Subprime Auto Finance The Year of the Bankruptcies

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May 1998

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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
subprime<a name="note1"></a><a href="#foot1">1</a>
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
billion<a name="note2"></a><a href="#foot2">2</a>
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.<a name="note3"></a><a href="#foot3">3</a>
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.<a name="note4"></a><a href="#foot4">4</a>

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.
<hr>

<h3>Footnotes</h3>

1 "Subprime" auto finance is taken to mean the same as
"non-prime" or "near-prime" auto finance for the purposes of this
article. <a href="#note1">Return to Text</a>

2 Estimated by CNW Marketing/Research.
<a href="#note2">Return to Text</a>
<a name="foot3"></a>

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.
<a href="#note3">Return to Text</a>
<a name="foot4"></a>

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. <a href="#note4">Return to Text</a>

Journal Authors

Michael C. Buenzow

Robert Carter Pate

Rishi Sadarangani

Journal Date

Friday, May 1, 1998 - 12:00