The Subprime Credit Crunch

The longest-running CEO on Wall Street, Richard Fuld, battled for more than a year to contain the fallout from bad bets on subprime real estate loans. Fuld’s defense of the 158-year-old investment banking firm, Lehman Brothers, ended when Bank of America walked away from buyout talks, forcing the company to file for bankruptcy—the largest in the history of our country.

Worldwide, the current credit crisis has led to more than $500 billion in write-downs. It has also claimed the jobs of at least 10 CEOs, caused Lehman Brothers, Merrill Lynch and Bear Stearns – all industry stalwart icons – to collapse and has put a stench on anything with the “subprime” moniker attached to it. How did this happen, and what does it mean for the subprime automotive industry?

First, let’s take a look at what went wrong. From the mid 1990s through 2006, there was plenty of cash available for investment banks, paired with an immense pressure to turn profits.  Simply put, there was too much money chasing too few high-yielding deals. Then, “creative” financing in the home mortgage sector started evolving as mortgage companies began popping up across the country. The huge margins on subprime mortgage loans paired with a housing boom and skyrocketing home values made real estate and high-risk mortgages very appealing to investors. It was virtually a no-lose scenario for the banks since they were loaning money on aggressively appreciating assets.

Can you imagine how aggressive a good buy here pay here car dealer would be if used vehicle prices increased 20 percent every year and there were plenty of customers with bad credit lined up to buy cars? Forget the stips; forget the down payment. Let’s make money! If the customer pays, you get high interest returns plus the origination fees. If they don’t, you repossess the collateral and sell it for a profit. You can’t go wrong! It sounds too good to be true, but that’s exactly what happened over the past several years.

In fact, Lehman Brothers, who purchased these subprime mortgage securities at a discount from brokers, accumulated an $85-billion portfolio and posted record profits in 2005, 2006 and 2007. The only company that backed more mortgage securities during the same time frame was Bear Stearns, which collapsed in March. Everyone was making money and nobody seemed to care that the guidelines for mortgage loans virtually went out the window. Customer income verification, debt-to–income ratios and payment-to-income ratios were unimportant. The bottom line is, most of these loans just didn’t make sense.

Ironically, many out-of-work mortgage brokers have been looking for jobs in the car business lately. I’ve personally interviewed over 100 candidates who sold mortgage loans to subprime customers and are now looking for jobs in automotive finance or sales. Each interview baffled me when I learned the stories of the lax underwriting guidelines. The fundamentals of finance were often disregarded and these gurus from Wall Street didn’t seem to mind.

What does this mean for the subprime automotive industry? It means that for now, and for some time to come, less money is available to lend. Finance companies get their money from two basic sources: securitization and capitalization. When they securitize capital, they sell assets like a portfolio of auto loans at a discount and hopefully make money on the spread. You can just imagine what the investment appetite for buying discounted subprime paper is right now. It’s not very good and our financing partners are struggling to find buyers.

Finance companies also get money by borrowing long-term debt or by selling equity in the company. This process is called capitalization and it works much like starting up a brand-new BHPH operation. You have to borrow (or invest) enough money to fund the projected origination of installment contracts for a specified period of time.

The availability of subprime capital is down and the demand is high. The economic forces that drive the markets are in full force and making it much more difficult to put a deal together today. Customer down payments are low and the banks have tightened their belts, perhaps more than ever before, slowing sales and adding to the current pile of challenges for the car dealer. This is a time when a dealership special finance team really gets to learn what they’re made of.

 The good news in all of this is that the special finance customer base is growing due in a large part to our cousins in the mortgage business, and where there is consumer demand and a sound, profitable business model to satisfy that demand, the money will follow. A quality relationship between the finance company and the dealer has never been more crucial to success in our industry than it is right now. But, if the dealers do their job to sell cars and put together profitable and collectable loans by adhering to the Five Standards of Finance, the banks will do their job and get the money.

The Five Standards of Finance:

1. Credit
2. Stability
3. Ability
4. Collateral
5. Structure

Credit
Understanding credit is about understanding the entire credit file and how a finance company will interpret the information. The credit score itself is just a small part of the equation. The credit report, however, tells the story.

Stability
The stability of an applicant is best determined by their time on the job (TOJ) and time of residence (TOR). Finance companies prefer two years or more on the job. If an applicant for a car loan has been job hopping and has had several jobs within the last two years, has been unemployed for long periods of time, or even worse, they’ve bounced around from state to state, they are viewed as unstable and thus a higher risk for a loan.

Ability
Ability is perhaps the single most important of all the standards. It alone will determine the payment a customer can actually afford. Payment-to-income (PTI) and debt-to-income (DTI) are the determinants for a customer’s ability to afford a car loan. The typical special finance deal will be capped at an 18 percent PTI (18 percent of the applicant’s “verifiable” gross monthly income).

This is why proof of income is so important to a special finance deal and should be collected early in the sales process. DTI is also an important factor when making a credit decision. Most finance companies will not approve a loan that causes the DTI to exceed 50 percent of the gross monthly income.

Collateral
The special finance deal is built around the collateral. The make, age and mileage of the vehicle will determine the term of the loan. The term and interest rate determine the payment, and payment is what the customer can or cannot afford. The deal begins and ends with landing the customer on the right vehicle early in the sales process—one that fits the customer’s budget in both down payment and monthly payment.

Deal Structure
Deal structure determines profit. Deal structure dictates loan risk. Deal structure will make or break the deal, and, the cardinal law of deal structure is affordability. Can the customer afford the payment? Can the bank afford the risk? Can the dealer afford the profit margin?

The risk meter for the bank is loan-to-value (LTV)—how much money the bank is lending in relationship to the book value of the vehicle. Every deal must be structured with LTV, profit and monthly payment in mind. A high LTV is a high-risk deal for the bank. DTI and PTI determine if the customer can actually afford the vehicle. But, together with the LTV, these three ratios determine the amount of risk for the bank and whether or not your customer gets an approval.