Disclaimer: This interview is for informational purposes only and should not be relied upon as a basis for investment decisions. In Practise is an independent publisher and all opinions expressed by guests are solely their own opinions and do not reflect the opinion of In Practise.

{audio:0:03:05} We understand the subprime space and come from the equity side, but on the ABS or bond side we are newbies and struggle. As you are involved in the subprime space, what are you currently seeing?

{audio:0:03:52} Everybody is finding it challenging in terms of closing on the deal because the spreads have significantly increased and, therefore, so have the yields demanded in the market. We are trying to close on our securitization and the yield will be the highest we have ever had, even though we were early in the market and our platform is fairly new. What generally happens is, the newer in the securitization area you are and the more securitizations you do, the better your cash flow and the more investors see you as a stable company. Our spread decreased in 2021 but we have seen a significant increase during 2022. Rating agencies are putting an additional buffer in terms of loss expectations, which is creating a challenge in terms of OC, additional requirements and some of the assets we need to buy.

{audio:0:05:30} How much has cost of funds increased across the board from 2021 to now?

{audio:0:05:45} I am more of a credit risk management professional versus an ABS professional. I do help in the credit risk management aspects of securitization, so I am aware of pieces, but I am not an expert, so I wanted to ensure we were all on the same page. The investment bank who is helping us with securitization told us to expect a 200 to 250 basis point increase in the overall yield expectation we are seeing from 2021 to 2022 at this point.

{audio:0:06:46} Could lenders increase yield to mitigate that situation?

{audio:0:07:13} Big players like Carvana or CarMax can control which accounts go into their overall pool, because that impacts the loss expectation which drives the overall ABS pool. They would look at the weighted average cycle, concentration across geography and the term, and the current challenge globally is the shortage of inventory which increases the inventory cost. That obviously drives the amount financed, from a customer standpoint, higher. Companies like Capital One or Ally can leverage their deposit to fund a high-risk customer or portfolio, so if they want to get better yield in the market, they can change what goes into their overall pool.

{audio:0:09:01} Are you implying that lower credit has been more impacted because people are worried about potential losses down the line, so there's an increase in the cost of funds for the lower FICO as opposed to the higher FICO?

{audio:0:09:17} Higher FICO also has a cost, but that has been less impacted. Inflationary pressure definitely impacts the subprime and deeper subprime segment more than prime, because folks are living paycheck to paycheck. Previous recessions had an impact on subprime, and higher inventory prices are increasing the amplitude of risk that a customer takes.

{audio:0:10:03} Is there prior data we could look at to see how subprime performed?

{audio:0:10:20} Look at debt to income and payment to income, if folks share that, because it has a huge impact on the overall asset. Look also at the delinquency trends on a calendar basis, because in a subprime space, 31+ delinquency is a good proxy to how accounts will perform six months down the line. If you see that trend increasing, that indicates charges will increase.

{audio:0:11:19} What is the link between 31-day delinquency and six months?

{audio:0:11:27} If an account becomes 31+ delinquent, the charge off policy for auto loan portfolio in the US is 120 days past due, so there will be a lag between a 31+ to a charge off. Not every account from 31+ will roll to charge off, but there will be some delay. Another indicator to look at is deferments, which is a temporary relief most providers would offer as a lever to delay their delinquency and charge off. They offer temporary relief to their customers by allowing them to skip payments for two to three months. DriveTime, Byrider and ACC are very creative and will often try to hide that in the footnotes. They might even change their life time deferment policy from three or four deferments to six. Customers who are in such stressed conditions are bound to charge off.

{audio:0:13:16} We have been blessed with very low delinquency rates for a while, even through Covid where at first it looked as though it would be tough, but all the subsidies meant it went the other way. Will delinquency rates return to normal or is there a hurricane coming where, in a recession, delinquency rates go up way above “normal”?

{audio:0:14:11} Last year and the first quarter of this year were exceptions due to the subsidies. A second piece which helped charge offs for some lenders was high recovery rates due to inventory pressure, because the wholesale value of used cars increased 20% year over year. In the used car space, the average amount financed has increased by $7,000 from $19,000 to almost $26,000. The term has also increased which is always a no-no in the used car space, because it has a direct correlation with charge off. We have seen second quarter delinquencies and even the tail end of first quarter delinquencies rise. Q1 of 2022 saw 60+ delinquencies at 0.6% in the used car space, versus 0.64% in 2020, so not very different, but 2021 was 0.5%, almost 10 basis points lower for the 60+. The 30+ which was 1.8% in 2020 is now 1.6% and was 1.4% in 2021, meaning a 20-basis point increase from last year. The trend is that it's rising month over month at a much faster pace than what we saw in 2020. If I wear my risk hat, that will be a challenge in the subprime space where inflation impacts every aspect. The typical subprime customer rents their house, and people pay their rent before their auto, because eviction in the US is fairly easy from a renter standpoint. If they own their house, their payment hierarchy will be slightly different. That is a recipe for a bubble to burst in 6 to 12 months’ time.

{audio:0:18:22} How do businesses who structure these deals react to that? Do they simply accept higher funding costs?

{audio:0:18:37} Do they focus on the pockets where they can make margin at an acceptable risk?

{audio:0:18:46} There are several levers Carvana can pull. They can increase their margin on cars. In 2019, Carvana's retail sales price for customers was slightly lower than their competitors as they were trying to gain market share, but they have increased prices as customers know the brand and the ease of doing business with Carvana, so they have also increased their margin. They could also pass on the increased cost of funds by increasing the APR, which Carvana and most subprime providers have done. They could increase the term of the loans.

{audio:0:19:46} This is the first time I hear that APRs are being pushed up. Our question was if their strategy was to wait and see what the others do and simply accept the compressed spread, or pass it through to the consumer, and you are saying most of them are passing it through?

{audio:0:20:17} Some of them pass 50% and others pass 75%, but I don't have good visibility. Carvana is a big player who does not have a liquidity problem, so they might take a 40% rate increase because they're public and from a liquidity standpoint it's not a significant pressure, versus DriveTime or other smaller players in the market.

{audio:0:21:25} Why are they more protected than others?

{audio:0:21:39} They are more protected because of their brand name and time in the market. Carvana currently have some brand dilution but there is still a significant demand in the ABS space for them to continue securitizing.

{audio:0:22:19} When Covid came in 2022 the market pulled back and froze up; is there any risk of the ABS market drying up?

{audio:0:22:43} One challenge is if the inventory pressure continues until the end of 2023. If the Fed continues to increase, and there is an expected 75 basis point cut next month, then the market will see a higher cost of funds which will result in a rise in consumer delinquencies. I would pay close attention to the Q2 numbers which will be disclosed. Q4 is a difficult time for most of the used car subprime market due to holiday shopping and people missing payments. If Q2 continues to go higher, which I am currently seeing in our portfolio, you will see some pressure in the used space in Q4, especially for Carvana.

{audio:0:24:39} The numbers you mentioned don't sound concerning yet as they still seem below 2020 levels. What numbers would we need to see to make it more concrete?

{audio:0:25:08} You would have to look at the ABS structure and what the breakeven CNLs are and where certain tranches of your bond will stop paying and not generate enough yield. Also look at the stress factor that rating agencies disclose. My forecast says we will see a 20% to 25% increase in charge off rates by end of Q4. Carvana will be slightly lower because they operate in both the prime and subprime space, so probably 15% to 18%. If you are a class B bond holder and your breakeven CNLs are at that range, that's where you will possibly start losing money. You have to look at how ABS deals are structured and apply your own intuition to come up with what the overall charge off rates will look like. Rating agencies are a good proxy but I would also use your own intuition.

{audio:0:26:49} Could you explain how Ally forward flow compares to ABS?

{audio:0:27:10} I heard of the deal but don't know the exact details.

{audio:0:27:17} How would you think of the economics of that versus an ABS transaction?

{audio:0:27:25} I'm assuming the forward flow agreement with Ally will take more cream off any deal that comes to Carvana. 

{audio:0:27:49} What do you mean by cream?

{audio:0:27:51} If Ally is servicing the loans, it will be at a discounted rate as they will purchase the overall loan. If it's a $10,000 financed amount, they will pay an advanced rate of 90% or 95%, so Carvana would get $9,500 in terms of the overall funding for that amount that was financed. Carvana make money because the cost of the car was only $9,000 and they received $9,500, so they're making $500. If they service the loans, they will make more money but I think Ally has their own servicing arm so I don't think they have an agreement. They are probably simply buying the loan and will service the overall loan. Carvana benefits by receiving a much higher advance rate with Ally, versus going through an ABS deal, and they get the cash immediately. They can also offer better deal structures to customers, so they could see higher conversions. If they fund that loan themselves, they would probably have to charge a higher APR.

{audio:0:30:05} Why would Ally mean a lower APR for their customers?

{audio:0:30:11} Because they are getting a better advance rate and can charge lower interest. Some of the APR is driven by what Ally offers versus Carvana, so it's more of an advanced rate that Carvana will be looking at.

{audio:0:30:42} If the two options to monetize the loan are through Ally or ABS, would Ally monetize higher than ABS for the same FICO score?

{audio:0:31:03} With the rising interest rate environment and them trying to gain market share, they will monetize at a better rate.

{audio:0:31:15} They don't break that out in the numbers so that's difficult to figure out.

{audio:0:31:23} Yes, they obviously don't disclose that.

{audio:0:31:26} It seemed like the Ally forward flow gain is lower than the ABS structures, which could be due to the mix but that's something we struggle to put numbers on.

{audio:0:31:46} The only way that can be lower is them targeting a more prime segment customer. The return expectations for a subprime will be higher from an ROE standpoint.

{audio:0:32:15} Did Santander monetize excess spread through forward flow or ABS?

{audio:0:32:28} Santander was unique in the way forward flow was structured, as the parent company Santander Bank were buying from the Santander consumer. The goal there was to minimize the overall cost of fund for the company and Santander consumer, so all the prime segment was on a forward flow agreement with Santander Bank. It was more of an internal transfer pricing mechanism and the cost to a Santander consumer was two to three times lower than going through an ABS deal structure. Santander Bank held onto large deposits which they used to fund other businesses within the Santander Bank Holding Company.

{audio:0:34:02} If you compare forward flow with ABS or any other funding source, how do you decide which avenue to go down and what is your plan B if those sources dry up?

{audio:0:34:33} Forward flow agreements are more for when you are trying to gain market share or are not competitive in a specific segment. Cost of funds from other sources continue to increase and you don't see any relief. To determine if forward flow is a better than ABS, liquidity pieces enter the picture. You get a better average yield from ABS but you need to look at warehouse capacities and availability, because ABS requires enough volume to do that deal. It boils down to what is important for you over the following six to 12 months. Whenever a new deal or customer comes through, you have to route it to your forward flow partner and have a contracting mechanism. Covenants are associated with forward flow agreements, so you need a minimum volume, but you look at short-term liquidity requirements versus long-term profitability. Carvana may not have a short-term liquidity need so a forward flow makes more sense because they're trying to grow.

{audio:0:38:41} Forward flow seems to provide stability with a partner who you have set up but, in return, the economics are slightly lower than ABS, which was slightly opposite to what we were discussing?

{audio:0:39:14} You are correct, from a liquidity standpoint, forward flow helps because you get up front cash. From a unit economics standpoint, forward flow has lower economics versus doing an ABS or using better host facilities, because you are servicing the loans in-house and not paying 3% to 5% rates depending on which segment you target.

{audio:0:40:24} What other sources are there if a recession makes funding an issue?

{audio:0:40:57} Selling part of the assets you service at a discount is one way to generate cash.

{audio:0:41:26} Do you mean existing loans?

{audio:0:41:34} Would that be almost like a fire sale of your asset?

{audio:0:41:39} Yes. Another piece is to figure out warehouse capacities which cost more. I have heard of complex deal structures in terms of proxy ABS or private securitizations that happen; where you don't need a minimum asset size, you could have a smaller capacity of $25 million.

{audio:0:42:33} Are you concerned of such a scenario in the market?

{audio:0:42:45} From a portfolio standpoint, I would say with 60% certainty that there will be at least 20% uptick in charge off rates in the subprime space.

{audio:0:43:42} We also followed Credit Acceptance for a while and there's always been the concern that one day this auto subprime financing market bubble will burst, which has been true for many years but so far it hasn't. Could Carvana partner with Credit Acceptance or find somebody else to fund them if they run out of cash?

{audio:0:44:56} Carvana could find a partner like Capital One who are also in the subprime space. Carvana is also facing regulatory challenges in how they handle their titles. They can fix those things but the CFPB is getting slightly more powerful and the new Indian guy could go after Carvana. They also have issues with financials in terms of the interesting engineering they do, so the SEC might also go after them. Consumers are still generally happy but some states, like Carolina, temporarily stopped originating loans due to title issues. They have a decent brand name and an okay overall process from a consumer origination standpoint, and they have built a good pipe line and platform. The purchase of the ADESA wholesale reconditioning facility will also help them lower the cost of reconditioning vehicles, which will allow them to generate additional revenue. They have enough brand recognition to partner with other providers such as Pagaya who are also trying to go public, and could offer them forward flow agreements.

{audio:0:47:58} There is enough demand for these type of investments even with rising interest rates, and you think mid to long term there will be demand?

{audio:0:48:22} The way notes are structured confused us because we see a lower interest rates on riskier tranches; how does class B have a lower yield than class A4?

{audio:0:48:48} Your class B in that example has an interest rate of 3% versus class C which is 3.3%. Credit enhancements are higher, 6.8 versus 3.7, but they are a buffer to the overall charge off expectations. Overall cash flow drives that interest rate and it could flip depending on how much credit enhancement you have.

{audio:0:49:43} The A4 to B comparison was confusing because both the interest and credit enhancement is higher for A4, so is there another input which causes that?

{audio:0:50:09} A credit enhancement of 9.85 was not enough as it should have been 10.5.

{audio:0:50:24} Would you have to dig into the waterfall profile?

{audio:0:50:30} Exactly, you have to look at the whole piece to get that.

{audio:0:50:35} Sometimes the accrual gives you the weighted average coupon, but what's the way to calculate the final overall cost of funds to Carvana of issuing this note? When I did the math of simply trying to multiply out, it didn't add up because notes are sometimes issues at a discount. Am I missing something?

{audio:0:51:12} Overall yield is determined by the two and three year bench mark swap rates corresponding to each of the classes, and then buffers are also added on top of that.

{audio:0:51:52} Can I calculate the yield for ABS investors with the prospectus information?

{audio:0:52:09} No, because you don't have the exact buffer that gets added.

{audio:0:52:25} When looking at waterfall and cash flow, there could be credit enhancements. Essentially, 20 basis points could be added on top of the bench mark rates, which may not be disclosed, which is what is happening here.

{audio:0:53:27} They say notes are over collateralized at times; where does it come from?

{audio:0:53:43} Are you talking about the bond note holder balance versus overall pool balance?

{audio:0:53:48} Yes, in terms of a credit enhancement, they say there's an initial over collateralization of the loan.

{audio:0:53:55} If the principal outstanding for my pool of assets is $100 million, I will only issue $90 million, which is a 10% credit enhancement. I expect a loss of between 5% to 10%, so at the time of origination you have 10% OC or over collateralization.

{audio:0:54:52} If there's over collateralization, the principal is lower than the actual value of the outstanding collateral?

{audio:0:55:05} The terms which are used are pool balance and note balance. Note balance is $90 million in that example, and that is what is issued to the bond holders. $10 million is your credit enhancement at the time of origination, which will change because every month your note balance will go down because you're paying off the note. The principal outstanding will also change depending on how the pool is getting liquidated. That OC will generally increase over time, because there would be a target OC of 15% or 20%, whatever the case might be.

{audio:0:55:47} We were trying to think through the economics of excess spread, because in the prospectus there are deals but there is a separate piece above that which is excess spread which is also sold off. Carvana had three different types of structures in that issuance; how do issuers monetize that piece of the stack?

{audio:0:56:30} I am not an expert so I will refrain from making a call there. I have some directional information but I also don't want to provide the wrong information to you.

{audio:0:56:54} If you could spend one minute on it, we'll take it.

{audio:0:57:05} Yes, with a grain of salt. The way excess spread works at a high level is that you have a waterfall and an expectation of how the portfolio will perform, but if it performs better, that's where excess spread comes into the picture, in terms of generating additional cash. That obviously has a higher risk, but also a higher return. Once you have paid your class A, B and C, there might be excess cash remaining because you paid all the interest and principal of all your bond holders, and that will go into your lowest class notes.

{audio:0:58:16} Are they betting that the performance will be better than the initial assumption, and if so, who sets the initial assumption price on that note?

{audio:0:58:27} Most of the time, an initial bench mark is placed by at least two rating agencies who rate your ABS deal. The structuring bank helps structure the deal, as well as market it to investors. The term that is used is that they syndicate the overall ABS loan to investors. Carvana is big enough to have their own ABS or capital markets team to do that internally.

{audio:0:59:26} Where could we learn more about the ABS topic?

{audio:0:59:53} There are some good books so I will send some links to Bill.

{audio:1:00:14} Which book would you recommend?

{audio:1:00:18} I will send you link; I can’t remember off the top of my head. There is one that has good commentary on the overall securitization, especially with respect to auto.

{audio:1:00:38} I always wondered who buys riskier tranches? The AAA demand is obvious, but if you go down the waterfall to class C or D notes or excess return notes, those are quite black box type of investments?

{audio:1:01:12} Hedge funds and family office-based investors who have money and whose investors are simply looking for a return at the end of the day but don't care how you invest. There are also some pension funds managed by institutional investors, but you are right, they are slightly black box, but the people managing these investments obviously know. These companies obviously make money from the servicing fee, at the end of the day. 

{audio:1:02:21} Is there a reason why Carvana would declare bankruptcy within two years?

{audio:1:03:00} Regulatory and operational risk related to compliance and too much leverage. It is important to verify a customer's income and cash flow in the subprime segment and often companies like Carvana and other private VC-backed firms have growth goals, not necessarily risk management. That is where you start seeing performance deteriorating exponentially fairly quickly. The biggest piece for Carvana would be that they do not manage their risk well.

{audio:1:04:33} Is there any way to figure that out before it happens? 

{audio:1:04:45} Performance indicators are first time defaults, early delinquency trends, 31+, 61+ and deferments. Many companies hide deferment or modification of their loans by playing with those numbers. You should also look at the overall FICO distribution of the portfolio because averages tend to skew numbers, as a portfolio could have 30% missing FICO.

{audio:1:05:51} Are you speaking about monitoring indicators on outstanding ABS notes? 

{audio:1:06:04} Abnormal behavior indicates higher risk than previously seen or expected. What does that mean because if they've sold off the risk, it now lies with the investor? Is your point that it tells us about Carvana's ability to secure deeds in future?

{audio:1:06:31} Yes, that's one, and the second is that they are also generating a servicing fee, and their day-to-day operations could get impacted because of those. 

{audio:1:06:47} Servicing fees go to Bridgecrest rather than Carvana, which is DriveTime.

{audio:1:06:55} Yes, I thought Carvana had started doing their own servicing, but I may be wrong. If they are servicing their own loans, that will be impacted. The DriveTime father son relationship is also slightly questionable. Some of the covenants could get breached which would create excess fees that would have a liquidity impact in terms of cash outflow.

Carvana: Finance GPU Challenges and Potential Solutions

Current Chief Risk Officer at Carvana Competitor

inpractise.com/articles/carvana-finance-gpu-challenges-and-potential-solutions

Carvana: Finance GPU Challenges and Potential Solutions(July 14, 2022)

Current Chief Risk Officer at Carvana Competitor

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