There's been a spate of articles recently about the recent spike in auto loans, specifically "non-prime" loans. It's all a bit confusing. I mean, sub-prime is bad, right? That crashed the economy once after a couple people stopped paying for mortgages?

Kind of, but not really.

See - the Fed created the problem by keeping rates low. Pension funds and bond investors, which like the safety of Fed Government Debt, also need to earn some yield to continue to grow. With Treasuries paying so little, they look to the Asset Backed Security (ABS) market.

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Why? Because losses are theoretically limited by the asset supporting the loan - i.e. your fuckin' car. Don't pay your loan? That's fine; they'll take the car, sell it and then put the proceeds towards the loan making sure the ABS market gets made whole.

So, whether you like it or not, you are part of a big, vicious, ABS circle.

Let's look at what happens when you take a loan with, say, Chrysler Capital (or Ford, or VW or GMAC, etc, etc, etc):

Step 1: You walk into a dealership

You find a car, you get a price and then you ask about that 4.5% for 60 months you saw advertised during Conan last night. After two hours of your time and a $250 "doc" or "origination" fee, you are driving home in your sweet, sweet Hellcat.

You get home, enroll in SpeedPay so you don't have to remember to write a check every month and then start doing burnouts. But the fun is just beginning at the banks.

Step 2: A bank buys the loan

Technically, the dealer was the originator and owner of your loan. But within a very short period of time, Chrysler Capital purchases the loan from the dealer. Sometimes dealers make money here (read: they usually make money here) - maybe Chrysler Capital pays 101% of the borrowed amount; maybe they don't require that origination fee to be passed along.

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This creates liquidity - the dealer now has another $50k in cash available so he can go make another new loan. But Chrysler, which just reimbursed the dealer, needs more cash to buy more loans. So, after they have a whole bunch of them - like 150,000+ accounts - they call up Goldman and say "hey, let's issue some debt."

Step 3: an Asset Backed Security is born

After Chrysler Capital has a whole bunch of loans - let's say $50M, or about 1,000 Hellcat loans - they need to turn those loans into cash. They can't wait six years for $50M to trickle in, or sales volume would fall off.

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So, they securitize via an ABS. $50M of loans that pay 4.5% coupons over 60 months generate about $1,000,000 per month.

Remember those Pension funds? They would like to earn more than 1% on their money, so they buy some ABS at a 3% coupon. Chrysler Capital pays about $750k per month on the $40M of debt it issues (the other $10M of loans is called "overcollateralization" and is essentially a buffer to keep losses from reducing the Pension Funds interest in the secured assets).

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Step 4: Profit

So, now Chrysler has $40M of cash to go make more loans. And they are earning about $250k per month (the difference between customer payments and what they pay the pension fund). That's about $15M over the 5 year term of the ABS.

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In total, Chrysler got $55M in cash for the $50M in loans they made.

But wait, there's more. Remember that $10M of overcollateralization? Chrysler gets that back, too. Let's assume that 100 Hellcat owners default (a 10% loss rate). That would come off the OC, reducing it from $10M to $5M.

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And Chrysler would earn interest on that $5M over the life of the loan - at 4.5%, thats about an extra $1M in interest. That brings Chryslers $5M profit to $11M!

So, here's the final tally: $50M in loans generate - drum roll please - $61M in cash - or about a 4% return. And the best part - from Chrysler's perspective - is that they get their whole $50M nut back within the first 90 days, and only have exposure to loss on 20% of the portfolio.

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Viola.

Welcome to Finance, bitch.

Edit to add: If a company like Chrysler Capital can turn the same $50M every three months, they basically earn 12% on that money. TWELVE PERCENT! The joys of annualization...