Why subprime auto lenders fail
Over the years, many of my articles have dealt with debunking journalist’s hit-jobs on the subprime auto finance industry. Auto loans have performed within a very reliable range across more than 25 years of credit cycles. The management teams of the largest lenders are both seasoned and rational, and actual cases of fraud destroying a portfolio are limited to a handful of cases. The auto finance industry, particularly in subprime, has proven to be very robust across decades of market volatility.
In spite of that, there are some during every credit cycle who manage to blow up their portfolios. This creates disruption in the capital markets, and casts everyone in the same light. In addition, these events fuel a never-ending stream of articles from the financial press predicting the next subprime meltdown. Subprime auto lenders do occasionally fail, and when this happens the primary culprits tend to be:
• Inexperienced Founders
• Unscalable Operations
• Weak Leadership
Douglas Adams, author of The Hitchhiker’s Guide to the Galaxy, once said, “Human beings, who are almost unique in having the ability to learn from the experience of others, are also remarkable for their apparent disinclination to do so.” I have seen many intelligent people come into auto finance who were very successful in their own right outside of this industry. Unfortunately, they tend to believe that their brilliance in a previous endeavor naturally extends to auto lending, which is frequently not the case. Experience comes from getting burned by mistakes so that you do not repeat them.
There are three general categories of experience that failing founders lack. The first is knowledge of the industry and the dynamics of the specific credit niche they intend to operate in. Auto lending is a very cash intensive business, and for subprime it requires leverage in order for the economics to make sense. Leverage means relying on debt providers who have very strict requirements regarding credit performance. When you fund loans, it takes at least six to nine months to detect performance issues. For the inexperienced founder, they will be lulled into a false sense of security during that period which blinds them to managing volume with proper controls. By the time they realize they are in trouble, they have lost their funding facilities.
The second category relates to a lack of experience with buying operations. There are several people I know who took on CEO roles at startup auto finance companies. These people had experience with large lenders, but lacked the knowledge that comes with owning responsibility for buying operations — which was a contributing factor to the demise of their companies. Some of these people had experience with data and metrics, but were not versed in the games customers, dealers or even your own underwriters can play if their incentives are based on volume. There are very stark differences, for example, between traditional subprime lending with a mix of majority franchise dealers and the lending done with deep subprime independent dealers. The former will produce between a six and ten percent annualized net loss rate on non-recourse contracts, while the latter will kick off between fifteen and twenty-five percent annualized net losses with contracts that have two months of recourse (assuming in both cases the operations have rigid discipline around execution of their credit and funding policy). If you apply the credit program of a traditional subprime lender to a deep one, particularly without discipline, you might as well set all of your capital on fire as it will be gone in less than a year.
The third category relates to a lack of experience with operations at scale. While I am a big fan of data and analytics, I know many fine lenders who do very well with smaller operations that do not employ sophisticated models. Leaders of these organizations have success by sticking to a well-executed strategy, with a limited number of dealers in a tight geographical region. Some of these lenders produce five to seven percent annualized net losses while similar paper at larger lenders produces ten to twelve percent. These smaller lenders run into severe challenges when they try to scale their operations doing things the same way they have always done them. When they enter new markets and ramp up the number of dealers they work with, the quality deteriorates significantly. An interesting fact is that almost all of those lenders think the buying practices of larger subprime lenders are absolutely crazy. The reason for this is that the larger companies have economies of scale, meaning their operating expense and cost of funds are hundreds of basis points lower due to efficiencies. This allows them to be more competitive on price, and modestly less restrictive on credit while still achieving strong returns. I have worked with many smaller lenders attempting to grow, and it is extraordinarily difficult to get them to adapt their operations to best practices as they are relying on their success at a smaller scale.
The issue of unscalable operations is, in fact, an extension of the first problem as experienced founders will understand the components necessary to build the organization at each phase. The primary hindrance to scale and efficiency is caused by judgmental underwriting. Do not misunderstand me, experienced buyers are critical to a lender in the early stages, but as the organization grows the variation in credit decisions becomes increasingly difficult to control.
Many lenders start out with a resident credit expert, whether that be one of the founders or an experienced operations leader brought in from the outside. The credit policy is typically well thought out, and based on prior best practices. As new buyers are brought in, they each have a slightly different view of what a good and bad deal looks like – typically based on rules from their prior employer. This leads to wild variation in execution and credit performance.
Years ago, I was consulting with a lender on automating their underwriting process. Such an exercise must be done in a measured manner, with input from experienced buyers to make sure there are not blind spots in either the policy or the models that are used to automate. This lender had an extensive list of rules that determined which one of eight tiers the applicant would fall into. When we finally completed coding the rules engine, the lead credit manager was furious that there were so many differences between the tier the buyer put the applicant in and what we had coded. We sat down with the team and went through each application that differed. At the end of that process, they realized we coded their credit policy precisely as they relayed it; however, their buyers were not following it. They did not track exceptions and had no idea how far away they were from their stated policy. By the way, the stated policy is what the warehouse lender is relying on when they provide the debt facility. The results are often terminal when they learn the lender is not executing on it. As it turned out, the senior managers saw the automation process as a threat to their control and ability to use their expert judgment on every deal, and so convinced management to abandon the project. Unfortunately, they are no longer in business, which is often the fate of lenders who refuse to instill controls and efficiency as they grow.
I believe in the insights of experienced buyers. Even when I managed risk and automation at a multi-billion dollar lender, we would have buying experts review samples of deals on a monthly basis in order to identify areas for testing and improvement. Analytic risk teams will often tell underwriters to just trust the data, which is fine if the data contains every risk you need to mitigate. You can’t control what you are not measuring. As such, collaborating with underwriters often leads to the discovery of new attributes which improve the models and credit performance. Experienced buyers are important, but their role changes as the organization scales.
Prior to my auto finance career, I was sitting among many managers in a team meeting where our new vice president was introduced. In the course of this meeting, one of the general managers got up and complained that he could not meet the company objectives because the people on his team were so useless. Apparently, this manager was also not self-aware. The new VP simply looked at him and said, “the fish rots at the head.” I had never heard this phrase before, but it comes from a fifteenth century Turkish proverb stating that the fish begins to rot from the head down. If you have problems within an organization, they start with leadership.
Successful managers learn things as they take on increasing levels of responsibility over a long period of time. An analyst is only responsible for their own work. New supervisors or assistant vice presidents often struggle because they went from being the best as an individual contributor to having to coach the success of analysts who are not as good as they were in the same role. When a supervisor gets promoted to a vice president or similar senior manager role, they become the coach of the coach which requires a new skillset. Senior vice presidents and executive team members become the ones who must transform corporate strategic goals into action plans with their subordinate managers. There are important learnings to be mastered at each stage, which if skipped or moved through too quickly produce weak leaders.
I have observed numerous examples of leaders who have never been in a chief executive role in their prior experience, or even had a significant number of direct reports. This does not mean that they cannot be successful, but they often do not have the learnings one obtains from a proper progression of taking on increasing levels of responsibility. Oftentimes, these leaders become fearful that they will be exposed to the capital partner and eventually be replaced. They construct barriers between their teams and the board, setting themselves up as a single point of failure. When problems arise, which they do for good and bad leaders alike, the fearful executive will fail to be forthcoming with the board. At some point, this leads to a performance surprise for the investors, board and capital partners.
Weaker leaders get themselves into trouble by letting the inmates run the asylum, and failing to act early enough to effect needed change. In contrast, the strong executive will not only be brutally honest early on with the board on risks and misses to the business plan, but they will develop and communicate a strategy on how they will deal with those challenges and how the board can measure that progress. In addition, the strong executive will enforce appropriate swim lanes among subordinate managers and ensure the adoption of proper controls. Many of you may be aware of Patrick Lencioni’s book The Five Dysfunctions of a Team, but may not know of his other book, The Five Temptations of a CEO. The latter is very quick reading, and does an excellent job highlighting factors that lead to weak leadership. I highly recommend it for anyone taking on a new leadership role.
Avoiding the Time Bomb
I grew up hearing many sermons on Sunday mornings. Whenever the pastor gave a particularly pointed message, half the congregation thought he was speaking directly to them while the other half was sure he was speaking about everyone else. As it relates to this article, the themes presented serve merely to point out that we may learn from other’s mistakes and thus avoid our own portfolio crises.
For founders entering the auto lending industry from the outside, it is important to know how wrong spreadsheet forecasts can be. The data you may be using as a proxy likely contains significant bias and does not encompass the risk of loans that were not funded, but were filtered out by buyers who knew what they were doing. It is wise to bring in an experienced front-end operations manager that has worked for a large lender. Go to conferences, and spend time with executive peers. Ask questions about potential blind spots and subject yourself to external reviews from recognized industry leaders.
For the smaller lender seeking to grow, speed and consistency are key. With a $50 million portfolio, you can afford to have buyers look at every application. When you pass $100 million, you will burn operating expense with the same process. Subprime lenders approve 35 out of 100 applications on average, and only tend to book around 5 deals out of that group (deeper subprime lenders with smaller portfolios may close more). There are costs associated with every application, the largest of which is headcount. Models may easily help you eliminate deals so that you do not have to double your payroll as you double your volume. Furthermore, adding judgmental buyers and new dealers will decrease the quality of execution and increase losses. Properly integrated into a solid credit program, analytic tools can limit the variability and help the lender deliver reliable credit results that preserve funding capacity.
For the inexperienced senior executive, I only offer the wisdom found in Proverbs 16:18, “Pride goes before destruction, and a haughty spirit before a fall.” One of my favorite anecdotes related to this comes from Arnold Schwarzenegger. When he first arrived in the United States to compete in bodybuilding, he had a massive upper body and bird legs. He would wear big, bulky sweatshirts to the gym, and expose his legs with tiny gym shorts. When asked about this he said if he exposed his upper body, people would compliment him all the time and he would get a false sense of accomplishment. He exposed his weak points so he would be motivated to fix them, and ultimately win. Find industry mentors and coaches who can identify the weak points and help develop them. I am speaking specifically about seeking regular guidance from people who have succeeded as senior executives in consumer finance. Additionally, surround yourself with strong leaders who can support decisive action and implement controls. Those people are not a threat, but a foundation to succeeding at the top and avoiding a blow up.