Here I am at the coffee shop again, contemplating the state of the subprime/nonprime auto finance industry. The last time I commented on this was in an article published in F&I magazine’s September 2008 issue. At the time, I said that I really didn’t have a clue what it was going to take to revive the industry. I’m not sure that I’m any more enlightened now, but there are a few hopeful signs.

One must always consider what AmeriCredit is up to, as it really does serve as the bellwether of the subprime finance industry. Well, another earnings call is scheduled in a couple of weeks, but, alas, the deadline for this article will not allow me to wait for that call (See sidebar on page 24 for results). However, it must mean good things when the stock price has risen by 100 percent since November 2008. It now stands at more than $14 — albeit with a dip in March 2009 to just over $3. The stock value is far from the heady days of 2001, but it’s still a great comeback from last fall. And AmeriCredit’s current stock price is pretty well in line with percentage gains in the major indices. That’s encouraging. On an annualized basis, the company’s originations have decreased from $10 billion in 2007 to about $850 million in 2009. But that decrease in originations may tell us something.

I do agree there is some correlation between large growth trends and failure to perform. However, I’m not convinced that the credit crisis is due solely to origination volume. I also don’t think that higher delinquency and losses in the auto finance arena can be blamed on the mortgage crisis.

First Signs of a Crisis

Back in the spring of 2007, it was becoming clear that the competitive pressures of seeking higher earnings, becoming full-spectrum finance companies, and, in the case of depository institutions, having practically unlimited funding available (while securitizations were fueling the rest), were going to cause the rims to start flying off the wagon wheels.

My take on the market at that time was this:

• Dealers were demanding looser buying guidelines and higher advances — and the finance industry responded with hearty approval!

• Risk management tools indicated that anything or anybody could be financed given the right credit “price.” Unfortunately, the price was more often APR and dealer discount than down payment.

• Terms were extended into the realm of the utterly ridiculous by the finance companies. I mean, really, 84 months for a subprime borrower on a non-highline used car!

• Many finance company sales reps were being paid on some sort of volume basis — practically all of them earned six figures or more. (“Let’s see, do I look after my pocketbook or the company’s?”)

• Finance companies tolerated and even encouraged dealer average gross profits of $5,000 per vehicle and higher.

Lest you think I am on the dealers’ cases, I have to admit that they are true capitalists who are in the car business to make a profit. However, any excesses were being happily funded by the auto finance companies that were in search of earnings, bragging rights, etc. Some — or actually lots — of management and board-level personnel were either asleep at the switch, didn’t ask enough questions or were just not as smart as they thought they were.

I do have some positive observations about today’s finance situation. The finance companies that are still out there are doing things in a saner manner. Underwriting guidelines have been tightened and advances have been reduced, which I think is probably just as important. It’s really hard to reduce write-offs when you start with a loan-to-value ratio of 140 percent or more, and the bulk of the defaults occur in the first 18 months.

If you get the chance, sit down with an auction price book, such as the Auto Lease Guide. Pick practically any car and follow its value for 60 months. To better envision the curve, put the monthly or quarterly values on a line graph. On that same graph, plot the declining monthly or quarterly balance of a finance contract. You will find that any loan can be upside down for many months. However, a longer term will keep it upside down for a longer period. But with even a 60-month amortization, the principal balance of the finance contract will significantly exceed the residual value for at least 30 to 36 months.

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Fixing Subprime/Nonprime Finance

So, to reduce net loss, a return to shorter terms appears to be prudent. Who would win in such a scenario? First of all, the consumer wins because he or she actually has hope of owning the vehicle some day. Second, if the dealer is one who encourages repeat business, shorter terms may actually get the buyer to return with a decent trade-in and a smile on his or her face. And, last, but certainly not least, the finance company will enjoy lower net losses, better loan performance, and fewer problems with warehouse line providers, the rating agencies, etc. Of course, the only way to securitize nowadays is to be guaranteed by the federal government through the Term Asset-Backed Securities Loan Facility, or TALF, as AmeriCredit recently did.

OK, that fixes the existing finance companies, but what about new entrants? Past incidents have proven that starting a finance company is challenging, to say the least. Do you remember when a few members of the old AmeriCredit team, led by Michael Barrington, started Sixth Gear in June 2008 with a huge commitment from Warburg Pincus and Lehman Brothers? Well, they failed, but not because of Sixth Gear’s management team. So, where does that leave the smaller entrepreneur?

You will have to think small and hope for the best. Given a proven model (one that will in all probability require you to fund using your own money, and whatever loans you can get from family and friends) that demonstrates your ability to originate and collect paper and maintain decent loss statistics, you might actually be able to put together a private equity offering, obtain a warehouse line of credit from a progressive bank and begin growing into a self-supporting company. It’s not a lot different from dealers who establish in-house financing operations, which are basically funded by the dealer and his or her friendly banker.

Liquidity help in the early going may be available from portfolio buyers, but the finance company really has to buy the paper “right,” as you will suffer substantial discounts from the portfolio buyers. Cash flow is difficult unless you already have some other means of providing capital. It’s fairly simple. You buy a finance contract for $15,000 with a term of 60 months and begin receiving approximately $360 per month. Following the first payment, you’re down approximately $14,640 on a cash basis. Obviously, you need a source of capital while you build your portfolio.

There is some encouraging news. I know a dealer who was hammered by Chrysler, but was able to continue operations as an independent, used-car dealer after being signed by two major nonprime lenders and a couple of local banks. He’s going to survive. But to be fair, he had sufficient personal liquidity to make it happen. Expect the finance companies to be very selective in signing new dealers, franchise or independent. With reduced originations, gaining lots of new dealers just isn’t a priority anymore. And if finance companies are no longer chasing volume, that means more rational buying practices on the part of the surviving finance companies.

At the end of the day, what we have here is survival of the fittest. The most financially fit dealers and finance companies will be the survivors. Let’s just hope that what currently looks like an economic recovery will sustain itself, and we can get back to being a little less tense as we sell and finance our vehicles!

Think Positive

With rising unemployment and weakening income growth still cutting into household incomes, no one is singing “Happy Days Are Here Again.” However, there were some signs in July and August that the economy might be in recovery mode.

• In July, Ford Motor Co. reported its first sales increase (1.6 percent) in two years.

• The Institute for Supply Management’s manufacturing index rose by 4.1 points in July, the largest increase since September 2005.

• During the second quarter, the gross domestic product shrank at a better-than-expected

• 1 percent annual pace after a 6.4 percent drop the prior three months.

• In July, the Dow Jones Industrial Average had its best month since 2002. 

• The S&P 500 composite stock index rose above the 1,000 level for the first time in almost 10 months in August.

Related Article: AmeriCredit Posts 4Q Profit; Looks to Sign Up Dealers

Jim Bass serves as treasurer of the National Automotive Finance Association. He can be reached at jbass@bobit.com.