The Hungry Ghosts


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A group of hedge funds, convinced they have found the next Big Short, are looking to bet against bonds backed by subprime auto loans. Good luck finding a bank willing to do the trade.

Money managers have looked at betting that subprime auto securities will tank for many of the same reasons that investors wagered against risky mortgage bonds in the run-up to the financial crisis: Loan volume has mushroomed in the last few years, lending terms have become looser and delinquencies are ticking higher. Mary Kane, an asset-backed securities analyst at Citigroup Inc., wrote in a note late last month that the bank has received “an explosion of calls” in recent weeks, after the movie “The Big Short” portrayed a group of traders that wagered against subprime bonds. The demand now is coming from hedge funds that trade everything from stocks to bonds, analysts said. But many banks, including Bank of America Corp. and Morgan Stanley, are not interested in making the bet happen for clients, according to representatives of the firms. Some said they fear that helping clients wager against car loans would be bad for their reputation, and that new capital rules and other post-crisis regulations would make the transactions difficult or even impossible to put together. “Most trading desks just don’t take that kind of risk now,” said Mike Edman, a former Morgan Stanley executive who helped invent credit derivatives that helped Wall Street banks bet against subprime mortgage bonds.

At least one trading desk has done this sort of trade. Etai Friedman, who runs hedge fund Crestwood Advisors LLC and manages $250 million, said he was able to work with a salesman he had known for years to buy an option that performed well if a custom-made index of subprime auto bonds fell. Friedman declined to identify the bank that did the trade, on which he earned a 36 percent return, but said finding a dealer was hard. “A trade like this is just taboo now,” Friedman said. Banks’ reluctance to help investors bet against subprime auto loans signals that may be paying more attention to how their trades will play with regulators and in the media, after having been criticized for crisis-era transactions. Goldman Sachs Group Inc. paid $550 million in fines and restitution to settle SEC charges that it misled investors when it helped hedge fund Paulson & Co. bet against mortgage bonds, and also faced a Senate subcommittee hearing and report about its role in the deals. Regulators have also been pressing banks to think hard about the ethics of the trades they do for customers after a series of market manipulation scandals in markets ranging from benchmark interest rate Libor to foreign exchange. William Dudley, president of the Federal Reserve Bank of New York, has warned banks that if they do not do more to stop wrongdoing, regulators will consider breaking them up. The U.S. Financial Regulatory Authority, an industry regulator, identified fixing banks’ culture as a top priority this year.

In addition to Bank of America and Morgan Stanley, Deutsche Bank AG and Barclays Plc, will not do these trades, said people with knowledge of their policies, asking not to be named because they were not authorized to speak publicly on the matter. JPMorgan Chase & Co. hasn’t done the trades and doesn’t recommend that clients do them, two people with knowledge of the bank’s activities said. Citigroup’s Mary Kane wrote that she advises clients not to do the trade, and an analyst for Wells Fargo said he recommends against such transactions. Representatives for the two banks declined to comment. For investors who see more risks building in auto securities, shorting the bonds is a tempting proposition. Outstanding auto loans grew by nearly 50 percent between 2010 and December 2015, the last period for which the data are available, and now stand at more than $1 trillion. Rapid growth can signal that lenders have not been paying enough attention to risks, as was the case during the housing boom last decade. There were about $170 billion of bonds backed by auto debt outstanding as of the end of last year, up more than 45 percent from 2010, but below pre-crisis highs. New risks are also emerging that weren’t seen in the last lending cycle. Those include longer loan repayment terms, ballooning loan amounts and more willingness to finance used cars. More car debt is going bad, at least judging by loans that are bundled up into bonds and sold to investors. Net losses on securitized subprime loans rose to 7.5 percent in November, marking the highest level since 2010, Standard & Poor’s data show. Many of those delinquencies are coming from newer subprime lenders that are less heavily regulated than banks.

Too many borrowers are likely driving away with cars they can’t afford, said Janet Tavakoli, president and founder of Tavakoli Structured Finance. Tavakoli sounded alarms about the mortgage bubble before its collapse. Now she’s predicting troubles brewing in auto securities. “The auto loan market is very similar to what we saw before,” she said, calling loan fraud one of her biggest concerns. “Borrowers aren’t well-documented, and in many cases they don’t even need credit scores,” she said. “It’s a real scandal this is happening.” Even if banks were willing to do the trades, clients would be foolish to bet against auto bonds, Citigroup’s Kane wrote in her recent note. Bonds backed by auto loans have historically performed well during economic downturns, in part because the deals have enough assets backing them to protect investors against a high level of defaults, she said. “Hit films are not the best source for trade ideas,” Kane wrote. “The Big Short,” based on Michael Lewis’s book with the same title, was released in December. In the subprime mortgage crisis, there were credit derivatives that investors could use to bet against an index of bonds backed by the home loans, but no such derivatives exist now for bonds backed by auto loans, said John McElravey, an ABS analyst at Wells Fargo. Inventing such a product is hard because few money managers want to use derivatives to bet that these securities will perform well — they would rather just buy the bonds outright. In other words, even if some customers want to bet against bonds with derivatives, few are interested in using these instruments to wager that the underlying securities will perform just fine, McElravey said. He is telling clients that betting against auto ABS is “a terrible idea.” Still, investors are expressing interest in the idea, said Don McConnell, a senior portfolio manager at BMO Global Asset Management in Chicago, who helps manage $15 billion of taxable bonds.

“Some guys over beers have asked to do these trades,” McConnell said. “It’s a very interesting concept.”