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.
The Truth About Subprime
About 30 percent of subprime auto borrowers are homeowners — and we can assume that the vast majority of those are mortgaged homes. But, can we assume that the mortgages are also subprime? There is absolutely no basis for such a conclusion. Mortgages are of different age than the auto loans, and there may have been some credit event subsequent to the mortgage date that resulted in a borrower being considered subprime for an auto finance transaction. Additionally, homeowners are currently and have always performed slightly better than renters on their auto loan obligations. Being a homeowner is a plus in most underwriting matrices of auto finance companies.
If you refer to any number of authoritative sources, there hasn’t been any unusual rise in either delinquency or defaults with the subprime/nonprime auto finance companies. In AmeriCredit’s earnings call on Aug. 8, it was reported that 31- to 60-day delinquencies actually decreased 0.4 percent from the same time in 2006. Reviewing the information that is publicly available from Standard & Poor’s revealed that defaults are on the decline in more recent vintages. In my private conversations with a number of auto finance executives, they all report no alarming changes in performance. So why is there all this hysteria? Doggone it, it’s the “herd instinct” once again.
My fear is that the word “subprime” is taking on such a negative connotation due to poor performance of a relatively small minority of real estate mortgages. Unfortunately, this could cause the investment community to shy away from supporting the warehouse lines of credit, commercial paper conduit and asset-backed securitization issues that are of great importance to many of the auto finance companies. At the least, greater spreads in interest rates over the comparable treasury rates already appear to be happening. What a shame, as the portfolios just continue to perform well. So, why is that?
Learning From Our Past
Risk management tools were not nearly as advanced back in 1996 and 1997 when the subprime auto industry had its performance crisis. Underwriting sophistication is considerably more advanced than it was then. Practically all mainstream companies use multi-generation scorecards that have been proven to price risk accurately, at least much more accurately than it was in the past. Vintage aging (static pool analysis) is much more widespread than it was in 1996 and 1997 as is the frequency of portfolio monitoring and resulting origination model adjustment. Simply put, the subprime auto finance industry is not going to experience the same portfolio performance degradation that the subprime mortgage business has, simply because the auto finance companies learned their lessons ten years ago. And they haven’t forgotten them.
All of the above is fairly logical and provable. Will that turn the herd? I doubt it. Hang on for another exciting ride.