Originally, there was a segment of subprime auto financing that was a fairly low-risk for dealers extending credit to their customers. If the downpayment is equal to what the dealer paid for a car, then risk management is much simpler and underwriting skill doesn’t matter much. The dealer could lend money to even the riskiest customers. Dealers could break even on the initial sale and hope to profit from the financing of the car.

Eventually, dealers who lent money to their customers (“buy here pay here”) learned how much money they could expect to lose on a subprime loan. They also got better at servicing their loans and improving recoveries. This allowed them to loan more aggressively and to offer lower downpayments. Since then, lenders have learned more about identifying good and bad credit risks, as well as getting better at servicing. This has allowed lenders to lend more aggressively.

Underwriting concepts

Reliability

One of the key insights is that the reliability of the vehicle is an important factor in credit risk. If a car needs major repairs, the borrower may be unable to make his or her monthly payment and will become delinquent on the loan. By selling more reliable vehicles, a dealer can afford to get more aggressive on the financing. Nowadays, lenders will look at the age, odometer reading, type (car/van/truck/etc.), and make/model of a vehicle to try to predict its reliability. Some lenders such as CACC will use third-party data providers such as AutoCheck and CarFax to look for reported defects for the car during auctions, possible tampering of the odometer, etc.

Affordability

Lenders look at the monthly payments of a loan versus the borrower’s income. The borrower’s income can be adjusted for rent and/or mortgage payments.

Employment stability

Lenders typically try to predict whether or not the borrower will lose his/her job based on things such as the length of employment and gaps in employment history. For first-time buyers, CPSS requires a minimum of 1 year on the job (link).

Loan compliance

Some borrowers will try to overstate their income and/or length of employment so that they obtain cheaper financing. The F&I manager at a dealership may encourage the applicant to do this so that they are more likely to obtain financing, increasing the chances of the purchase closing and the F&I manager receiving a commission. If the dealership does not have “skin in the game”, they may encourage their F&I managers to do this to drive more sales.

Lenders have to protect themselves from this type of behaviour by verifying that the information on the loan documentation is correct. In general, lenders have to protect themselves from dealers, dealership employees, and borrowers from gaming the lender’s underwriting process.

Credit history

A bad credit rating, no credit, number of bankruptcies, number of repossessions, etc. are all indicators of the borrowers’ likelihood of repaying the loan.

Term of the loan

A longer loan provides more time for the borrower to lose his/her job, for the car to break down, etc. etc. As time passes, older vehicles become less valuable due to advances in technology. The value of the vehicle also drops as it is driven.

Number of cars owned

If a buyer only has access to a single car, he/she may be more likely to avoid defaulting on the loan to avoid having his/her only vehicle taken away. CPSS for example prefers that the borrower has only one open loan. See their guidelines (PDF link) as the guidelines provide a huge amount of insight into their underwriting. The other benefit of only one open loan is that one loan is more affordable than two.

On the other hand, some lenders will not accept a loan if a trade-in car was used to pay the downpayment.

Gouging the customer

A BHPH (buy here pay here) dealer can gouge the customer by inflating the interest or the principal of the loan. If the customer does not understand their credit rating and the financing options available to him/her, a F&I manager can take advantage of the situation by charging the customer a higher interest rate.

The principal of the loan can be inflated in various ways. The dealer can simply have a display price for the vehicle well above the cost the dealer paid to buy the vehicle. This will not work for all dealerships as the inflated pricing will turn off certain types of buyers. The dealer can upsell the customer on service contracts (extended warranty), GAP insurance, etc. etc.

For BHPH dealers and companies like Credit Acceptance to underwrite profitably, the reward has to exceed the risk. They are incentivized to make borrowers pay principal and interest well above the wholesale cost of the car. With most specialty finance companies however, this behaviour is not desirable. Many specialty finance companies want to see that the loan is well collateralized.

Servicing concepts

Locating borrowers who move

Normally, repo guys can find a car by staking out the borrower’s residence or place of work. They will wait for the car to be momentarily unattended and then use that opportunity to repossess the car. The normal tactics do not work if the borrower moves. Debt collectors have to employ skip tracing techniques to find the debtor and/or the car.

At the origination stage, many borrowers will insist that the borrower provide at least 5 references. Later on, if the loan servicer needs to find the car to repossess it, they may contact the references to try to get information on where the borrower is.

Vehicle remarketing

Doing minor repair and clean-up work to a car can significantly improve its value at an auction.

Chequing accounts

Setting up the customer to automatically send payments from his/her chequing account may reduce delinquency.

Simply knowing the customer’s banking information helps the servicer if the car is repossessed. If the proceeds from the repo do not cover the loan balance, the servicer can sue the borrower and take money out of his/her bank account. The issues with this approach is that attorneys cost money and that the borrower may not have much money in his/her bank account. Nonetheless, CACC’s underwriting suggests that this is an effective tool. Customers are rated three points higher on their CAPS system if the customer has a chequing account (see car buying tips for Credit Acceptance).

Garnishing wages

This is another tool in the debt collector’s toolbox. Collectors have to determine the cost-benefit of this method as attorneys are not cheap. This technique does not work if the debtor changes jobs.

Other ways of improving servicing

Predictive dialers (Wikipedia explains them) can be used to reduce the amount of time debt collectors spend waiting for customers to pick up. This technology generally require at least several collectors to work. Many BHPH operations may have only one or two collectors calling borrowers and do not have the scale to use a predictive dialer.

Many delinquent borrowers do not pick up their phone if they are being bombarded with calls. Call centers may call from different telephone numbers (including unknown/unlisted numbers) to try to get in contact with the borrower if the borrower is intentionally not answering calls from the servicer’s normal number. The call center may also have IT systems in place to record the time of day for successful and unsuccessful calls, promised made and kept or broken by the customer, etc. etc.

The skill of a collector matters. Effective techniques may be boiled down into a script for other collectors to follow. Collectors can be monitored for performance, whether or not they follow the script, etc. etc. An effective collector will be better at convincing the borrower to stay current on the loan, to voluntarily turn their car in to avoid repossession fees, etc. etc.

Lending models

Buy here pay here

The dealer itself finances loans to borrowers who cannot obtain financing through normal means. This model can be challenging if the BHPH dealer has poor underwriting. The BHPH dealer has to focus on making loans with good risk/reward. It has to be good at gouging customers while simultaneously maintaining good underwriting standards and being reasonably good at collections. These dealerships generally do well by efficiently attracting subprime buyers and deploying a sales team that can effectively close purchases.

Specialty finance

The tension in this model is that dealers are continually trying to find the best financing. Because of this, there is an element of adverse selection at work. The dealers will go with the lender with the lowest pricing for a given borrower’s situation. They generally pick off the lenders who are making underwriting errors. To protect themselves against this, the specialty lenders have to reject the majority of loans offered to them to avoid situations where they may get picked off. Specialty lenders need to be extremely cautious in dealing with BHPH dealers. The BHPH dealers will keep good loans for themselves while gaming the lenders’ loan approval process and finding weaknesses in their underwriting.

I am guessing that specialty financing companies do best with dealerships that do not have the scale, willingness, or expertise to start a BHPH operation. All car dealerships will generally attract some level of potential subprime buyers as their satisfied customers will recommend the dealership to friends and family. Specialty financing allows these dealerships to make subprime sales without the hassles of learning how to originate and service subprime loans. They also do not have to put their capital at risk.

Specialty financing with fixed fees



Credit Acceptance charges high fixed fees to dealers on its program. The fixed fees incentivize the dealer to generate a large number of loans through Credit Acceptance. This reduces (but doesn’t eliminate) the effect of adverse selection from the dealer shopping around for the best financing. This system is arguably more efficient as the dealers spend less time trying to pick off lenders and lenders spend less effort protecting themselves against adverse selection. It also allows Credit Acceptance to offer financing across a much broader range of situations. This benefits the dealer as it allows them to generate sales that they otherwise would not be able to make.

The downside to this model is that the dealership must make a huge commitment to the lender. They have to pay the fixed fees, learn the system, and have enough of the right inventory. Credit Acceptance has to employ a large number of MAMs (market area managers) to attract new clients and to help existing clients succeed on the program.

Dealer financing

Some subprime auto lenders also have programs to provide financing to dealers to help them grow their business. Credit Acceptance for example will buy loan portfolios from successful dealers who have a history of originating good loans. It is essentially a form of expensive financing. This line of business can be risky because the dealers no longer have “skin in the game”. With less incentive to originate good loans, they may lower origination standards and try to underwrite as many loans as possible. The buyer of such loans can potentially suffer unusual losses. To avoid this, Credit Acceptance is very careful about what loans it buys and charges a high price to give itself a margin of safety.

Stick to prime financing

Many banks, auto manufacturers, and credit unions have realized that subprime lending isn’t worth the effort or risk and that they should stick to their core businesses. Subprime financing is simply very challenging.

Niches

The competitive landscape has changed to the point where car dealerships will specialize in specific niches. Some dealers on Credit Acceptance’s program will specifically advertise that they offer financing for customers with a bankruptcy on record, no credit, poor credit, etc. This plays to Credit Acceptance’s strength of offering financing across a very wide range of risky situations.

Car-Mart, a publicly-traded chain of BHPH lots, advertises downpayments as low as $99. Most specialty financing companies will require much higher downpayments compared to BHPH lots. The extremely low downpayments can work as long as the BHPH lot only offers low downpayments to customers with reasonably good credit, solid employment records and low risk of moving. Low downpayment offers basically target customers who manage their finances poorly and spend all of their savings, as opposed to people who have intentionally chosen not to pay their bills in the past.

Industry cycles

The industry is cyclical because there are few barriers to entry. When credit markets are loose, there is a tendency for companies to enter the market with loose origination standards. BHPH dealers may (unintentionally) take advantage of these startups by selling bad loans to the financing company and keeping good loans for themselves. Loose lending is generally detrimental to all subprime lenders as it forces lenders to lose market share if they do not lower their underwriting standards. Returns on invested capital depend on the competitive environment.

In my opinion, investors need to consider the cyclicality of the industry. High returns on assets may simply be a product of a favorable competitive environment. High returns are not sustainable unless they are backed by very efficient operations that keep costs down or some type of difficult-to-replicate value creation (e.g. software, training, etc.). I also think that investors should focus on returns on capital rather than returns on equity. Investors should not pay any premium for leverage.

Efficiencies and innovations in subprime lending (figuring out that the reliability of a car matters, computers, etc.) rarely translate into increased profits. Competitors generally copy new tactics. Ultimately, competition drives down pricing and thus eliminates increased margins from innovations in subprime lending. Unusual returns on capital are due to the operators running these businesses. I do not think that there are any moats in this industry.

*Disclosure: Long CACC.

Links

CACC Part 1: A wonderful business buying back its shares

CACC Part 3: Why Credit Acceptance is brilliant

CPSS guidelines – This document covers Consumer Portfolio Solution’s lending policies and provides a lot of insight into their underwriting.