Monday, December 18, 2017

You Can't Make Something From Nothing

What will cause the next recession?   Companies with flawed business models that lose money, but the stock market is presently going ga-ga over.   Eventually, reality will set in.

This morning, an article in Forbes about an "ex-con who is now a billionaire!" that gushes how a guy with some sketchy connections to Charles Keating is now a "success"story with his used-car mega-dealership.   He's a billionaire!

On, paper, that is.  Likely your paper.

You see, he owns Drive Time, a car dealership that sells used cars to subprime borrowers.  He also is a primary shareholder in Carvana, an "e-commerce" used car dealership that (you guessed it) did an IPO and whose stock shot way up.   They have some trendy eye-candy things going on, like "used car vending machines" in a couple of cities - the sort of thing the plebe investors lap up.

The problem is, of course, Carvana is hemorrhaging cash, and a lot of people are short-selling the stock.  The company simply isn't making any money and doesn't appear to have any plans to.  On the Drive Time side, while there is a lot of money to be made in sub-prime auto lending, there is a lot of money to lose as well.  And with sub-prime loan default rates going up (and 1/3 of Americans delinquent on their loans in general), the entire mess could blow up in their faces, much as the sub-prime mortgage fiasco did.

The problem is, when you loan money to a lot of insolvent people, they tend not to pay it back.   And when you have hundreds, thousands, tens of thousands, hundreds of thousands  - maybe millions - of these loans, well, it will be very, very hard to claw that money back.  The logistics of even repossessing the cars staggers the imagination.

Subprime borrowers - like payday loan borrowers - usually always end up in default, and it ain't hard to see why.   With the payday loan people, they borrow money and then borrow more money to pay back the earlier loan.  The process continues until loans are being used to pay back loans used to pay back loans..... etc.   It is like a reverse Ponzi-scheme.   Eventually, the borrower can't pay even the tiniest fraction of what is owed, and they end up in bankruptcy court.

The same is true for sub-prime auto lending.   You've seen these types of dealers - the "buy here, pay here" used car lots that advertise the weekly cost of a car.  Or weekly leases - which require you to have the car repaired at that dealer.   All horrible rip-offs of the poor.   They over-pay for the car, over-pay for the interest, and over-pay for the insurance.   They pay 2-3 times as much for a used car as I would for a new one.

Once again, the snowball effect comes into play.  The wealthier client gets the 0% financing, the best prices (because they are smart enough to go online and shop around), and pays the least for insurance (because they don't "drive it like they stole it" like poor people do).   The poor, on the other hand, have the reverse snowball - costs pile upon costs.  Interest rates are in the double-digits.  Cars that have loan balances higher than their resale value are costly to insure - because the owner has all the incentive in the world to set fire to the car.

And often - almost all the time, in fact - these types of buyers end up trading in their car, usually when they've blow the engine - and folding the negative equity from a previous loan into a new one.  I knew a young girl who did this - three times in fact - until it became so costly, she let the re-po man have the keys, declared bankruptcy, and then started taking the bus.   Yes, drugs were involved.

It is not a matter of if  but when with this type of borrower.   And as a business model, you can make a lot of money in the short-term by writing these risky loans, and show enormous profits as the borrower can make the first few payments.   But eventually, when the loans start going South, the initial huge returns evaporate.   And I suspect that is what will happen to Drive Time.  There is a reason these fly-by-night used car dealers fly-by-night.  They don't stay in business very long because they can't.   Either they have so much bad paper they go under, or people get wise and stop doing business with them.

On the internet side, Carvana isn't even making money - hemorrhaging cash like any good "dot com" business.  The problem for Carvana is the same problem all these "tech-that-aren't-tech" companies face - they are not "technology" but mere merchants, selling fungible products in an industry that is deadly competitive.   Maybe a "car vending machine" might attract a customer or two, but frankly, I think most people are less interested in the "sales experience" than they are in the long-term value and use of a car.

And the used car business is already crowded with used car dealers - including mega-dealers like CarMax, which has been "vending" used cars for some time now.   What is it that Carvana has that none of these other companies have or could have?   And no, "car vending machines" isn't the correct answer.

These are flawed business models - not sustainable ones, in my opinion.   If they don't make money consistently and for the long haul, then they are just flash-in-the-pan, making money in the short term, or in the case of Carvana, not making money at all.

And it seems that a lot of the companies that are talked about today in the financial press fall along the same lines.   And since it appears there are not a lot of stocks left to invest in, since so many companies have gone "private", the small investor increasingly looks to these hyped stocks as the next "sure thing" that will life them from poverty to billionaire status overnight.

A reader continually chastises me that saving money, investing wisely, diversifying investments, and investing for the long haul will "never make you rich" but only make you comfortably middle-class.   Maybe that is true, but long-shot oddball hyped investments are more likely to make you dirt poor than they are to make you a billionaire.

The only ones who get rich from schemes like that are the people running them, not the people investing in them.   And when the guy running a scheme is an ex-con who went to jail for financial fraud, well, you should know what to expect and have no one but yourself to blame when it all goes horribly wrong.   I mean, how much more do you have to advertise this as a raw deal?

Sadly, Forbes posits this as a rags-to-riches story, rather than a flim-flam man selling the latest flim-flam.

You know, comfortably middle-class ain't so bad, really.   Compared to poverty and old age.

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