Pop quiz: what is "Auto ABS" ?
(A) A gadget that helps tone your tummy muscles;
(B) Automatic brake system that helps your retain control of your car;
(C) Bonds backed by loans on car purchases.
The answer could have been (B) except that a car's anti-lock brake system (ABS) always kicks in automatically; all you have to do is brake hard enough to make your car skid in the absence of the ABS. The correct answer is (C): "Auto ABS" stands for "auto asset-backed securities".
Oh brave new world. And of course, after sub-prime mortgages there's ... sub-prime auto loans.
And yes, some of those could well be under water. Because the value of a new car drops as soon as you drive it off the dealer lot.
Perhaps these new beasts are direct descendants of those mortgage-backed securities; in fact, it was after the financial crisis of 2008 that all auto ABS, even the riskiest ones of the sub-prime kind, did very well. After all, Americans could live without home ownership - but without car ownership you might as well find a quiet ditch and lie down to die. For most Americans, a car is essential for survival: how else to get to your job?
For this reason, perhaps sub-prime auto ABS are not as risky as mortgage-backed securities. Maybe that's why they're so popular. Almost too popular: 2013 saw the issuance of $21.5bn of auto ABS, and lots of Wall Streeters are looking to get a piece of the sweet pie.
But the pie isn't large enough to feed the appetite (or is it greed?). So creative traders have pumped up the pie with the financial equivalent of high-fructose corn syrup, and cleverly named it "pre-funding".
This is how it works: Instead of putting together a stack of car loans adding to $500million, they put in all the car loans they can find, say $400million, and top off the rest with $100million in cash, with which they buy more car loans as they become available, after the securities are sold.
As Tracy Alloway says in the Financial Times, "It’s the equivalent of spending your poker winnings before you’ve bought the ticket to Vegas."
And that gives you an idea of how safe these instruments are.
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