The next 'Big Short' trade has a lot of problems

The Big Short Jaap Buitendijk ParamountJaap Buitendijk/ParamountChristian Bale as Michael Burry in ‘The Big Short.’

On February 11, Bloomberg reported that there is a new “Big Short”-style trade forming against subprime auto loans.

According to Bloomberg, investors are starting to make bets that the record number of auto sales — and by extension growing number of auto loans of any quality, though subprime is the primary concern here — is creating an unsustainable credit bubble similar to the housing market in 2007.

The problem is that the two aren’t really comparable and for reasons both academic and practical, the idea of a subprime auto loan bubble and a “Big Short” trade against it doesn’t add up.

The current situation is different than 2007

One of the biggest issues that brought down the housing market in 2007 was not only the sheer number of mortgages, but the mortgages extended to people that couldn’t afford them.

The number of subprime mortgage holders with bad credit and lower-than-needed-incomes to repay those mortgages was elevated during the housing crisis. Currently, the people taking out auto loans are more trustworthy.

“Data from the New York Fed’s Quarterly Report on Household Debt and Credit show that credit quality for auto loans has changed little in recent years and that credit growth has been solid across different grades of borrowers,” said Daniel Silver, economist at JP Morgan, in a note Friday.

So far, Silver noted there has not been an increase in payment delinquencies and the credit scores for people taking out auto loans is better now than it was before the 2007 recession.

“The median credit score for a new auto loan has come down only very slightly lately and it remains above the scores reported for much of the few years before the financial crisis,” said Silver. “And even for lower-quality borrowers, we see little change in credit scores for the 10th and 25th percentile of borrowers in recent years.”

A car is not a house

The other issue with the trade is that an auto loan is structurally different than a mortgage.

In a paper earlier this year, Amir Sufi of the University of Chicago summed up why auto loans are simply less risky than mortgages: you can repossess the asset.

Here’s Sufi (emphasis added):

“Since the housing bust, foreclosure timelines have stretched to more than 1,000 days in some states … In auto lending, by contrast, the lender may determine that the debt is uncollectible and repossess the vehicle in as little as 60 days following nonpayment … While cars are a depreciating asset, consumers are nonetheless maintaining their personal vehicles longer than ever … that translates to stronger, more accurate and predictable collateral for auto loans, a direct contrast from the often speculative value of houses during the run-up to the financial crisis.”

And there are other reasons loans on cars are different, too.

Sufi notes that auto loans have a shorter duration, a larger percentage of the loan is paid in a down payment, and they are nominally smaller.

All of these factors mean that any bubble in the auto loan market simply cannot get as big as the mortgage market, even if some pockets of vulnerable subprime loans are popping up.

Doesn’t add up

The size of auto debt market has increased and so have the number of securities backs by subprime loans. However, both of these numbers are still below pre-recession highs and the credit situation is better.

As Bloomberg reported, many large financial institutions have refused to execute the trade for clients, with some arguing it was bad for their reputation.

Whether or not it is bad for their reputation is debatable, but as for the trade itself? It doesn’t seem to make much sense.

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