In the early 1990s, the subprime automobile finance industry was regarded as a Wall Street darling. Earning growth rates of 100 percent were not uncommon as capital poured into the industry in the form of warehouse lines, asset securitizations and equity offerings. In January 1997, Mercury Finance Co., the largest independent subprime¹ auto finance company, disclosed accounting irregularities. This event started a chain reaction that led to the collapse of many large players in the industry.

Defining the Subprime Auto Finance Sector

Companies in the $400 billion² auto finance industry generally operate in one of two distinct sectors: prime or low-credit risk, and sub-prime or medium- to high-credit risk. The vast majority of this financing is made to prime borrowers on purchases of new cars. Prime borrowers are those consumers having a credit history of at least three years, non-delinquent historic performance on installment debt, and at least two years of employment. The prime market is extremely competitive, and is dominated by the captive acceptance companies (GMAC, Ford Motor Credit, etc.) and certain money center banks.

Subprime borrowers have at least one serious blemish on their credit history, or no credit history at all. The former group might have significantly impaired credit histories, with multiple delinquencies, charge-offs, repossessions and bankruptcies, as well as relatively low household incomes of $20,000-$40,000 annually. The latter group might include recently divorced or separated people who do not have an independent credit history, as well as college and high school graduates who have only recently entered the work force. Annual originations of subprime auto loans range from $40 billion to $70 billion, or between one-tenth and one-sixth of total auto finance originations. Most companies in this sector finance medium- to late-model used cars with low to medium mileage. Typical loans range between $5,000-$14,000. The adjusted periodic rates (APRs) to borrowers generally exceed 15 percent and presently average about 22 percent for the entire subprime industry, capped by local state usury laws. However, many of these loans are purchased at discounts, which effectively brings the yield over state usury caps.

Dismal 1997 Performance

In all, 24 of the 26 public subprime auto finance companies saw their stock prices decline in 1997.³ The largest decreases were experienced by First Merchants Acceptance Corp. (99.8 percent), Reliance Acceptance Group Inc. (98.2 percent), Mercury Finance Co. (93.9 percent), Search Financial Services Inc. (86.9 percent) and AutoInfo Inc. (86.6 percent). In all, nine subprime auto finance companies experienced stock declines of more than 80 percent last year.

The news at the beginning of the year sent tremors through the entire industry. In January, Illinois-based Mercury Finance Co. announced that it had discovered accounting irregularities, which forced four years of results to be restated. The negative impact of the adjustments was more than $90 million. The same month also saw American Auto Finance Corp. of Park Forest, Ill., file for bankruptcy prior to being acquired by GE Capital Corp. In February, Dallas-based Jayhawk Acceptance Corp. declared chapter 11 bankruptcy after taking a $15.5 million charge as a result of unexpected credit losses. In July, Illinois-based First Merchants Acceptance Corp. declared bankruptcy after defaulting on its credit agreement. Denver-based Western Fidelity Funding Inc. became the fourth subprime auto lender in 1997 to seek protection in bankruptcy court when it filed for chapter 11 in August. Several other non-public subprime companies faced serious liquidity crises, but have been able to avoid bankruptcy. In early 1998, four additional subprime auto finance companies, Reliance Acceptance Group Inc., Search Financial Services Corp., First Enterprise Financial Group Inc. and Keller Financial Services Inc., filed for bankruptcy protection.

Reasons for Bankruptcies

Competition and Deviation from Underwriting Standards: The environment of readily available credit resulted in many new entrants in the subprime industry. At least 20 subprime automobile finance IPOs were issued in the three-year period between 1991-1994. As the number of subprime automobile finance companies increased exponentially, competition for market share intensified. More competition caused credit quality to deteriorate, while increasing the pricing of loans.

Inexperience of Entrants: New lenders had liberal credit standards, did not implement credit scoring and inadequately provisioned for credit losses. In many instances, when poor-quality loans were purchased, instead of reducing growth with an emphasis on collections, many companies tried to grow out of the problem by masking the questionable old loans with an increasing number of new loans.

Extreme Leverage and Securitizations: Wall Street’s focus on earnings growth and stratospheric return on equity led many companies to over-leverage their balance sheets through asset securitizations. Companies would hold a subordinated piece in the securitizations. The value of this tranche was determined by the company based on projected cash flow models that incorporated expected pre-payment and loss assumptions of the underlying portfolio. These residual assets were then used as collateral for warehouse lines of credit obtained to purchase even more loans. When losses came in higher than projected loss rates, the value of these assets diminished significantly, throwing the company into a liquidity crunch as credit line advance rates were exceeded and debt to equity covenants were violated.

Lack of Funding: The industry’s bad news at the start of the year depressed the stock prices of most companies in this sector and made equity financing difficult. Meanwhile, commercial paper was drying up and warehousing companies were tightening lending standards.

Dealer Fraud: Dealers who indulge in illegal business practices, such as forging signatures on sales contracts, falsifying information on credit applications and wrongfully repossessing vehicles are widespread in the subprime auto business.

Consumer Defaults: The increasing debt burden of the average American consumer has contributed to rising delinquencies, defaults and personal bankruptcy filings.

Underestimating Losses: The poor financial performance and quarterly losses reported by many companies during 1997 were often attributable to an increase in the loan-loss provision. Ironically, the boost to the loan-loss provision was not driven by a sudden deterioration in portfolio performance, but was due to inadequate reserving at loan inception.⁴

Inadequate Systems: Companies often allowed portfolios to grow rapidly without giving due consideration to the capacity and suitability of the computer systems backing up the servicing functions as well as management information capabilities.

Determinants of Success

Given the high default risk, the following factors are key to survival in the subprime auto finance business:

•Careful, systematic underwriting, with strict attention to borrower credit qualification, dealer experience, vehicle resale value, non-refundable discounts and down payments. Experienced subprime underwriters are skilled at identifying borrowers whose credit histories were marred by events that were either outside their control or unlikely to recur.

•Hands-on servicing and aggressive collections must be core competencies. Some companies use behavioral scoring techniques based on prior payment patterns to determine when to make a collection call. Requiring borrowers to make a meaningful down payment at time of purchase raises their personal cost of default.

•In the highly competitive subprime auto finance sector, risk management tools are very important to success. The most important tool is the ability to reliably track the performance of loans purchased from each dealer, on a static pool basis. Lenders with static pool data can evaluate loans by dealer, branch, underwriter, state or region on a monthly basis. Finance companies must also carefully monitor the auto dealers by keeping track of the percentage of loans approved to the number of credit applications received and the ratio of loans funded to the number of credit applications received (book-to-look ratio) by dealer.

•Within the auto finance industry a choice of three operating platforms exists:

1) Decentralized (Branch-based) Platform: A network of small storefront-like offices located strategically in neighborhoods where customers reside and dealers operate. Underwriting can be controlled centrally or assigned to the branch manager within certain centrally prescribed guidelines. The principal advantage derived from the de-centralized platform is the close proximity to the customer. The drawbacks include greater expenses and heavy reliance on branch managers.

2) Centralized Platform: Centralized platforms are characterized by heavy investments in information systems that automate much of the underwriting, funding and servicing functions. Originations are done indirectly by purchasing notes from dealers and through wholesale brokers. Collections are centralized with advanced technology such as automatic/predictive dialing machines and online access to imaged loan files. Managed appropriately, centralized underwriting allows lenders to adjust underwriting criteria instantaneously and monitor the static pool performance of loan production. Critical success factors are the ability to successfully deploy and employ technology and develop economies of scale. The primary disadvantage of this platform is the lack of personal contact with the customer with regard to collections. Additionally, a company may have difficulty detecting dealer fraud.

3) Hybrid Platform: Includes a centralized processing and early-stage collections facility while maintaining several regional offices strategically located throughout the country. The hybrid platform has a number of advantages versus the centralized platform, and is less expensive to maintain than the wide-flung branch-based model.

Industry Outlook

The average American consumer cannot pay cash for a new or a used vehicle. Therefore, the purchase of an automobile is usually financed. New cars are also becoming less affordable. In 1994, 51 percent of the median annual family income was required to purchase the average new car, a significant increase over the 45 percent required in 1989. As of 1995, the five-year cumulative annual growth rate (CAGR) for used car sales was 3.5 percent, more than twice the five-year CAGR of new car sales, at 1.4 percent. Given the supply of off-lease vehicles entering the market, the fundamental reasons for growth of the used car market seem sound.

Subprime auto finance has hit some potholes recently. Although there are several reasons for this, the common denominator is deteriorating asset quality measures and rapid increases in volume. This situation leaves the industry ripe for consolidation, especially if the economy weakens in the near term. Some of this is already evident as witnessed by Monaco Finance Inc.’s acquisition of about $81 million of auto loans from Pacific Consumer Funding Corp., Capital City Acceptance Inc.’s acquisition of Emergent Group Inc.’s two auto divisions for $22 million, Household International’s purchase of ACC Consumer Finance Corp. for $200 million, Conseco’s takeover of NAL Financial Group Inc. for $21 million, Search Financial Services Inc.’s acquisition of MS Financial Inc. for $21 million, etc. Clearly, increased competition and deteriorating consumer credit fundamentals have combined to differentiate weak operators from the strong in this rapidly maturing industry.

In the future, economies of scale will be required to compete profitably. Although smaller companies cannot generate the same economies of scale as the large companies, they can often deliver better service by being more flexible. Companies will continue to adopt new technologies, particularly in the areas of risk management and credit scoring. Underwriting standards will continue to be tightened and watched over carefully. Given the pressure on companies to meet certain growth targets, the importance of consistent underwriting and tight monitoring controls cannot be emphasized enough. Nonprime Auto News recently reported that the National Auto Finance Association, a trade group for the subprime lending sector, is working on creating standardized financial performance reporting guidelines. With standardized guidelines, the industry is expected to cross an important threshold in terms of investor perception and availability of capital, and may even once again become a Wall Street darling.

---

Footnotes

¹ "Subprime" auto finance is taken to mean the same as "non-prime" or "near-prime" auto finance for the purposes of this article. Return to Text

² Estimated by CNW Marketing/Research. Return to Text

³ According to Nonprime Auto News, a subprime auto finance industry publication that tracks the performance of 26 publicly traded subprime auto loan companies. The authors relied on this publication for some factual research. Return to Text

⁴ According to a Moody’s Investors Service special report dated January 16, 1998 that provided insight into the causes of the subprime auto finance market’s recent deterioration. An excerpt of this report was recently published in Nonprime Auto News. Return to Text