Last month, I wrote an article about some of the lessons buy here, pay here operators should learn from the recent subprime mortgage meltdown. I received numerous comments about this article and several respondents offered additional insights, which I want to share with everyone. If you have not read my previous article, you can download it free of charge at the NABD Website, www.bhphinfo.com in the “News & Views” section.
My previous article centered on two of the lessons that buy here, pay here dealers should learn from the subprime mortgage market: Poor underwriting decisions multiply into huge losses, and it takes time for the problems to surface, but ultimately, someone always pays a huge price for the mistakes.
The subprime mortgage losses and the financial pain that they create are expected to increase during the next twelve months. Analysts estimate that approximately two million adjustable rate mortgages are scheduled to reset during the next year, starting in October. The recent Federal Reserve interest and discount rate cuts are an obvious attempt to soften the blow and to reduce mounting foreclosures. Unfortunately, these cuts don’t solve the default problems and many more foreclosures are expected. The government also plans to provide relief by refinancing some of these subprime loans before they default via subsidized loan programs, in order to avoid massive foreclosures.
What is clear is that underwriting mistakes caused the problems and as these adjustable rate mortgages reset the new repayments will, in many cases, exceed the financial means of the customers. This problem highlights the need for better underwriting with structures designed so customers will pay over the entire life of the deal rather than just the initial few months.
Losses increase when principal payments are not made and the collateral depreciates. In the buy here, pay here industry, profit and cash flow are generally maximized when customers pay, not when the collateral is repossessed. The lesson is improperly structured deals cause losses, even when the underlying collateral is good and the customer actually wants to repay the loan.
Losses in the subprime mortgage market are due to unexpected declines in housing values. The owners and the banks that gave them the mortgages did not contemplate such declines. Government subsidized refinancing will help defer the foreclosures in order to give borrowers more time to pay and for property values to recover. In the buy here, pay here industry, however, collateral values (used vehicles) always decline and therefore principal amortization is needed to keep the lender’s loan-to-collateral relationship from deteriorating. Extensions on repayments and refinancing often fail to cure customer repayment problems because during the deferral period, the collateral may deteriorate faster than payments are received. In these circumstances, the loan-to-collateral relationships (i.e. losses) are increased and the customer may default anyway!
I mentioned in my previous article that good underwriting requires the gathering and independent verification of credit information. Sales people (and mortgage brokers in the subprime real estate industry) who receive sales commissions can’t be totally objective about granting credit to a customer. Therefore, some separation between sales, credit approval, and verification is recommended. Failure to independently verify customer information is dangerous, not only because underwriting decisions may be based on inaccurate or incomplete customer information, but also because it increases the likelihood of fraud. Not verifying credit information is like a walk in quicksand. You get in too deep before you realize it, and then struggle to get out!
Everyone in the buy here, pay here industry knows the importance of keeping the vehicle running in order to keep customers paying. Often deferred down payments and repair note financings are used to facilitate the purchase of the vehicle and to pay for repairs, which arise during the term of the installment contract. These additional or supplemental payments must be considered at the time of underwriting to evaluate whether the customer can really afford the vehicle they are purchasing. Just as higher adjustable rate payments should have been considered for subprime mortgage customers, failure to provide for sufficient financial flexibility also causes defaults!
In the months ahead, we will all pay the price for the subprime mortgage meltdown! In order to avoid the same situation in the subprime auto industry, we all have to learn from these losses, so we don’t repeat them. More credit-impaired customers are expected to enter the buy here, pay here market as a result of subprime mortgage defaults, and buy here, pay here operators need to take a more prudent long term approach when underwriting these customers.
Kenneth B. Shilson, CPA, is a principal in Shilson, Goldberg, Cheung & Associates, LLP and president of Subprime Analytics (www.subanalytics.com), which performs electronic portfolio analysis. Mr. Shilson is also the founder of NABD, which will host an Underwriting & Collections Conference in Houston, Texas, from November 11–13, 2007. For registration to the conference or for more information, visit www.bhphinfo.com or call 713-290-8171.