And So It Begins – The Subprime Realignment

canstockphoto0491353So, GO Financial and now, Dealer Funding has taken the brave steps to stop competing in what has been a very hot, and many say overly competitive, subprime automobile market for the past  five years.  You may be able to add Westlake Financial’s captive Western Funding to the list, where a major shake up at the senior management level of Western Funding recently has left that company without a President or CFO.

The sentiment on the street is fairly consistent, private equity groups own the vast majority of subprime finance companies competing in the market today, and they have lost their appetite for more of the same. With yield compression, performance issues, and securitization becoming an expensive form of financing, is this a business the PE groups want to be in?

The elephant in the room remains their exit strategy or lack of one.  By now, the PE groups realize they have invested in an industry that has little or arguably no franchise value. For most, the value remains the mark to market value of their loan portfolio. Unlike a chain of tire stores or group of fast food restaurants, for example, which have a franchise value and can be resold in the open marketplace, subprime auto is different, even if you’re as large as Flagship Credit, with a portfolio somewhere north of $3 billion in assets, and have a great management team. Finding the right or willing buyer can be extremely difficult, if not impossible, at this stage of the business cycle.

Part of the issue is the misconception by the finance company executives that PE groups are in the subprime lending business. Let’s be clear: PE groups are in the PE business. Their job is to deploy investors’ capital wherever they realize the highest risk-adjusted returns. When margins disappear, so too does the PE desire to lend to, own or participate in that industry segment. It’s really that simple.

There is a bright side: subprime companies are to be applauded for the advancements they have made during this economic cycle, particularly in the technology area. Subprime companies are better at processing information, data, understanding  and pricing risk than ever before.  All of this is great news — the shortcoming, however, has been on the capital markets side of the industry. The industry cannot rely solely on securitization for funding growth. We have seen this model fail before for essentially the same reasons.

Where does that leave us? Unless subprime finance companies can find alternative financing sources, this cycle will repeat itself every seven to nine years.  Let’s face it: unless you’re a bank or a public company, lending money is a difficult business.

Maybe in the next cycle we will see new and alternative sources of financing. Maybe a tech company like Prosper will subsidize if not replace securitization as the predominate financing source for subprime automobile financing. Just maybe.

Bobby Lazenby is the CEO of Lazenby & Associates, a risk management consultancy.

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