As you may have noticed from the previous posts, NICK’s loss provision ratio has remained elevated essentially since the crisis. This does not indicate that NICK’s balance sheet is still stuffed with bad loans made prior to 2008. Remember, loans are typically paid down within four years of origination (or written off even sooner, if they are not repaid). I doubt NICK has a single performing loan in its portfolio that was originated prior to 2008.

Rather, the elevated loss levels can be attributed primarily to the very low cost (and easy accessibility) of capital in the U.S. since the financial crisis.

Cheap and easy capital has two practical consequences for lenders. First, it allows lenders to reduce the interest rates they charge, yet still earn their desired net profit margin. If capital costs you 100bps less, you can charge your customers 100bps less, and everybody stays happy. Simple.

You can see this effect somewhat in NICK’s recent results. As the cost of funds (the lighter orange area) has declined, there has been a partially-offsetting increase in losses (the darker orange area), such that the sum of the two (both areas combined) has been far more stable than either individual metric:

But what you also see is that even after adjusting for the cost of capital, NICK’s the sum of interest costs and loss rates has still been climbing for the past few years, despite a modestly improving U.S. economy. This brings us to the second and more important consequence of cheap and easy capital: increased competition.

The increased competition manifests itself in a few different ways.

The first manifestation is an increase in new entrants. Banks are more willing to lend to start-ups, diversified financial companies, etc. New entrants are common, and since more players are eating from the same pie, the slices get smaller. This is expressed primarily in lower gross yields. Loans that used to earn 29% now earn 28%, or 27%, because a lender who still requires 29% will never get any deals done.

The second manifestation is degradation in the quality of the lenders in the industry. Insofar as the strong (or smart) survive, the lenders who remain after a crisis are the best lenders (or the best capitalized). The new entrants that come later are likely to be either inexperienced, or in search of a fast buck. These lenders are more likely to have loose lending standards (forgoing income verification, etc.), either out of ignorance or out of aggression.

Finally, the third manifestation of increased competition is an escalation of leverage in the system. More leverage means more sensitivity to volatile profits, and thus a greater likelihood of blow-ups. In addition, when leverage increases, most lenders will accept lower unlevered returns. Why? Because a company that earns 1% on loans but is levered 21x generates the same return as a company that earns 7% on loans with 3x leverage.

So the likes of Nicholas find themselves competing against players with low lending standards and a lot of leverage. This is hard to do. As the saying goes, it is difficult to compete against a business that is bankrupt but doesn’t know it yet.

Luckily, we have 20 years of history to show us that NICK has never had a problem preserving its chastity in the midst of dissolute competitors. This mentality is one of NICK’s defining features, and it pervades the company. I have worries about every investment, and this company is no exception. However, NICK losing its restraint and getting dragged into sloppy underwriting is expressly not one of my worries.

In short, current business conditions are bad. I’ve spoken with executives at multiple subprime auto lenders, and most of them say the same thing: this is the worst competitive environment of their careers. Common complaints include “we see a new competitor every week” and “competitor X no longer requires income verification”.

But the worse things get, the closer we are to a turn in the cycle. It is very possible we will have a “Phase 4” quite soon, but the chances are almost nil that NICK will be caught in the carnage. The company has resolutely stuck to its guns through the current cycle, forgoing rapid loan growth in order to maintain lending requirements that, although relaxed in the past few years, are still among the most sterling in the industry. Unless there is an external economic shock, I would only expect NICK’s losses to increase slightly even when “Phase 4” arrives and competitors start having serious financial difficulties.

How much further, exactly, do we have to go? I don’t know, but I doubt it’s very far.  Just look at what has happened to NICK:

Pre-tax profit has fallen from a cycle-average (not even the peak!) of 10.9%, all the way to 7.4%. That is a big deal—a reduction greater than 30%.

Or take CPSS, an experienced lender with scale. That company is currently operating at a 3.5% pre-tax margin. Nor is CPSS alone in operating on a narrow margin. Industry giant Santander Consumer operates at a pre-tax margin of 4%. And I am sure there are many smaller private lenders with similar or worse margins.

Such thin margins mean there isn’t much of a buffer left to absorb shocks from falling yields, rising losses, rising interest rates, rising compliance costs, or any combination of the four.

In the next post I’ll analyze what NICK’s earnings power is today, as well as, more importantly, what its earning power is over the cycle.