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What is the Future of the Subprime Market?

September 2008, F&I and Showroom - Feature

by Jim Bass

It came as quite a shock to most people in the automobile retail and finance business this May when it was announced that Triad Financial Corp. was ceasing originations in the indirect dealer channel. After all, Triad had been through three or four ownership changes since its founding in 1990, and had always come out on the other side stronger for the experience. The performance of Triad’s $3.8 billion portfolio was acceptably within expected parameters and the professional staff was very well-regarded in the industry.

However, the financial markets put the whammy on Triad when its line of credit was not renewed by one of its warehouse line providers. With that news, the rating agency Moodys downgraded Triad’s credit rating from B2 to Caa-, a junk bond rating. When that happened, Triad’s liquidity, its source of funds, virtually dried up. This led management to reach the decision to cease active operations. As of this writing, Triad exists primarily as a servicer for its existing portfolio. Roadloans, a direct branch of Triad, is still operating, but is rumored to be for sale.

Cause and effect

How does a fine company like Triad come to this point? It’s really pretty simple: You’ve heard of the subprime mortgage crisis that led to a full-scale, worldwide credit crisis. There have been many articles and comments regarding that crisis, and the auto and credit-card crises are quickly following. What’s puzzling is the lumping of all these together, particularly mortgage and auto. Does it really follow that a person who has trouble with his overpriced mortgage will, ipso facto, default on his car loan?

I don’t believe that performance statistics have borne that out. If a person must go from being a homeowner to a renter, that person still needs transportation to get to a job, go to the grocery store, or have a social life. Delinquencies are up somewhat, but there has been no wholesale turning in of automobiles.

Unfortunately, perception rules the day, and the perception is that anything that has the term ‘subprime’ associated with it must be in dire trouble. So, non-renew a credit line, which in turn causes credit ratings to fall. Just like that, liquidity vanishes and the self-fulfilling prophecy is complete.

I am constantly amazed that the very smart and well-educated folks on Wall Street seem to be no more capable of going their own way than a bunch of cattle. Once the herd instinct takes over, fear of going against the prevailing wisdom drives most decision-making. The result for our industry is a lack of resources for subprime auto finance.

What about the lenders who do not depend on the markets for their liquidity? I’m speaking of companies that have been acquired by the large depository institutions, such as WFS – Wachovia; Summit Acceptance – Capital One; Regional Acceptance – BB & T; Auto One, Transsouth, and Arcadia – CitiFinancial Auto; and Wells Fargo Auto Finance – Wells Fargo Bank, among others. Even though there hasn’t been the same crisis of liquidity issues within these institutions (other than that caused by the banks’ mortgage operations), their landscape has changed as well. Originations have been reduced, by approximately 50 percent in most cases.

Why is that, when the portfolios are still performing? In my humble opinion, it goes back to the herd instinct I mentioned earlier. The banks do not wish to be criticized for being active in subprime because the rest of the cattle might start selling the banks’ stock, thereby reducing their market caps.

Running against the herd

There are exceptions. Take, for instance, Grupo Santander, the Spanish-owned institution that acquired Drive Financial from Halifax Bank of Scotland awhile back. Santander, which is not overly concerned with the opinions of its U.S. shareholders, has prodded Drive Consumer USA Inc. to become a growing source of funding for the subprime departments of dealerships across the country. So, even though the bulls run in Pamplona, evidently the herd falls apart with Santander’s U.S. operations. That is, they appear to be willing to make their own path and take advantage of a good business climate, pundits be damned. According to Drive’s Website, it currently has about $4.8 billion in its auto portfolio. According to the latest quarterly report on the Santander Consumer Finance Website, that division is generating substantial profits for the company.

Meanwhile, the bell cow, Fort Worth, Texas-based AmeriCredit, continues to have its own problems with liquidity. Although there was a successful securitization completed in early June, the terms were somewhat punitive and the conventional wisdom is that the next one will be even more expensive for the company. AmeriCredit has joined the other large companies and reduced its originations forecast dramatically in anticipation that liquidity will continue to be difficult for the foreseeable future.

OK then, if most of the old, established companies are having issues, let’s just form some new ones. At least they wouldn’t be burdened with old performance statistics to worry the herd. The newest success stories are the beginning of operations for Sixth Gear Solutions Corp., Exeter Finance Corp. and, most recently, Inspire Auto Finance.

Sixth Gear has put together a debt and equity package (read: liquidity) of close to $1 billion from Warburg Pincus LLC. No doubt the experienced team that Michael Barrington (ex-CEO of AmeriCredit) put together helped convince Warburg to jump into the fray. Word is that Sixth Gear spent a lot of time and money getting ready; having all procedures, systems, buying programs, risk management, and the like completely in place prior to signing the first dealership. And, rather than trying to sign every dealership immediately, a very deliberate rollout was planned and is proceeding at a moderate pace. Now, there’s a plan: Be Prepared, grow with careful deliberation, and success should follow!

Exeter also is led by ex-AmeriCredit executives and obtained its financing (approximately $60 million) from Navigation Capital Partners. Sam Ellis, the CEO, has a rich background in risk analysis and product pricing that should serve the company well. Although capitalized at a lower level than Sixth Gear, Exeter also has planned its growth with a carefully thought-out plan that should give comfort to its investors, not to mention dealer clients. Similarly, Inspire was founded by a team of executives with no shortage of experience in subprime auto lending.

What the future holds

Is there any hope for additional new companies being formed? The dynamics of this marketplace have made it almost a foregone conclusion that additional finance companies will be formed. The demand is still very strong for subprime/nonprime financing. That demand will grow as the captives and mainstream banks continue to be cautious in underwriting any but prime credit customers. Expect a number of smaller firms to form, perhaps with some regional or demographic specialty that will enable these newcomers to begin with lesser amounts of capital than Sixth Gear and Exeter.

However, the days of giving what were, frankly, outrageous LTV calls to dealerships in this credit spectrum are thankfully at an end. Dealerships are having to again carefully structure their finance deals to accommodate lower LTVs, additional purchase discounts, and more careful scrutiny of applicants. That is what, in the long run, will ensure that the new companies survive and prosper which is to everyone’s benefit – the dealerships, the customers, and the lenders.

It is amazing that Triad, with its long record of successful operation has effectively failed while newcomers spring up, some with significant funding, both equity and debt. But, that seems to be the way this and most other industries function – longevity is elusive. Does growing too large impede entrepreneurial success? Let’s leave that discussion for another article.

Jim Bass has more than 20 years’ experience in the sub/nonprime auto finance industry. He is currently treasurer of the National

Automotive Finance Association. E-mail him at jbass@special-finance.com.

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