Lessons Learned as CFO of Sub-prime Lender

Background                             Continued development of ever more sophisticated, and often not yet stress-tested, fixed income derivative instruments coupled with a surge in liquidity in global financial markets over 2005 to mid-2007 spawned widespread commercial and investment bank, private equity, hedge fund, institutional and retail investor excesses.  Unlike many prior financial market “Bubbles,” however, this one germinated and multiplied primarily in fixed income/credit markets…professionals and amateurs alike either ignored the need for risk-based price premiums or forgot how to price them or both.                                              

Upshot → a “Credit Squeeze” that wrapped its tentacles around lenders, borrowers, financial engineers/facilitators/rocket scientists, investors and savers alike; froze most derivative markets; erased layers upon layers of confidence (built over decades) in fixed income markets from overnight repo to 40-year bonds; reduced the stock market capitalizations of most financial institutions by 50-75% (or more); helped bring down an 85-year old investment bank (Bear, Stearns); rocked credit ratings agencies; stunned mono-line and multi-line insurance companies; forced regulators to take drastic short-term actions, the long-term effects of which are unclear (i.e. the danger of “Moral Hazard”); overwhelmed the ability of Congress to understand the complex sequence of events and its impact (the result of which may be legislation that carries with it the unwritten “Law of Unintended Consequences”) and played to individual members’ basest political instincts (particularly in a presidential election year); helped encourage the usual element of fraud and deception that plagues all societies; fed unending and provocative content to the print and electronic financial media; had the securities tort bar salivating at myriad opportunities to file class actions; and left the public at large, already burdened with a generally abysmal financial IQ, confused, afraid and, in some instances (e.g. IndyMac Bank’s failure and FDIC intervention), near panic. 

 

Home Ownership           The American flag, apple pie, Chevrolet and the concept/myth of “Home Ownership” all evoke images and kindle hopes and dreams firmly embedded in our national ethos.  Depression era legislation created a number of government agencies (e.g. the Reconstruction Finance Corporation and the Federal Housing Administration in 1934) and quasi-government agencies [e.g. the Federal National Mortgage Association (“Fannie”) in 1938] to help restore confidence and reinvigorate the housing market, particularly for single-family homes.  The “no down payment” and “government guarantee” portions of the G.I. Bill enacted in 1944 enabled home ownership for many WWII veterans.  The Federal Home Loan Mortgage Corporation (“Freddie”), with a charter similar to Fannie, was born much later in 1989.  Today, Fannie and Freddie hold or guarantee almost ½ of all residential mortgages outstanding in the country, with a total face value of more than $5 trillion.

 Sub-prime Lending                  This segment of the personal loan market was long relegated to help finance consumer purchases of household appliances and used cars.  Advances in mortgage securitization and the tidal wave of global liquidity cited above gave many of the world’s largest lenders (e.g. Citigroup, HSBC, Merrill Lynch, UBS and Wachovia) the courage to stray from core competency and to initiate or expand Sub-prime lending both in the automotive and the housing sectors: used cars, single family dwellings and condominiums.  The stage was set for what we now find has brought financial markets to a precipice of fear not seen since the Great Depression.  Balance sheet strength and integrity were sacrificed on the altar of short-term profitability.

Sub-prime Auto Lending         The basic rule governing Sub-prime auto lending in the used car market is both simple and startling: 25% of all borrowers in Sub-prime “C” and “D” credit risk categories (“A” and “B” being “Prime”) default on their loans in the first three to nine months of their contracts. 

To operate successfully in Sub-prime auto lending requires strong senior management leadership and daily enforcement of the disciplines of the business (laid out below)…lessons learned the hard way over years of activity.  It is a true “Vince Lombardi business” - one that requires relentless emphasis on the basics – “blocking and tackling” - over and over…hour by hour…day by day…24/7/365.

 

Lessons Learned

 

Origination

 

§         Sub-prime used car loans are auctioned daily by both franchise new car dealers and by stand alone, often “Mom and Pop,” used car dealers

§         Competition requires Sub-prime lenders to turn around these offers in 15-30 minutes

§         Must value (“underwrite” i.e. “purchase”) collateral at auto auction wholesale price levels with discount for repo costs

§         Purchase decision by most Sub-prime borrowers is based on what the individual can afford to spend and not on the vehicle of choice or its options

 

Underwriting

 

§         Vehicle statistics: manufacturer, model, year, mileage and body condition

 §         Borrower credit profile…not just his/her so-called Fico score…many “C” and “D” borrowers have bad credit histories or no prior credit record at all…some have no bank account

§         Borrower down-payment (should be 20% of purchase price to ensure borrower has “skin in the game”) and source of funds

§         Dealer profile including pay out history of prior loans purchased from that dealer

§         Dealer discount and “hold back” (to ensure dealer has “skin in the game”)

 

Collection 

§         Weekly, in cash (at a bullet-proof payment window) or electronically via Western Union , other third-party electronic payment service providers or via direct bank account debit

§         Must initiate aggressive action upon non-payment – next day!

§         Sophisticated software record keeping and tracking programs are vital

 

Repossession

 

§         Almost always an emotional (and sometimes dangerous) event

§         Best done via professional, state-licensed third-party service providers

§         Sell collateral immediately in local auto auction to repatriate capital

 

Balance Sheet

 

§         Keep debt-to-equity ratio below 25% to provide cushion if credit markets tighten

§         Leverage by arbitraging revolving bank line of credit with “junk bond” financing rates

Summary

 

Vehicle v. Residential   The single-most defining difference between Sub-prime vehicle and Sub-prime residential lending is the so-called “After Market” liquidity of the underlying collateral: i.e. How easy is it to sell/dispose of repossessed collateral – vehicles v. houses? 

Used car auctions occur every week day in all major metropolitan areas, and these auctions almost always offer deep liquidity as vehicles carry many commodity-like characteristics.  After Market liquidity for single-family homes and condominiums, however, is illiquid since the underlying collateral is much more fragmented, has a much higher price tag and carries many differentiating characteristics.                                                           

In addition, while consumer laws exist to protect driver-borrowers, home-owner borrowers have a much stronger hand in a foreclosure or repossession situation thanks to the “American Dream” discussed above.  Historically, the U.S. Congress has been much more receptive to the complaints of dispossessed homeowners than it has been to dispossessed drivers.

 

Finally, when operating in any market, it is important to remember the “Law of Supply and Demand” from Economics 101, the basic calculus that guides all investors, speculators and traders: “What’s bid for at what price, and what’s offered at what price?”