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The Divide in Subprime

October 2007, F&I and Showroom - Feature

by Jim Bass - Also by this author

The hysteria surrounding the “subprime mortgage crisis” has reached a crescendo that is deafening. As of press time, I have read of 40,000 people in the “credit” industry being laid off, interest rates going up, mortgages no longer being available, and, of course, several companies going bankrupt or having serious liquidity issues (e.g., Countrywide). While the situation is no doubt serious, I sincerely believe that emotional overreaction has again overruled good sense.

I recently had the opportunity to speak to a number of investment bankers in New York about nonprime auto finance. Uppermost in their minds was the effect that the mortgage problems are having, will have or might have on auto finance. There are a number of things that should be remembered when pondering this question. One is, as I just heard Ben Stein report on CBS Sunday Morning, the subprime percentage of the overall mortgage market is quite small. Why only that portion is getting all the press is a mystery to me.

When Volume Overtakes Quality

The question surrounding the subprime mortgage market is whether volume has overtaken quality underwriting? Frankly, the situation in that market is reminiscent of the mess our industry got into in 1996 and 1997. At that time, there was too much liquidity in subprime auto finance, and volume began to drive the market. Just as in auto finance, the sales folks were more than willing to sell whatever products the risk management and credit side of the house presented them. So, when a mortgage broker was presented with a slam-dunk product, why wouldn’t he sell it, especially when, just as in auto finance, there is the opportunity for finance charge participation, origination fees, etc?

Similar to subprime auto, getting the product financed is most important to the customer. The only other consideration that comes into this mode of thinking is the customer’s monthly payment.

The problem here is only a few customers can tell you the interest rate they are paying. Most customers probably couldn’t even tell you who their lender is when they walk out of the real-estate office after closing a deal, or when they’re driving that new vehicle across the curb. So, is there blame to be assigned?

I suggest that the investment returns touted to investors, usually highly educated and sophisticated people, captured a great deal of interest, and, subsequently, capital. Money that sits in some safe interest-bearing account or instrument doesn’t support the promise of high income, so a new high-yielding vehicle was found — subprime mortgage. The issue has been that the programs were, from an underwriting and safety perspective, very poorly designed. From a marketing and sales perspective, they were attractively designed. There were obviously lucrative fees involved, hence the absolute deluge of television, radio, internet and print ads offering these mortgages. What an easy sell! And sell them they did.

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