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Author: howardroark Big red star, 1000 posts Top Favorite Fools Feste Award Nominee! Old School Fool Add to my Favorite Fools Ignore this person (you won't see their posts anymore) Number: of 21325  
Subject: Credit Wedges Date: 8/16/2010 3:56 PM
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CarMax still securitizes. In fact, they barely stopped. Their most recent pool was issued last month. Details for the under-stimulated:

http://www.sec.gov/Archives/edgar/data/1259380/0001193125101...

If you don't know, CarMax mostly buys and sells used cars. Used, but not usually very old. This is not a buy-here-pay-here repo operation disguised as a used car lot. Average sale prices are over $15K. About two thirds of its sales are financed on the lot -- either directly from CarMax Auto Finance or through a third party lender deal. All subprime (currently around 8% of total) is currently farmed out to Santander. So CarMax Auto Finance is a prime, collateralized used car lender. But it is a securitization vehicle, so the actual lending is done by outside investors. For the most part, CarMax is just the intermediary.

In early 2006, when credit conditions were so good that strip mall owners were bribing every Tom, Dick, Steve, Barry or Dov Charney just to borrow from them, CarMax Auto Finance also issued a securitization pool. That pool was eerily similar to the most recent incarnation. Well, eerie to those of us who are easily frightened by similarities in complex financial structures.

In both cases, $600-$700m of used car receivables were being securitized. The borrowers' average FICO scores were 690-700. The average loan-to-value was around 95%. The typical contractual loan maturity was about five years. Neither set of lenders required initial overcollateralization from CarMax. In other words, $600m of notes were backed by only $600m of receivables, not, say, $615 million. Actually, the 2006 pool had a slight (0.5%) initial O/C requirement while the most recent pool has none at all. Over time, both pools required a smallish O/C build-up which serves as credit enhancement. In the 2006 pool, this was 1.65%. Now, it is 1.5%. The structure of the notes in terms of seniority and waterfall is also very similar.

In other words, to the extent that we have gone from credit nirvana to the new normal, the effects don't really show up in the terms of these loans. Of course, I haven't mentioned price. In 2006, the weighted average fixed coupon on the notes was 5.33%. Pretty cheap financing. This was only 30-40 points above Treasuries of similar duration (the yield curve was pretty flat at the time). The recent pool? The weighted coupon is only 1.44%. The yield curve is steeper, so the spread to Treasuries is trickier depending on duration, but it isn't much different. Maybe a bit higher, but not much after considering the lower O/C.

In case the one interesting morsel got lost in my lullaby, let me restate: People are willing to lend 2-3 year duration money to used car purchasers at 1.44%. Well, not quite. Even without an initial O/C or a big build-up O/C requirement, the spread between the actual loan coupons and the rate on the notes provides a lot of protection for the note-holders. But it is still largely true that the underlying lending conditions for these loans look roughly as healthy as they did back when the people were singing songs about liquidity falling on our heads, except that risk free rates are much lower now.

So here is the funny thing. The underlying loans charge almost the same rates. The 2006 loans averaged 9.98%, while the 2010 loans average 9.45%. So in 2006, the spread between what borrower paid and what lenders received was 4.65%. Today, that spread is 8%. This is a huge difference. Now, it's okay to say that some of this difference does reflect credit conditions. That is, the bigger the spread the more credit protection, so the rates that lenders are charging relative to Treasuries have to be judged relative to the excess spread. But when you think about the way these deal are structured, you realize this isn’t the real story told by these exploding spreads.

The real beneficiary of the big spreads is CarMax. Not necessarily in an evil, I-want-to-call-them-CarShark-on-my-blog kind of a way, but beneficiary nonetheless. Remember, if borrowers were paying 9.45% and lenders were receiving 5.00% instead of the actual 1.44%, the lenders’ cushion would be just as big, except they would actually get to keep some it. Instead, anything unused by losses accrues to CarMax. But as a pure originator, CarMax has essentially no capital at risk. You remember the originator model, right? In its purest sense, you originate loans under a non-recourse warehouse facility and then sell them into non-recourse securitization. The only capital you ever put on the table is the warehouse haircut, which for a prime originator can be minuscule. In practice, many originators become impure after being exposed to bad influences, and end up taking more warehouse risk, retaining the junior piece of the securitizations, overcollateralizing, and creating EPD risk for themselves. During the ugly days, Carmax did some of this. But they are doing none of it now.

Right now, Carmax will fund a loan through its non-recourse warehouse at some teeny, tiny haircut. It will then sell that loan into its term securitization as linked above and retain none of the subordinated interest. In return, it gets the excess spread, the 8% delta between the 9.45% loan rate and the 1.44% securitization note rate. Now, losses for the most part reduce the excess spread, so it really gets 8% minus the annual loss rate. Currently, that is about 1%, as reflected in CarMax’s allowance for loan losses. So the expected annualized spread to Carmax over the life of the deal is 7%. Carmax says it costs about 1% of receivables to run its finance business, including servicing. So CarMax’s expected earnings on this deal nets to 6% of receivables originated. But that 6% is against roughly no capital. Sure, you need a few computers, some software, and some office space to run an origination and servicing business, but not much. That's not Joe the mortgage broker economics, it's Match.com.

Compare this to the 4.65% spreads they were generating in 2006. Ex-losses and expenses, this nets to 2.65%. 2.65% on basically zero capital is still nothing to cry about. What’s the source of this value? One way to think about it is to compare Americredit, where operating expenses generally ran 2.5-3% of receivables. So of the 2.65% net spread on the 06 deal, another 1.5%-2% is what CarMax gets for have naturally lower origination costs. This comes a little from the overhead leverage of having an actual, related business besides origination, but mostly from the extremely low cost of storefront origination. This is the source of most of the value you see in retail credit card deals. Subtracting that cost advantage, you are left with 65pm to 100bp in excess spread, a less shocking return for riskless intermediation. But the 2010 version of these deals is so fat, the wedge remains astounding even after truing up for lower origination costs. If losses come out as expected, KMX stands to take in ~$80 million over the life of this deal net of losses and expenses as compared to ~ $35 million under a similar deal in 2006. And that's just this deal, they've pulled off three deals at these levels and counting.

I think a reasonable way to describe this wedge is as an index of the state of trusted underwriters. The current semi-liquidity trap is commonly (and reasonably) described as a shortage of risk free assets relative to demand. But a better description might be a little more expansive: A shortage of trustworthy lower risk but still risky assets relative to uncertainty. With the former torch carriers of underwriting assurance in the doghouse (Moody’s, et al.), a general paucity of underwriters who emerged mostly unscathed through the downturn (no CarMax securitization investor ever came close to losing a dollar), and banks seemingly no longer trusting themselves to leave the doughnuts out, there are pretty juicy monopolistic profits to be had by originators in good standing. One feature of this is probably sticky credit, where consumer rates aren’t coming down as much as they would based on both the short end of the curve and pure credit spreads if more trustworthy originators were available to bridge the huge gap between lending demand and consumer rates. In the meantime, for the lucky few, the pure origination business has become everything it was cracked up to be and more.
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