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Friday, November 23, 2007

Sub-Prime Mortgage problem sounds a lot like prior Sub-Prime Auto Finance problems from the 90s.


My buddy is a real estate investor. When I asked him the other day “how’s business”, I was very interested in his take on the situation. Like everyone else, I’ve heard all the bad news about the Sub-Prime mortgage industry. Freddie Mac down two billion for the quarter. Moody’s estimates 1.7 million homes will be lost to foreclosure in 07-08, double the prior two year total, and a conservative number to many. Citigroup CEO resigns after a ten billion dollar write down, Merrill Lynch loses eight billion, and it’s CEO.

What I didn’t know was exactly how this happened, or more importantly, when it would hit rock bottom. I figured my buddy could clue me in, and in doing so, I believe he hit the nail on the head. Several times during his analysis he used the term “Reset Rate”. I knew a reset was the point when a loan resets to a different interest rate, usually a higher one. What I didn’t know was that there was a mechanism in place to track this number. I guess I shouldn’t have been surprised, because I’ve learned during the start-up phase of Find John Doe that almost everything can be tracked.

His business, like mine, is directly tied to the Sub-Prime mortgage fall-out. When he told me the high water mark for resets will happen this March, when One Hundred and Ten Billion Dollars in mortgage paper will reset, he caught my attention. When he told me the high months in 2007 were September and December at fifty eight billion each, and when he further explained that the first six months of 2008 will reset at an amount that’s almost equal to what will have reset in all of 2007, I got my answer. We’re in big trouble, again.

I say again because while we were talking, I started to realize that this was sounding way too familiar. I’ve been in the auto finance industry since 1982, and in 1999, I was a small player in the clean up of the Sub-Prime auto financing carnage. Not many people outside our industry even knew of our woe’s back then, mainly because our troubles happened at the same time Internet 1.0 started to implode, and mostly because we’re talking about car loans, not home loans.

I’ll never forget when a client of mine explained Sub-Prime auto financing to me back in the mid 90s. At first, it didn’t sound much different than what some of the mouse-house finance companies you see in rural strip malls were already doing, charging highway robbery interest rates to try and cover their butts in case a large percentage of the deadbeats they put on the road couldn’t make their payments. My client further explained that due to the popularity of credit scoring and better credit reporting methods, there were more people that needed second-chance financing than all the mouse-houses could handle. Then he mentioned a word I’d never really heard associated with auto financing; Wall Street.

Back in those days, my wife and I owned a medium sized repossession business that paid the bills and kept us busy running a business that really needs a screenplay written about its idiosyncrasies to fully explain what goes on behind the scenes in one of America’s more interesting industries, but I digress.

When my client explained how Wall Street investors were looking to purchase large, securitized pools of auto loans, I asked him a simple question; who is going to find the people who skip, and who is going to repossess their cars? He smiled knowingly, and within a couple years my wife and I grew our business into the largest repossession company in the country. What happened was actually pretty straight forward. I quickly realized that these Wall Street investors needed to hire a servicing company to work all these loans they’d purchased, so I started looking around to see who these servicer’s were. Suprisingly, there weren’t many. When we located the one’s who were getting into this during the infancy of Sub-Prime servicing, we soon realized that the one’s servicing the loans were struggling with a process that many lenders have struggled with for years; skip-tracing and repossession.

I’d been hired by Chrysler Credit back in 1982 as a field rep, which was a corporate way of saying repo man. After five years at Chrysler and a year at Mitsubishi’s start up financial arm, I branched out into the private sector to manage two small Los Angeles repossession companies. My wife and I then started a skip tracing company in 1989, and after a few cocktails we named it after a film we’d just seen; Skipbusters. When the Sub-Prime wave began to hit around 1995, Skipbusters started to get really busy, especially after the delays in collection activity that should have taken place on these loans, but didn’t, because each loan had now changed hands from originator, to Wall Street investor, to servicer, in a relatively short period of time. Within a year we had contracted with a nationwide network of what we considered to be the ‘best of the best’ repossession companies in the country, and we were locating and they were popping hundreds of cars every day.

It was during this time that one of the largest servicers came to us with a problem. They were having trouble finding the best repossession companies to do their work on their “normal” repossession assignments. Anyone who has ever been associated with repossession knows the word “normal” is not in our vocabulary. Anyway, they wanted to know if we would manage their repossession process for them. We did some research and quickly determined that no one in the country was doing this type of work. Manheim Auctions had tried it a few years back, and when I called and discussed their experiences with the person who managed this process for them, they suggested I don’t attempt it as it “blew up in our faces”.

We then polled the repossession companies we were sending work to through Skipbusters, and everyone said they were up for more volume, so we formed a company called American Recovery Service. We started by managing the repossession process for many Wall Street investors, and then we branched into doing work for mainstream companies like VW credit, General Electric Capital, and other more traditional lenders. Within two years, our business doubled and then tripled, and we were handling a then industry record fifty thousand assignments for repossession a year. In March of 1999, after too many eighteen hour days and with two kids who didn’t know their parents well enough, we sold our companies to a large auto transport and towing company that expressed a desire to get into the repossession industry. We were the sixty-sixth and last acquisition this company did, but unfortunately, most of the promises they made were never kept.

In hindsight, the promises weren’t kept for three reasons. First off, our main customers, the Wall Street investors, were starting to really take some huge losses. Many were going out of business, and that started to affect our business right after we sold the company. Secondly, the Internet bubble was starting to burst, and that was carrying over into many industries, including ours. The third reason is one that I now see as the biggest reason back then, and the biggest reason now, given the current trouble the Sub-Prime mortgage industry faces. It’s a reason that is as old as time; Greed. When I started to see the house of cards the company who bought mine was built around, I resigned and left the auto finance industry after a twenty-year career.

As I now look back on those times, I can see how greed played an important role in the creation of the Sub-Prime auto industry mess. When my buddy was explaining the current woe’s of the Sub-Prime mortgage industry, I quickly connected the dots and realized that greed must have played a role in how we got into the current situation we are in. It was then I recalled seeing the cover of this week’s Fortune magazine sitting on my nightstand, an issue I’d yet to read. I remembered the cover saying “WHAT WERE THEY SMOKING?” and it showed the faces of four recent CEO’s who resigned their positions amidst the looming crisis. When I got home after talking to my buddy, I read the accompanying article. It went on to detail the billions in losses and write downs major corporations are now having to record when they try and assess the value of these high risk mortgage loans they still carry on their books, “and no one seems to have any idea what they’re worth”, the article goes on to say.

So, when my buddy told me “We’re waiting for the reset to hit the high water mark, and then we’ll see what the fall-out is”, I now realized exactly what he was on to. The problem is caused when the reset amount is more than the person can afford to pay, and it’s compounded when there is no equity in their home because the bottom has fallen out of the housing market. The equity they thought they would have in place to allow them to refinance their loan is not there, i.e. no one will make a $300K loan on a home now worth only $270K, especially when it appears $270K may be $250K in a few months.

The Sub-Prime mortgage problem was caused by a number of factors. For starters, lenders gave brokers too much flexibility in lending qualifications, making it difficult for the lenders to properly assess the risk of each loan. Not that anyone cared, because they all were riding the wave and making money hand over fist, but it was the first breakdown of the most common of all lending practices; qualification. The next factor was the poor structuring of loan products by investment banks. The popular adjustable rate loans in 2005 and 2006 looked great to the rookie investor jumping on the house flipping bandwagon, or even more sadly, to the first time homeowner who was sold a bill of goods they ultimately never could pay. These loans, which are now the one’s that are resetting at record rates and causing the largest impact in the current blood-bath, did not offer lenders or their customers many options when we saw a 200 basis point rise in mortgage interest rates and the sharp decline of new home sales and dropping sales prices. “If the home goes up just half the amount it’s gone up in the past two years, you’ll have more than enough equity to refinance it at a reasonable rate before your balloon is due”. Those are some famous last words many people heard as they signed up for a loan that would eventually become a foreclosure.

So when will it hit rock bottom? My buddy said they’re expecting the fall-out from the first four months of ’08 to hit hard in Q2 and Q3, “because it takes a while after the reset for the foreclosure process to run it’s course”, he said. I agreed, and then I started to wonder how this will carry over into other industries, especially the one I have now jumped back into after a six year absence, auto finance.

When you take a closer look at the number of these loans due to reset in 2008, and the scary similarities to the Sub-Prime Auto Loan problems we witnessed first hand back in 1999, I believe you will agree that the problem looks like it will get worse before it gets better, and statistics are starting to show this problem is starting to carry over into other financial sectors.

An article in the Columbus Dispatch titled “Car sales are the latest Sub Prime casualty” recently stated, ”Payments on 2.73 percent of auto loans made through car dealerships were at least 30 days past due in the first quarter of 2007, a 10-year high, the American Bankers Association said.
Called indirect loans, this type of financing accounted for about 75 percent of all car loans in 2006, said research firm J.D. Power and Associates.”

Tom Krisher wrote, in an article from this past Monday titled “Analysts worry that mortgage troubles could spread to auto loans ”Lehman Brothers analyst Brian Johnson said his analysis of auto loan-backed securities sold by Ford Motor Credit Co. and GMAC Financial Services showed some higher delinquency rates for October and September compared with recent years.”

Experience also tells me that the finance companies that go into 2008 prepared to handle the worst will come out of this much better than those who go in with blinders on, unprepared.

My suggestion to the finance companies is to find a way to recognize a problem before the problem finds you. Identify your high-risk accounts, especially those directly affected by the Sub-Prime mortgage fallout. Update your vendor lists, make sure you have the help in place to handle the storm when it hits, i.e. solid repossession companies and reputable skip tracing companies who have been tested through a champion v challenger program in the larger metropolitan and higher volume areas. Make sure you have a plan in place to see the signs of trouble, and work your early stage accounts harder than ever when those signs show a problem starting to happen. With the tools we now have available at our disposal, this process has never been more efficient, but if you don’t free up and devote your management and IT resources toward looking into the future, you may find yourself wishing you had done that a year from now.