When The Music Stops, Who Gets Stuck With The Bad Loans?

Bad LoansThe Federal Reserve is raising interest rates. Higher rates = higher monthly payments = more defaults. Who will get stuck with bad loans?

Wolf Street recently interviewed Mike Jackson, CEO of AutoNation, the largest auto retailer in the country:

“We knew ‘free money would inevitably end. Affordability would become an issue…’

The double whammy are rising costs for highly leveraged companies, such as auto dealers, and consumers facing rising prices of vehicles to be financed at higher rates. Something has to give.

…. Finance and Insurance (F&I)…is where the dealer makes money off arranging auto loans with lenders…sells additional warranties, dubious insurance products, and miscellaneous fluff & buff.

…. As is industry norm, the dealer makes more money in F&I off each vehicle than by actually selling the vehicle.”

A recent Wall Street Journal (WSJ – behind paywall) article reports:

“Banks have spent much of the past 10 years chasing ultra-creditworthy borrowers. Yet that slice of the market, which has grown as the economy has improved, is largely tapped out.”

Our current economic growth has been built on a mountain of debt. It is unsustainable.

FRED Federal Debt Chart

Our debt has increased from around 60% of Gross Domestic Product to over 100% in the last decade. The boom is financed by consumers up to their eyeballs in debt.

Wolf Street’s article, “The State of the American Debt Slaves, Q3 2018” sums things up well:

Non-housing Debt Chart

“…. Consumer debt is up 49% from the prior peak at the cusp of the Financial Crisis…thus continuing the time-honored trend of debt rising faster than nominal GDP.”

What happens when the music stops, and the loans can’t be repaid?

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Then

My son Dean was at the Naval Academy and wanted to buy a car. He found his dream and got the “best price” from the dealer.

Our banker looked over the paperwork and said he wouldn’t make the loan. The payments were too high for his income, and the real value of the car was lower than the dealer’s price.

When we left, I explained the bank did him a favor by not lending him money, he can’t afford the payments. He also provided a clue – the dealer is charging too much. He should be negotiating with the dealer, not overpaying for a car.

The salesman was grinning as we walked in, anticipating a sale. Dean handled the situation. He calmly said he couldn’t afford the payments and the car was overpriced. They must cut the price, or he would shop elsewhere.

The salesman offered financing. He said, “No, the bank told me what I can afford.” They made a substantial price concession and he bought his first car. I was proud when he said, “Thanks for the great lesson Dad.”

Now

The aforementioned WSJ article is titled “Why Your FICO Score Could Get a Boost in 2019”.

Move the goalposts

The U.S. didn’t crack 3% GDP for 7 years. They had to figure out how to “goose the numbers” to look better politically. Research & Development & Hollywood Royalties were added to the GDP calculations…. R & D? Really?

It took a couple of years for these new items to work their way into the calculations, but guess what we have now? Greater than 3% GDP…. See? It was easy to do! Just move the goal posts!

Another case of “if you can’t beat ‘em, cheat ‘em”…

– Chuck Butler 11-9-2018

“Credit scores for decades have been based mostly on borrowers’ payment histories. That is about to change.

…. The UltraFICO Score…isn’t meant to weed out applicants. Rather, it is designed to boost the number of approvals for credit cards, personal loans and other debt by taking into account a borrower’s history of cash transactions….

…. The new score…is FICO’s latest answer to lenders who after years of mostly cautious lending are seeking ways to boost loan approvals.” (Emphasis mine)

Nerdwallet fills in some details:

“Credit newbies are more likely to see a significant benefit, assuming they have not had a negative account balance in the past three months and maintain a decent savings balance. (meaning $400 or more.)”

The WSJ article adds:

“Applicants will be able to choose which accounts they want considered when the score is recalculated.”

Banks want to boost loan approvals as there are not enough people with good credit. FICO scores can improve as much as 20 points if you have a $400 savings account and have not overdrawn your checking account in the last 90 days? Gimme a break!

When the going gets tough, move the goal posts. If there are not enough good FICO scores available, goose the numbers to create the illusion you found some more!

What happened to giving honest feedback to a potential borrower?

The dirty little secret

Good friend and mentor Al (fictitious name) was a big-boy banker; involved in all aspects of banking. Many sought his advice until he recently passed away.

His back-porch lessons explaining what really happened with the Fed’s bank bailouts were priceless.

There are around 4800 commercial banks in the US, down from 6800 in 2014. America’s top five banks control 47% of the banking assets. The remainder is divided among 4795 banks.

Al said bank examiners really scrutinize the smaller banks. They regularly audit them, ensuring they have a solid loan portfolio and will remain solvent. Banks want to keep the auditors happy.

When smart bankers lend money, they look at the loan in terms of how a bank auditor would grade the loan. They keep the prime loans and sell the rest to get them off their books. (Note the significant reduction of small banks since 2014)

Who buys them? Most are bought by investment firms, packaged together and resold to retail investors as loan portfolios. They package a bunch of risky loans with just enough better ones to get a good rating from the rating agencies.

There are countless articles, like the NYT, “Ratings Agencies Still Coming Up Short, Years After Crisis”:

“The mistakes that led to the 2008 mortgage crisis can’t happen again, right?

Not so fast, particularly if you’re talking about credit ratings agencies like Moody’s Investors Service and Standard & Poor’s. Eight years after these companies were found to have put profits ahead of principle when they assigned high grades to low-quality debt securities, some of the same dubious practices continue to infect their operations. (Emphasis mine)

…. There’s an entertaining – and illuminating – scene in the movie “The Big Short” that perfectly captures the pathology. As a Standard & Poor’s employee played by Melissa Leo replies when asked why the ratings agency didn’t insist on higher standards: ‘They’ll just go to Moody’s’.”

“The Big Short” is about how one Wall Street Guru, Michael Burry, reviewed thousands of individual loans, concluding the loan packages were full of bad loans, the market was corrupt, and many would default. They bet against the US mortgage market and made billions when the collapse finally came.

Changing FICO score methodology and jacked up bond ratings creates the illusion of prudence. It’s putting lipstick on a pig!

The next sucker can worry about default.

Who gets stuck?

The Hutchins Center tells us about last time:

“…. In QE1, the Fed purchased a total of $1.25 trillion in mortgage bonds, $200 billion of debt issued by government-sponsored mortgage companies Fannie Mae and Freddie Mac…. The third and final round…(included) an open-ended commitment to buy another $40 billion per month of mortgage bonds until the economy recovered.”

Federal Reserve's Assets Chart

When the music stopped the taxpayers got stuck with the bad loans.

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What about the retail investor?

Subscriber Carl S. voiced a major concern of many readers with his question in the comments section of our recent article, “Is The Fed Engineering A Market Crash?”:

“You talk about stocks, but how would a recession affect holding corporate bonds (the good stuff, not junk), much of which is top tier financial institutions?”

Here are some considerations

  • Are the bonds non-callable? We had much of our nest egg in CDs when the last crash happened. We didn’t lose money however; our CD’s were called in – we lost our major source of retirement income. Callable bonds/CDs are not safe when the Fed drops interest rates.
  • How do you own the bonds? Are the bonds held individually or packaged in a bundle? Much like buying a barrel of produce, you don’t know what is hidden in the middle. What happens when investors try to liquidate? Will the better holdings be sold off to pay for those liquidations?
  • Did your broker pitch you to buy them? The major brokerage firms bundle these together and sell them, touting safety and good yield. Your friendly broker may not get a commission, but his/her performance is measured on how they sell their company’s products. Higher interest rates don’t always mean better, they may also mean higher risk. Caveat Emptor!
  • Are you positive the corporate issuer can repay them? Carl mentioned top-tier financial institutions. Are you betting on another bailout if things collapse? I would not want to risk any of my retirement money on bonds from Sears or GE today even though they were once highly revered companies.
  • Is the differential between yield between bonds and FDIC insured CD’s worth the risk of default? There should be a solid interest rate spread, enough additional interest for taking the additional risk of default.

Be careful relying on FICO scores and agency ratings. Be like Mike (Michael Burry), do your homework. When the music stops, we should be as far away from risky debt as possible.

When the crash does arrive, there will be plenty of terrific investments on sale at bargain basement prices.

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On The Lighter Side

I hope everyone had a wonderful Thanksgiving weekend. We took our son Dean to the airport on the 20th and it was already jam-packed with travelers.

Jo and I are headed to Prescott, AZ for the annual parade and tree lighting ceremony. I watched this YouTube video, loved it, and we decided to go last year.

The first Saturday of December they have a big parade, thousands of people turn out. As the sun sets, children are invited on the courthouse steps and everyone joins in Christmas carols. When the switch is flipped, and the lights go on, it is magical. It reminds us of the America we grew up in and feels very comfortable to us.

We are keeping our fingers crossed for good weather. It may be warm for the parade and several more layers of clothing added for the evening event.

I want to take a moment and thank our readers who go to our website LINK for their Amazon shopping. As an Amazon affiliate, shopping through our site helps us offset our costs.

And Finally…

Some may feel I’m living in the past enjoying things that remind me of our youth. Friend Tom G. supplies us with my answer:

Living In The Past Humor

Why is it we never forget the words to the songs of our youth?

Until next time…

2 comments

  • Rick Govern

    Hi Dennis:
    Your newsletter was interesting regarding bonds. My former money manager had several individual bonds in my portfolio. I have started to look at them. Many don’t pay a rate more than a 2-3 year CD with much more risk. The ratings on these bonds are sometimes difficult to find. It appears several of these are BBB rated or slightly better/worse. I don’t trust these bond rating agency given what happened in 2008. I also don’t trust the insurance companies that are supposedly insuring these bonds against default.

    In addition he put me in several closed end bond funds. He said they were good deals as they were selling at a discount to NAV. Upon further research, these CE bond funds ALWAYS trade at a discount to NAV (typically 5%-8% annual average discount). The theory is that you hold these for a long time and the interest payments make up for the loss of principal due to the discount. With the Fed raising rates, these CE bond funds now trade at a 10-14% discount to NAV. Even though the yield is higher than CD rates, the loss of principal is not covered by these higher yields. In recent days you can tell there is some buying as these discount are much higher than the annual average discount to NAV. This buying will end when they reach the typical annual discount to NAV or when the Fed raises rates in a couple weeks.

    Personally I will take the more stable, lower CD rates. This is just my view. Maybe I am missing something.
    Thanks,
    Rick

    • Dennis Miller

      Dear Rick,

      On behalf of all of our readers, thank you for sharing. I am very concerned about what might happen to investors who think they are safe in bond funds because they are diversified.

      Best regards,
      Dennis

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