Wednesday, Sep. 26, 2007, 08:00 PM UPDATED 11:59 AMBy Nick Zulovich
HOUSTON — About 30 days ago, 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 relating to this article, and several respondents offered additional insights, which I want to share with everyone.
If you have not seen the previously referenced article, you may download it free of charge at the National Alliance of Buy-Here, Pay-Here Dealers Web site at www.bhphinfo.com in the "News & Views" section.
My previous article mentioned that two of the lessons which should be learned are:
1. Poor underwriting decisions multiply into huge losses.
2. It takes time for the problems to surface, but someone ultimately pays a huge price for the mistakes.
The subprime mortgage losses and the financial pain that they create are expected to surface during the next 12 months. Analysts estimate that about 2 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's 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 deals rather than just the initial few months.
Losses are increased when principal payments are not made and the collateral depreciates in value. In the BHPH industry, profit and cash flow is generally maximized when customers pay and not when the collateral needs to be repossessed.
The lesson for both industries is that 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, in part, will occur because of unexpected declines in housing values from previous appraisals. Such declines were obviously not contemplated by the owners.
Government-subsidized refinancing will defer the foreclosures in order to give borrowers more time to pay and for property values to recover. In the BHPH industry, collateral values (used vehicles) always depreciate, and therefore principal amortization is needed to keep the lender's loan-to-collateral relationship from deteriorating.
Extensions on repayment and refinancing often don't 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 (and the 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. Salespeople (and mortgage brokers in the subprime real estate industry) who receive sales commissions can't be totally objective about the granting of 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 upon 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 BHPH industry knows the importance of keeping the vehicle running in order to keep customers paying. Often deferred down payments and repair note financings (side notes) are used to facilitate the purchase of the vehicle and to pay for repairs that arise during the term of the installment contract.
These additional or supplemental payments must be considered at the time of underwriting in evaluating whether the customer can really afford the vehicles 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 all will pay the price for the subprime mortgage meltdown. Therefore, it is hoped we will learn from these losses and not repeat them in the subprime auto industry.
More credit-impaired customers are expected to enter the BHPH market as a result of the subprime mortgage defaults, and BHPH operators are encouraged to take a more prudent long-term approach when underwriting these customers.
Ken Shilson, CPA, is a principal in Shilson, Goldberg, Cheung & Associates LLP and president of Subprime Analytics (), which performs electronic portfolio analysis. Shilson is also the founder of NABD, which will host an Underwriting & Collections Conference in Houston on Nov. 11 to 13. For registration to the conference or for more information, visit , or call (713) 290-8171.