An Anomaly Hiding in 1.73 Million Repossessions

You hear it before you see it.

A flatbed truck in the driveway at six in the morning. A man with a clipboard. The car you drive to work is going up on the ramp, and your neighbor is watching through the blinds. You were two payments behind. You meant to catch up.

Last year this happened 1.73 million times. That's the most repossessions since 2009, the year after the last crash.

The average new-car payment is now about $774 a month. For people with weak credit, that bill sits on top of rent, food, and a credit-card balance. And they are falling behind at a rate we have never measured before.

In January, 6.90% of subprime borrowers were at least 60 days late on their car loans. That's the worst reading in the data, which goes back to the early 1990s. It eased to 6.80% in February. Either way, it's a record.

So here's the strange part.

Those car loans don't just sit at the bank. They get bundled together and sold to investors as bonds. And those bonds are doing fine. Better than fine. The ratings on them keep going up.

In one recent year, the firms that grade these bonds handed out 313 upgrades and 11 downgrades. So the people are drowning, but the paper built on them is being marked safer.

Same loans. Two different stories. That gap is what I want to walk through this week.

Start with how the loans get sold. A lender pools thousands of car loans and sells slices of the cash flow to investors. The top slices get paid first. The bottom slices take the first losses.

So the senior buyer sits behind a wall. Late payments have to chew through the bottom slices before they ever reach the top. The deals are built with extra room on purpose.

There's a second reason. Most of the market isn't weak credit at all. Prime borrowers make up roughly three-quarters of these car-loan bonds, and prime borrowers pay. Their late rate sits near 0.4%, barely off where it's been for years.

And the senior slices get paid down fast. As they shrink, the cushion underneath grows as a share of what's left. So a bond can be aging while its grade rises.

But the wall only works if the loans behind it are what they say they are. Hold that thought.

When a borrower stops paying, the lender takes the car and sells it at auction. Whatever it fetches comes back to the deal. That number is the recovery rate, and it has fallen.

At the end of last year, lenders recovered about 33 cents on each dollar owed. Before the pandemic the figure was closer to 44 cents. So every default costs more than it used to.

There's a reason. The cars backing weak-credit loans are older and higher-mileage. They don't bring much at auction. And there are more of them coming through, all at once.

So the cushion is doing two jobs at the same time. It has to absorb more defaults, and it gets back less on each one. The wall holds. It just has less behind it than the math first suggests.

The graders see this. They keep upgrading anyway. The structure has held through every cycle so far, so the assumption is it holds through this one. Probably it does.

A Texas lender called Tricolor sold used cars to people with no credit history. It built a portfolio worth billions and borrowed against those loans from big banks.

Last September it filed for bankruptcy and shut down. Then the trustee opened the books. What he found, in his words, was fraud of extraordinary proportion.

Prosecutors say Tricolor pledged the same loans to several banks at once. About $800 million of collateral was promised more than once. In a review after the collapse, roughly 29,000 of 70,000 active loans carried duplicate vehicle ID numbers. The same cars, counted again and again.

Each bank thought it held the car. Several banks held the same one.

JPMorgan wrote off $170 million. Fifth Third took a hit near $200 million. These are careful lenders with whole departments built to check this.

The wall in a deal is only as good as the loans behind it. Here the loans were partly an illusion, and nobody caught it until the lender was already gone.

Three more things worth keeping track of.

Two bond markets split last week. Treasury yields jumped, with the 2-year up 19 basis points, and futures even began pricing a rate hike. Tax-free municipal bonds went the other way. Their yields fell as much as 10 basis points. The two usually drift together. They pulled apart, and that tug-of-war between fear of higher rates and a rush for tax-free income is worth watching.

The Swiss franc pays you nothing and keeps climbing. Switzerland's policy rate is 0%, the lowest in the world, and short Swiss government bonds yield less than zero. Yet the franc trades near an eleven-year high against the dollar. When people are scared, they pay to park money somewhere safe. The Swiss central bank meets June 19, and it may have to step in to slow the climb.

The car-bond market already had one scare. After Tricolor failed last fall, the price gap on the riskier slices widened by about half a percentage point in a month. Then bank earnings came in clean, buyers came back, and the gap closed again. The fright lasted weeks. Whether the next one fades as fast, we'll see.

In 1963 a man named Tino De Angelis cornered the market in salad oil.

He ran a vegetable-oil company in New Jersey. Banks lent him money against the oil sitting in his tanks. To prove the oil was there, inspectors came and measured. A warehouse arm of American Express vouched for it and issued receipts. De Angelis used those receipts to borrow from dozens of other banks.

The tanks were mostly seawater. A thin layer of oil floated on top, so when an inspector dipped a line, he hit oil. Under it was the ocean.

When one tank was checked, he moved the same oil to the next tank to be checked. The same oil, counted again and again.

On paper he had pledged 1.8 billion pounds of oil. The real number was about 110 million. He had borrowed against oil that was fifteen times larger than what existed.

It came apart in November. Fifty-one banks were owed more than $180 million against collateral that wasn't in the tanks. Two Wall Street brokers went under. American Express stock fell from $60 to $35.

The receipts were real. The oil was not.

I keep coming back to that picture. A line dropped into a tank. It touches oil, so the oil is there. Nobody drains the tank to check what's underneath. The whole system runs on the assumption that the thing you can measure is the thing you own.

The same cars pledged to several banks. The thin layer on top that passes the test. The careful inspector who measures exactly what he's shown and no deeper.

A grade on a bond is only as honest as the collateral under it. Most of the time the oil is real. We'll see.