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Waiting for the Signal

In 2005 and 2006, CDO’s were being pushed like crack.  I remember asking many of the pushers why I would leverage into credit at historically tight spread levels.  Their stock answer: “Because you can get a AAA rating at a much higher yield!  This thing will never break because it has so much subordination!”  My follow up question: “how do you know the correlations that you are using are right?”

Now I definitely did not know how bad it could get, but I was smart enough to know that you cannot make a (good) apple pie with a bunch of rotten apples.

Fast forward to today: searching for investment income (yield) and capital relief (lower capital requirements/higher asset ratings).

Jump into the news from WSJ:

The consumer-lending joint venture of private-equity firm Fortress Investment Group  and insurer American International Group is planning a rare securitization of subprime personal loans as early as this week, in the latest test of risk appetite for asset-backed bonds, where soaring demand has pushed yields to record lows.

The $604 million issue from consumer lender Springleaf Financial, the former American General Finance, will bundle together about $662 million of loans secured by assets such as cars, boats, furniture and jewelry into ABS, according to a term sheet.

Are you kidding me?  Furniture?  Do I get a personal loan and show them a picture of my couch?  Do you think when I figure out that I won’t be able to pay back my personal loan that I might take my couch with me?  Are they going to hold the items in a massive pawn shop?

It gets better:

The 190,627 loans in the Springleaf deal have an average FICO credit score of 602, in line with many subprime auto ABS. But the average coupon of 25% on Springleaf’s personal loans is above that on even “deep subprime” auto loans, probably because there is no collateral for 10% of the issue, an analyst said.

The “A” rated slice of the debt may yield near 2.5%, or two percentage points over an interest-rate benchmark, according to price talk circulated to investors.

Holy s*#t.

With 190,627 loans, that implies that the average loan size is about $3,000.  How exactly do you think you will collect on any of those loans if there is a default?  Do you think it might cost more than that to even get one guy to pay it back?  Average FICO of 602?  If you know a bit about credit scores, you know how trustworthy this group has been in the past.  There is just 10% of subordination protecting this bond and for putting your head in the guillotine you get a sexy 2.5% interest rate every year…thats $2.50 for every $100 you put on the roulette table…

Unfortunately I think this is only the beginning.  This deal might not get done, but the next one probably will.  If the current environment (easy monetary policy and lack of devastating global events) persists then this debt fuelled euphoria will go further than you could possibly think.  I know that in ’05 and ’06 I was amazed, maybe this time will be even more awe (nausea) inducing.

Maybe it is time to look at some of the market signals that worked in 2007-2008 to see what we should be watching.

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