collection tactics are aggressive (e.g., remote GPS car shut off, garnishing wages)
Follow the Money: The Socially Responsible Enablers
The real question is: Who is funding it? After all, the funding is what allows the business to scale. Indeed, these loans are scaling – which risks putting tens of thousands of people into loans they will never be able to pay back and perpetuate a cycle of poverty.
Credit Acceptance Corporation (CACC), a publicly traded business in subprime auto lending, is a good example of the general financial model. At a high-level, CACC has a network of used car dealers selling old cars. As dealers sell cars, CACC finances these through their dealer-partners. CACC’s own funding comes from the debt on its own balance sheet and through periodically packaging groups of loans and selling these Asset-Backed Securities (ABS) to others looking for high-yielding securities via Wall Street.
Who is the ultimate financier, then? Meaning, who is funding companies like Credit Acceptance Corporation. Research into the bonds, warehouse loans and ABS related to Credit Acceptance Corporation revealed they are owned by many companies and investors that seem to be very focused on being “socially responsible” per review of their stated corporate philosophies. Holders include Wells Fargo, Calvert, The Hartford, American Family Insurance, Mutual of Omaha and J.P. Morgan Chase & Co (see Figures 10 and 11).
Research into the stated social responsibility philosophies of these holders highlights such admirable goals as economic inclusion and community building (see Figures 12-15 below). Unfortunately, that stands in stark contrast to the impact that many of these types of loans have on borrowers and their communities. In the future, the negative impacts will only get worse: when the economy turns down, the larger loan amounts and length will be devastating for many borrowers.
Many of the groups below are good companies with many decent people working there. Regardless, their capital may ultimately be blamed as the fuel that drove this type of lending to unprecedented levels. While the knee-jerk reaction may be to argue that these investments are aligned with their social responsibility goals somehow, I would politely suggest these groups take a few moments to do the following:
- Read/listen to every link at the back of this report.
- Read customer complaints online, read the lawsuits, talk to borrowers.
- Probe how variable service contracts and GAP insurance work.
- Do the math of the loan agreements to the borrower (add car repairs as well).
- Probe why certain companies do not disclose typical data – are they hiding something?
- Ask yourself why these businesses sue their customers so much.
- Ask why some lenders have average loan terms of ~5 years, but do not write off bad loans for 10 years? See question above.
- Brainstorm hypothetical newspaper articles that may be written about your involvement – especially in an economic downturn when this might become a fixture in the news.
Note that there are many more investors with similar social responsibility goals involved in these loans. Those listed below are by no means comprehensive nor meant to single any one group out.
Final Thought: What Might Dr. Martin Luther King Say?
Dr. Martin Luther King always thought about the root cause of problems. This is evident is his quote at the beginning of this newsletter: that we must not, “…overlook the circumstances of economic injustice which make philanthropy necessary.”
Being pragmatic, he would not be surprised to find some unscrupulous lenders to the poor: there always have been and always will be. Rather, he would focus on the root cause that is leading to such high levels of lending today: the ultimate financier of those loans.
What might Dr. King say to those financiers, especially those that talk genuinely about social responsibility yet seem to be investing heavily in these loans? My guess is he would make the following points:
- Recognize your capital is the fuel driving these loans to scale to unprecedented levels
- Social responsibility is as much about what you don’t do, as it is what you do
- This is going to end badly, why would you want to be there? [the carrot]
- Society is more transparent & viral than ever; #ThisLoanRuinedMyLife [the stick]
No doubt he would end on a positive note, stating something he said in a speech many years ago: “The time is always right to do what is right.”
For those that have interest, additional information is available via the links below:
- John Oliver on Auto Lending [it is always good to start with well-informed comedy] April 2016
- They Had Created This Remarkable System for Taking Every Last Dime From Their Customers – Mother Jones with the Investigative Fund, April 2016
- In a Subprime Bubble for Used Cars, Borrowers Pay Sky-High Rates, The New York Times, July 2014
- Wheels of Fortune: A Vicious Cycle in the Used Car Business, Los Angeles Times, November 2011
- Credit Acceptance Report – Reality Check, 3 Reports: December 2017, February 2018, March 2018
- Wheeling and Dealing Misfortune, National Employment Law Project, AFL-CIO – July 2017
- Dirty Money (2018), Episode 2 is on Payday loans, similar issues as in auto subprime lending (Be sure to watch until the end for the last few minutes of Q&A with Scott Tucker, CEO).
Interviewer: “Do you think you are a moral person?
Scott Tucker: “I’m a business person.”
(Spoiler alert: He was sentenced to 16 years in jail. Click here)
Source: Forbes – Money