It’s classic subprime: hasty loans, rapid defaults, and, at times, outright fraud.

Only this isn’t the U.S. housing market circa 2007. It’s the U.S. auto industry circa 2017 – wrote Bloomberg today.

It’s great that Bloomberg is noticing this. But where were you when this started years ago? This outcome was inevitable.

To put it in context, during 2009 only roughly $2.5 billion of new subprime auto bonds were sold. And in 2016 there were $26 billion sold.

This shouldn’t be a surprise. Yield starved investors, especially institutions that need to make 6%+ per year to cover future liabilities (such as pensions or insurance companies) have been forced to demand anything with relatively “higher” yields.

No matter the risk . . .

All this courtesy of the Fed. A near decade of zero interest rate policies and $4.5 trillion in printed money had to go somewhere, right?

And now the Fed is hastily tightening.

Sound familiar? Greenspan starting hiking rates from their then record lows of 1% in 2004. This was the first thread in the unravelling of the real estate and MBS (mortgage backed securities) bubble.

Today, Yellen is hiking. In fact, they started December 2015 with the first rate hike.

And auto loan defaults have been surging. Unsurprisingly. And just like 2004, the Fed’s hiking is the first thread in the unravelling of the auto loan bubble.

Derivatives and banking are needlessly complex. But we can simplify it.

Banks need to generate income through fees and commissions. Wall Street has dire need for higher yielding returns for themselves and customers. Car manufacturers need to keep sales growing to move inventory and boost their share prices. Car dealerships make money and employ more. And anyone with a pulse can get a brand new luxury car at low rates with 100 months to pay it off.

For investors, the allure of subprime car loans is clear: securities composed of such debt can offer yields as high as 5 percent. It might not seem like much, but in a world of ultra-low rates, that’s still more than triple the comparable yield for Treasuries. . . But the question now is whether that premium, which has dwindled as demand soared, is worth it. . . “Investors seem to be ignoring the underlying risks,” said Peter Kaplan, a fund manager at Merganser Capital Management.

It’s like a game of ‘ditch the bomb’. Each group is trying to move the risk off their hands as fast as they can.

For instance, the bank makes loans to subprime lenders which they then sell the “rights to” (the rights to the interest payments the borrowers will make monthly) with a slight premium to Wall Street.

Wall Street has rewarded lax lending standards that let people get loans without anyone verifying incomes or job histories. For instance, Santander ((NYSE:SC)) recently vetted incomes on fewer than one out of every 10 loans packaged into $1 billion of bonds, according to Moody’s Investors Service. The largest portion were for Chrysler vehicles.

Now Wall Street has the bomb.

They package up these “rights of interest” into tranches and derivatives called Auto-backed securities, or ABS for short. Which is then sold, for a slight premium, to yield hungry customers like mom and dad retiring, income funds, pensions, etc.

Now they have the bomb in their portfolios.

When auto loans default – the interest rate payments stop coming in. So the ABS derivatives won’t yield anything. Basically making them worthless. Or at least much less valuable.

And with recent surge in auto defaults, and higher borrowing costs from the Fed, the groups will do what they can to keep the party going. For example, lenders loosening lending guidelines and car manufacturers giving large rebates and deals to incentivize buyers.

This leads to flat out fraud and incompetence.

Remember in the movie by Michael Lewis, The Big Short, when Christian Bale’s character Michael Bury investigated the MBS tranches that we’re rated Aaa? Only to discover they were worthless. And what was once highly rated can sour quicker than anyone dreamed of.

Back in May, Bloomberg published a piece headlining that Santander only vetted 8% of loans they put into their ABS, which were shipped to Wall Street. A quote from the article read, “The Moody’s analysts didn’t make any claim that noteholders were at risk as the bond-grader simply looked at the new data available in the deals to provide analysis on how lenders underwrite… Moody’s rated the Santander deal as high as Aaa in February. Investors who bought into the securities included Massachusetts Mutual Life Insurance Co., according to data compiled by Bloomberg.”

It’s as if we learned nothing from 2008. . .

Since 2009, car loans have exploded over $1.1 trillion. Becoming a huge market for investors.

With subprime loan originations dramatically rising over the last few years, this tells us a couple things. First, investors are yield starved and are accepting much higher risk for a slight increase of income. And secondly, the pool of the most creditworthy has exhausted, thus banks have been lending to less and less attractive borrowers.

Wall Street is probably deluded from the unashamedly sickening moral hazard running rampant since 2008. The idea that the federal government will bail them out again. The “too big to fail” are bigger than ever.

But there is one thing most financiers aren’t pricing in. . .

How many borrowers are using their cars as collateral for new debt? If the used car prices fall dramatically, so does their asset-to-debt ratio. Just like in 2008, if the home price fell, they get underwater on their pre-existing debts and can’t refinance. Especially with the Fed raising rates.

Yes, that worked so well in 2008 for real estate and MBS’s. . .

Remember, it isn’t the gradual rising defaults that will topple or shake markets. It is the sheer panic when investors doubt what is even in these ABS derivatives. As we learned during 2008, no one will touch them from fear the loans contained are tainted. Once everyone runs for the exit, that is when liquidity and markets crash. Everything comes to a standstill.

Reading about auto defaults surging brings to mind one of my favorite economist’s theories. The late Hyman Minsky’s Financial Instability Hypothesis (FIH).

The FIH is simply times of sustained stability breeds instability. I wrote about this in a previous Seeking Alpha article here. There is also a grand book on how increased speculative lending and over-leverage leads to an eventual death spiral of falling asset prices, curtailed lending, and liquidity evaporation. The Origins of Financial Crisis by George Cooper and it is a must read.

The key take away is the years of booming borrowing/leverage and business growth will be followed by deflation, risk aversion, over-saving and illiquidity. Which leads to, as Keynes stated, the Paradox of Thrift i.e. the economy finds itself in a self-caused contraction.

Paradox of Thrift states that individuals try to save more during an economic recession, which essentially leads to a fall in aggregate demand and hence in economic growth. Such a situation is harmful for everybody as investments give lower returns than normal.

The big qualm I have with Keynes and Minsky, is they blame capitalism rather than examine how the Fed causes this.

Yes, cycles occur. Even without central banks there are booms and busts. What goes up will go down, tears turn to laughter, and the sun rises and sets. It seems like the only known universal law is cycles.

But the Fed artificially intervenes and chooses themselves when rates must go up or down – not the market. After years of forcing yield starved investors to bid up asset prices and be riskier, they are now suddenly tightening. This will almost certainly, as history shows us, cause a contraction and rising instability.

Any time there is only a handful of bureaucrats that intervene within sensitively priced markets to influence them, such as interest rates, for an entire economy as they deem fit, ends up with unintended consequences, cronyism, and inevitable failure.

Therefore, we can expect auto defaults to further surge and future demand to decrease, crippling ABS derivative prices and their income for their owners. All the businesses, such as Avis Budget Group (CAR) and Hertz (HTZ), as well as individual borrowers that depend on used car prices will suffer.

There is more to it, obviously. God knows I don’t know every little gear in the economic machine. But using empirical based tools such as the Austrian Business Cycle Theory, Minsky’s Financial Instability Hypothesis, and Irving Fishers Debt-Deflation Disease – we can get an idea.

And using a framework of ‘optionality’ we learned from Nassim Taleb – we can benefit from the chaos.

We do this through purchasing long dated 1-2 year out-of-the-money PUT options on first order stocks, such as Ford (F), General Motors (GM), Fiat (FCAU), and Tesla (TSLA) which will be directly affected from falling car loans and subsequent declining vehicle demand. Then the secondary-effected equities such as banks, like Santander Consumer Holdings (SC), Wells Fargo (WF), and Capital One bank (COF).

This gives us plenty of time and a very low cost way to speculatively profit from a weakening auto market. After a near decade of continued growth, a currently tightening Fed, and higher subprime loans only confirms we can expect more downside than up from here.

As Taleb tells us: be anti-fragile. Don’t get crippled from the sudden instability. Rather be conscious of its existence and use it to profit.

And don’t be the one left holding the bomb when it explodes. . .