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The Next Subprime 'Time Bomb' Is Ticking -- Here's How To Profit

Thursday, January 02, 2014 10:00 AM

We all remember the subprime mortgage crisis. The financial system was thrown into chaos, and many homeowners lost their overleveraged homes during those dark days.

Fortunately, the vast powers of the Federal Reserve were summoned to help stabilize the housing market, and along with it, the entire economy. The Fed worked its monetary magic, and the housing market is finally returning to normal.

However, there is another crisis brewing just under the surface.

The sector this potential crisis is in isn't as large as the subprime mortgage sector, but it's still a $27 billion sector, according to Forbes magazine. In fact, Forbes reports that 1 in 4 Americans may be participants in this potential crisis.

I became aware of this potential time bomb last year. A close friend was financially destroyed by the subprime mortgage crisis. He is an investor and was overleveraged on more than a dozen investment properties. He was finally forced to declare bankruptcy to get out from under the mountain of debt.

Within a week of the bankruptcy filing, he started getting letters from companies like Wells Fargo (NYSE: WFC) and General Motors (NYSE: GM). While my friend was used to getting nasty letters from banks and finance companies, these letters were very different.

These were not demand letters challenging his bankruptcy, threatening lawsuits or anything the least bit negative. Believe it or not, these letters were pre-approval letters for auto credit!

In fact, one financial company actually sent my bankrupt friend a check for $30,000 to be used at any participating auto dealer for the car of his choice. He took the check and bought a used BMW.

I couldn't believe it. Here's a bankrupt guy with a credit score in the low 400s, working a menial labor job, with automobile credit being thrown at him by several large and reputable lenders. These were not the "buy here, pay here" sharks at the corner used-car lot.

While I was happy for my friend, I was reminded strongly of the subprime mortgage crisis. Folks with really bad credit and sketchy employment were able to get mortgages that they really couldn't afford during the subprime mortgage crisis.

Now the same thing is happening with auto loans.

I have started to see more and more advertising for this type of lending, raising the question of whether the subprime auto loan market will explode like the subprime mortgage market. I wondered, if this situation is truly a financial bubble, when will it burst -- and how can I best position myself to profit?

After asking these questions, I thought of John Paulson making $3.7 billion during the collapse of the subprime mortgage market. The thought of replicating just a tiny fraction of Paulson's success motivated me to find the answer. Here's what I discovered.

Bloomberg has reported the average loan to value (LTV) for subprime auto loans has increased to 114.5% this year from 112% in 2010. Loan to value is a measure of the money lent as a percentage of the market value of the asset. A 114.5% LTV means that the auto loan is for 14.5% more than the actual value of the car. For comparison, the average LTV of subprime auto loans in 2008 maxed out at 121%.

This increase in LTV is signaling greater competition and a decrease in underwriting guidelines in the subprime auto sector. In other words, more and riskier loans are being made.

Subprime auto lender Exeter Finance, recently acquired by the Blackstone Group, has reported an increase in late payments from 5% in 2012 to 7.8% this year. However, it's important to note that subprime lenders Banco Santander's (NYSE: SAN) U.S. consumer unit and GM Financial have reported lower loan losses from 2010 loans than losses from loans originated in 2007 and 2008.

Flickr/Andrea_44
Can GM remain profitable after the U.S. Treasury pulls completely out?

How To Profit If the Bubble Bursts
GM, which is heavily involved in subprime lending, has improved dramatically since its pre-bailout days. The company has posted more than $1 billion in net income in each of the past four quarters.

However, 88% of GM's North American consumer finance receivables are firmly in the subprime category. In fact, GM listed consumer receivables 31 or more days late at $1.1 billion, a 34% increase from last year. Making matters worse, auto dealers with weak financials currently owe GM nearly $1.6 billion, per Bloomberg. This is up from just $12 million, indicating a radical increase.

The question is, can GM remain profitable after the U.S. Treasury pulls completely out? Remember, the Treasury Department filed its final plan to close out its GM holdings in September.

I think GM made the mistake of placing short-term profits before long-term goals with its aggressive pursuit of highly risky subprime loans. As more and more subprime borrowers default, GM's bottom line will be hurt substantially. No company can withstand massive defaults of loans.

The technical picture shows a double top in the $41.50 range on the daily chart. I would not be surprised to see General Motors trading at $28 within the next 15 months.

Risks To Consider: Shorting any stock can be very risky due to the theoretical unlimited upside. Be sure to always use stop-loss orders and diversify when investing.

Action to Take --> I like General Motors as a short if price drops below $40 on a daily close. Placing initial stops at $42 and a target price of $28 makes solid investing sense.

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David Goodboy does not personally hold positions in any securities mentioned in this article.
StreetAuthority LLC does not hold positions in any securities mentioned in this article.