Experience D’Orth By Bill Orth
SUBPRIME LENDING & CATCH 22
I was reading yet another article about the subprime lending mess recently and found myself thinking: “I used to do that!” But in a more responsible manner, and with cars, not houses. When I was in high school, my father, who had retired from the car business, wanted to teach me about it…from the ground up. Just to have something to do, he had invested in a couple of used car lots of the Buy Here/Pay Here variety, and used them to show me how this industry operated at its most elemental level. In the South, such businesses are commonly called ACR lots—for ACcounts Receivable. In Colorado, the term was always Pot Lots, as the elderly cars sold at them were called, for some reason, pots. Buy Here/Pay Here, however, was common everywhere else and defined the business. Inexpensive cars & trucks were inventoried and sold to folks who were unable to pay cash or to qualify for conventional lending. A BH/PH operator did his own credit evaluations and did not act as an agent for a bank or loan company; instead, he was the loan company.
Some might say he preyed on the more vulnerable elements of society. Another view is that the BH/PH industry made it possible for individuals and families who live & work a bit outside of mainstream society to get independent transportation. Folks who may not have full credentials, or much of a financial track record, or who generally have menial jobs and a somewhat impermanent lifestyle have a Catch 22 problem: They can’t earn money without a job, and without a car, they can’t get to a job. Conventional lenders turn away unconventional borrowers, so an unconventional lending methodology was developed.
Typically, older trade-ins were purchased from new car dealers or wholesale auctions. These would be shined up, tuned up and offered up…at $10.00 per week. At a time when new cars sold for $2500, a still-reasonably-solid ten year-old one could be bought for just a few hundred. The usual format was that the buyer had to save up a down payment that would just about cover the dealer’s initial investment in the car and his weekly payments would constitute the profit…if they continued. If they did, the now-paid-off car would be accepted as the down payment on another one a bit newer and nicer and the process repeated, possibly at $12.00 or $15.00 weekly. In the 1950s &’60s, most laborers were paid weekly, and in cash. This cash was stretched, $3.00, $5.00 and $10.00 at a time to cover rent, other necessities and a car. A ledger was kept at the car lot and each payment recorded when it came in, usually on Friday. A missed payment triggered a… learning process.
In those simpler times, it was easy to retain a set of keys for each car financed. The borrower’s residence and employment were checked carefully before credit was extended and if the obligation was missed, the next day an agent picked up the car and held it until the account was current. Remember the Catch 22? A belief in many of the rougher segments of society is that any sign of mercy or compassion is an indication of weakness. Those having difficulty covering all the bases naturally try to find out who will allow some leeway…and then often exploit it. Therefore, it is important when you have money out on the street to establish right away that some other creditor must be the charitable one. Such probing is to be expected, and when it is immediately reined in, rarely does it reoccur and business proceeds agreeably. In the ACR business, it is assumed that 10% of your loans will go bad no matter how aggressive your collection activities. These delinquent borrowers usually never intended to make the payments and managed to slip through the screening process forearmed with nefarious experience, bogus information and guile. Obviously, this is a cash-intensive business and the operator must be very careful to maintain his capital, so this can’t happen too often.
My father would vigilantly watch the books at the two places he funded and if losses began to trend much past 10% a management change was soon called for, as obviously, greater diligence in looking at applicants and a more accurate “gut” was needed. The loan was a judgment call based on verifying the employment and residence information that was provided plus the manager’s experience with other borrowers from that locale and job site.
After thus seeding my preparation, my father put up the money for a light green 1955 Ford Tudor V8 that needed a clutch. He had been tutoring me for years on how to maintain cars, so that wasn’t a hard job for a sixteen year-old to manage. He impressed upon me that it was critical that ACR cars be made as reliable as reason allowed, because of that Catch 22 again. If it quit running, the borrower would simply quit paying. The clutch, some Bondo work on the rocker panels and a rattle-can touch-up produced my first retail sale. $100 down and an agreement of $10.00 per week for twenty-six weeks. That became the seed money for the 1953 Plymouth Cambridge sedan that badly needed seat covers and brakes…and soon I was collecting $10.00 a week walking-around money, without flipping burgers! But I was crawling under old Plymouths after school, getting filthy installing brakes and putting $9.00 Sears covers over skunky old seats.
Naturally, the number of weeks contracted for was a measure of the expected profit margin and the anticipated likelihood of getting it, with a cushion built in to cover the aforementioned 10% that would vaporize. Speaking of percentages, the effective rate was pretty high, but reflected the high level of risk. Naturally, real estate loans are at softer percentages because the collateral is pretty difficult to drive out of state! Such borrowers tend to be very loyal, however, and one sale nearly always led to another, plus the referrals that were given to new additions to the buyer’s work crew. As time went by, I usually had three or four of these cars bringing in revenue, but, of course, that also required ongoing supervision and repairs. It was an interesting business that kept me busy through high school and it taught me many more valuable lessons than typical teenage jobs do, but as my senior year wound down, one by one I sent my clients on to other ACR lots.
So, how does all that relate to the home loan scandal? The principal common denominator is giving borrowers who do not meet traditional lending guidelines a way to acquire a necessary asset. But to do so, these automobile borrowers had to demonstrate solid, adequate income to cover the new debt along with their other obligations. Our current lending meltdown was largely precipitated by teasing normally responsible folks into contracting for homes well beyond their means. In addition to starry-eyed optimism about steady appreciation and salary raises, this concept required multiple layers of collusion, from kited appraisals, over-eager realtors (no capital ‘R’) and mortgage brokers earning commissions based on loan size. It was in everyone’s interest to get people to sign up for as large a loan as possible, and once Mr. & Mrs. Borrower were on their own, it was their problem to make the payments, since no recourse haunted these agents—only the eventual lending institution was in jeopardy. Speaking of lending institutions, therein lies another layer of culpability, since the mortgage originators approved applications with only the most cursory of inquiries or income verification. These shaky loans were then bundled into large packages salted with a few really attractive blue-chip million-dollar mortgages and sold to institutional investors.
Therefore, the difference is that carefully investigated, vigilantly monitored subprime loans, at a manageable amount for the borrower, have demonstrated a 90% success rate for fifty years. In contrast, a large segment of our national mortgage industry in their downtown glass towers didn’t follow the same common-sense lending guidelines that my mentors on dusty one-acre lots ringed with strings of bare light bulbs applied to their menial clientele. Whether the payment is $10.00 per week or $2500 per month, if the borrower can’t raise it reliably, they simply quit paying, and that big, secure, immobile collateral now becomes a problem because the lender can’t simply go out and pick it up! So, which is the more immoral to “subprime” borrowers? To set up loans that are carefully placed within their ability to pay, albeit at high interest and heavy oversight, or to place thousands of families in homes with loans so flimsy that far more than 10% will fall into foreclosure?
-- Bill Orth –