I often listen to the Classic Radio channel on Sirius Satellite Radio when I'm in my car going somewhere important, such as meeting a dealer or finance company in the Dallas/Fort Worth area. I enjoy hearing some of those broadcasts, which I remember fairly well from my youth. A few weeks ago I was listening to a "Fibber McGee & Molly" show, which was originally broadcast in 1939. On the show, McGee and Molly would often discuss all sorts of commonplace events, definitely with a comic flair — such as walking home from the movie theatre and having locked the door and forgotten to take the front door key.
In this particular broadcast they were discussing their credit problems. Had Molly mailed in the payments on the washing machine, refrigerator and the car? The car had been originally financed in 1932 and had been refinanced twice since that time. Both were fearful that the car might be repossessed due to their failure to make the payment on time. I doubt the term subprime existed at the time, but McGee and Molly almost certainly would have fallen into that category today. This was an episode from almost 70 years ago when the United States was still in a recession. There were fears of entering a global war and people needed some laughs to lighten up. The situation seems to parallel today’s environment even though some details are different.
Have we really learned anything new in the past seven decades? One wonders considering the current situation that has developed in the subprime/nonprime auto finance market. To me, it just makes no sense. I understand the credit crunch as it applies to subprime mortgages. We now know there was precious little underwriting of any sort, no proof of income in many cases, and a market driven by greed — the greed of many different players. I discussed this situation in an article that appeared in the October 2007 issue of F&I magazine. However, the total lack of underwriting hasn't been widespread in the auto finance sector. If anything, the diligence with both dealers and borrowers has been much better than it was in the early to mid '90s. But while the underwriting techniques, stipulation checking and skills are in place, there is one flaw quite similar to the '90s.
The Easy Money Period
There was sort of an "easy money" period where obtaining both equity and debt for finance companies was much less challenging than in, let's say, 1996. Very large institutions, such as CitiFinancial, Wells Fargo, Wachovia, and Capital One, jumped on the subprime auto finance bandwagon. Available equity increased by hundreds of millions, and debt availability was not very challenging due to the ease of placing asset backed securitization offerings. That combination led to competition for market share, which slowly eroded some of the traditional industry standards. Combined with the virtual drying up of liquidity, this situation has caused a lot of consternation in our field.
When subprime finance companies fought for market share (i.e., larger and larger portfolios), even with the use of sophisticated score cards, a general degradation in effective finance company yield occurred due to over advances, buy rates that were too low, and the disappearance of just about any fee structure. This occurred so the dealers could increase their gross profit and choose one finance company or bank over another. And, as the Everly Brothers used to croon, "Let it be me" became the mantra in the subprime auto finance industry.
There were few companies that did not follow that model, and they have survived the crisis pretty well. Those conservative and oft criticized companies didn't run up the size of their managed portfolio during the easy period, figuring there would be a comeuppance when the market cycle rolled around again toward tightening up. So, who's the smarter one? Well, that depends on your point of view.
Because of the liquidity crisis finance companies are facing, it is clear that dealers who specialize in subprime customers are facing very difficult times. The list of companies that have cut their originations by 50 percent is growing. Triad Financial quit indirect originations altogether in May. This drastic reduction in originations is bound to have a negative impact on dealers, especially independent dealers. As a matter of fact, I believe finance companies that marketed heavily to the independent dealers are using the crisis as an excuse to abandon the independent market. Up until a year ago, the independents were signed with minimum diligence to fuel the growing finance company portfolios and drive up market share. That practice has just about ceased.
Shifts in Lending Practices
What corrections are being made? Loan-to-values ratios and maximum advances are noticeably lower than a year ago. Discounts on contract purchases are spreading across ever higher credit tiers, buy rates are up (usury laws in several states limit this aspect), and administrative fees are becoming more prevalent. The overall effect of those moves is to raise the effective portfolio yields from the mid-teens to the low-twenties, which will help the finance companies regain some of their losses. Many dealers are now willing to accept finance purchasing programs, which would have made them throw the sales reps out of the dealership a year ago. I've even been told by a very savvy dealer principal that it may be time to restart some form of dealer recourse programs, so that contract purchase markets can survive and vehicles can continue to be sold to the subprime consumer.
I was advised in mid-May that all the institutional investment money is hiding in U.S. Treasuries, so I was heartened when AmeriCredit executed their $750 million securitization at about the same time. The securitization was more expensive in terms of over-collateralization, but the interest rates on the various branches were not punitive. So, perhaps the investment community realizes they cannot hide in treasuries forever and really do need to participate in the private investment markets, particularly with AAA-rated securities.
As we dig ourselves out of the current credit situation, I fervently hope finance companies, banks, as well as soon-to-be-formed finance companies keep at the forefront of their managements' minds that no amount of market share can be justified in another loan-to-value, low-effective-yield, market-share building race. However, I have witnessed this cycle twice in the last 15 years and I'm not sure this won't happen again. It's difficult to remain conservative, while all around you are enjoying the good life of growth and prosperity!
This brings me back to "Fibber McGee & Molly." Just as the humor and life situations from that period are applicable to today, so is the business cycle. The cycle can be uncomfortable, the timing can be inconvenient, but there seems to be no stopping it. Consumers cannot acquire things they need or want by paying cash, so buying on credit seems to be a constant. This creates demand for credit providers, such as finance companies, which must raise funds from the investment community, and off we go. Let 'er rip!
Jim Bass serves the industry as a subprime auto finance consultant, and as a board member and treasurer of the National Automotive Finance Association. He can be reached at [email protected]