Q&A: Auto Loan Hedge Fund Anything But Subprime

May 30 2008 | 10:25am ET

Need a car but can’t get a bank loan? Try a hedge fund.

San Francisco-based American Pegasus is stepping up to service “subprime” auto borrowers, turning a tidy profit doing so. Since launching its $84 million Auto Loan Fund in 2005, American Pegasus boasts annualized returns of 21.18% and has never had a losing month. FINalternatives recently spoke with CEO Benjamin Chui about the fund’s success and his outlook on the credit crisis.

FINalternatives: Why an auto loan fund?

Chui: Our firm, and myself in particular, seek opportunities in markets with fundamental inefficiencies. In the auto loan space, there is a fundamental mispricing of credit for subprime borrowers. Financial institutions, primarily led by commercial banks, have simply shied away from this segment of borrowers, making it willing to pay a high price for car loans.

FINalternatives: Describe the kind of borrower that your firm considers for loans.

Chui: We look at whether the borrower can repay the loan or not. We look at the debt-servicing-to-income ratio and want to make sure that’s no more than 40% of their monthly income. We make sure their auto-loan payment-to-income ratio is less than 20%. We look for people with steady jobs with more $1,200 in income per month for individuals and more than $2,000 for joint filers. We currently have approximately 7,000 outstanding loans in the portfolio.

FINalternatives: What are the risks involved in managing such a fund, and how do you manage those risks?

Chui: The first risk factor is default risk, which is a function of unemployment more than anything else. The second factor is recovery rate risk, referring to how much of the defaulted loan we can recover by selling the vehicle we’ve repossessed: The higher the price we can sell the car for, the more of the loan we can recover. The third risk factor is reinvestment risk, which is the likelihood of us redeploying the cash into new loans with similar interest rates and credit profiles. The biggest factor affecting the reinvestment risk is competition willing to lend at lower interest rates to the types of borrowers we’re targeting.

FINalternatives: What is the ideal environment for a fund like this one?

Chui: In period of low unemployment and a growing economy, we tend to enjoy better returns. The recent subprime mortgage crisis is actually helping the fund rather than hurting it: The fact that there is a credit crunch has enabled us, since late last year, to heighten our underwriting standards, resulting in higher-quality borrowers and commanding higher interest rates because of lack of competition.

My biggest fear has always been commercials banks one day waking up and coming into this market. When they do, we will simply have to stop making any more loans and wind up the fund because they can lend at 15% and be happy at that level. But because of the credit crisis, we believe the day they come into the market is delayed.

FINalternatives: Many hedge funds are pouring into credit in the wake of the subprime crisis, but have you seen any competition in the auto-loan space?

Chui: We have not seen any other single-strategy funds in the market that’s doing what we’re doing. But as more firms realize the kind of profits they can make in this relatively inefficient market, we should expect more investors coming in.

FINalternatives: What is the fund’s capacity?

Chui: The used car market is around $200 billion, and the subprime segment we’re looking at is approximately $40 billion, so we’re literally a drop in the bucket. However, we would face a management limitation at approximately $500 million. These loans are about $11,000 on average, so for every $1 million that comes in, we’re talking about 90 to 100 new loans, and at $500 million that’s a lot of line items.

by Hung Tran

In Depth

PAAMCO: Will Inflation Deflate the Asset Bubble?

Jan 30 2018 | 9:49pm ET

As the U.S. shifts from monetary stimulus to fiscal stimulus, market pricing should...


CFA Institute To Add Computer Science To Exam Curriculum

May 24 2017 | 9:25pm ET

Starting in 2019, financial industry executives sitting for the coveted Chartered...

Guest Contributor

Boost Hedge Fund Marketing ROI By Raising Your ROO

Feb 14 2018 | 9:57pm ET

Tasked with delivering returns on client capital, a common dilemma for many alternative...