Back to the Future - Circa 1993

With the growing numbers of calls and e-mails from some very skilled dealers and SF managers trying to get their arms wrapped around the “new” industry, I feel like the industry had gone back in time.

First, the good news. (There is some—not much, though.) As I have been saying for some time, the industry isn’t going away. As was pointed out at the 2008 National Auto Finance Association conference by Amy Martin of Standard and Poors and by Bernard Weinstein, an economist from the University of North Texas State, the number of people entering the subprime credit market is unfortunately growing at a record rate, and isn’t likely to slow down for some time. They agreed that while key market indicators don’t reflect a recession, we are in one (as I have been warning since October) and that it has been caused by, among other factors, a collapse in the credit sector.

As I see it, there are two major problems for the SF industry. One is, for some, a significant lack of capital. Comparing the first five months of 2008 with 2007, there have only been approximately $1.2 billion in subprime asset-based securitizations, as compared to about $9.2 billion a year ago. For those finance companies that depend on such securitizations for capital, that is a very big deal.

The second issue is lack of ability to forecast the economy. Wall Street and finance companies can price anything as long as the economic forecast can be predicted. With what is nearly a perfect storm existing in the economic world, as Mark Floyd, the co-COO of AmeriCredit, stated at the NAF Association conference, usually you are worrying that the light at the end of the tunnel isn’t a freight train, but now, for many, it is difficult to see the end of the tunnel. Indeed, I have been saying for six months that this cycle could last 12 to 15 months. Based on what I see now, July 2009 might be the first uptick, and if it isn’t, I predict it to be the first quarter of 2010.

Today, the SF business looks much more like it did in the early to mid-90s than it did just 12 months ago. The perception of finance companies is that the industry was out of control and clearly in favor of the dealers. I might not share that opinion nearly as strongly, since the finance companies were the ones that turned up the competitive heat on each other, but 12 months ago, dealers certainly had the benefit of very high loan-to-value (LTV) offers, lower pricing and aggressive buying.

Now, all of that has changed. The LTVs have shrunk considerably. Finance companies are trying to shrink their amount to finance (transaction prices) in order to make terms more affordable and guard against the shrinking disposable incomes of customers stemming from higher food and energy prices, as well as under-employment (loss of overtime and second or third jobs due to employer cutbacks).

Here are my takeaways. First, AmeriCredit shrank their originations by $6 billion in 2008 from 2007, which represents about 27,500 deals per month that they aren’t doing. They are not alone. With Triad recently leaving the market after losing favorable credit terms with their primary warehouse line and HSBC and CitiFinancial tightening their belts, I estimate the Big Seven are funding 40,000 fewer deals per month than in 2007. This isn’t much different than what occurred briefly in 2003, but then there was an end in sight. This time, it is much different.

As a result, the balance has clearly swung in favor of the finance companies, and for the next year at minimum, you must be prepared to deal with lower LTVs. It is the way it is going to be, and no amount of rehashing is going to change that.

Similarly, the finance companies as an industry must price their loans more conservatively. Certainly, some companies did so as long as 12 months ago and they will choose to err on the side of conservatism until they feel they have a crystal-clear view of the economic future.

Be prepared for more due diligence of new dealer signups (especially independents – sorry, folks), as well as ongoing periodic reviews. Finance companies today track more data than ever. With delinquencies and charge-offs rising, they are more sensitive to dealer fraud than ever. They know that it may take two years for the true impact of rogue dealer or manager transgressions to become evident, and some have installed some sophisticated methods to help set up red flags.

Maybe as significant as anything else, the sentiment is that now, for perhaps the first time since the early to mid-90s (whether by choice or coincidence), the customers are being held accountable for their credit decisions. In recent years, a customer could literally tank their obligation with one finance company and likely be in a newer, nicer vehicle with little or no down payment from another company the same day. Those days are over.

Most likely what the dealers are going to feel the most is a push by finance companies to not only make the paper more affordable to the customer with lower monthly payments, but they are going to require more real cash down. The challenge is that both finance companies and industry experts calculate that for every $100 increase in down payment required, customer demand (or, more likely, the ability to pay) decreases by 7 percent. If real cash required increases by $500, that would mean a staggering drop of 35 percent in volume.

An additional takeaway is that customers are also going to have to be willing to accept a lower-tiered vehicle than they have become accustomed to, again temporarily stemming demand.

Dealer inventory must be nimble and must include inventory to accommodate lower LTV and transactions with lower prices.

Expect benchmark gross profits (75th percentile) to drift back to 2004 levels, closer to $2,800. Benchmark closing ratios, at least for a period of time, will likely settle around 12.5 percent, with the elite dealers (top 90 percent) closing near 16 to 17 percent instead of their customary 22 percent.

Finally, similar to the “old days,” you must learn to be efficient with your finance companies. Look-to-book and approval-to-funding ratios are suddenly very important with the majority of the finance companies. Right behind that, and indeed even more important for some, is how your paper is performing. Dealers need to establish communication lines with management-level company officials to make sure that they understand how their paper compares to the average of their area or region. You must remember how to be good partners in business.

The SF business isn’t going away, but unless you experienced the business in the early-to-mid 90s like I did, you may not recognize it for awhile. Make the changes in your business model, and you will continue to be able to enjoy the spoils.

Until next month,
Good selling