Hammer Time: The Bad Credit Blues

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Tax returns have been filed. Refunds have been sent to those of us fortunate to get one. Those few lucky consumers at my lot with that government issued check in hand have already bought their next ride.

It’s a quiet workplace  at the lot right now. I have all of 15 vehicles, and the majority of those were either trade-ins or repos.

That’s the good news. Now time for the bad news.

A long-time car dealer met me at the auction the other day and told me this…

“Steve, one of my employees was wanting to get an ’05 Impala from me. Well, her credit wasn’t good at all and I didn’t know if I’m gonna keep her for the long haul. So wouldn’t ya know? She headed off to the Dodge dealership and got herself a three year old Charger with 22.8% interest, and all the fees in the world on a seven year note. They’re fixin’ to make 15 grand on that deal.”

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The fifteen grand isn’t the real killer on that deal though. Dumb people make dumb decisions all the time.  It’s not even the term of the note since seven year notes have become as common as kudzu here in the world that is sub-prime financing.

The killer is the financing company that did the deal. This company was able to steal a deal that would have been nearly untouchable a year ago. A seven year note on a late model vehicle with a customer that fielded a 560 credit score and a high debt balance.

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This is the type of deal in our business that usually required you to self-finance the vehicle. Not anymore. Auto lenders are barreling deep into sub-prime territory and that’s huge for our industry.

A car that is five years newer than that ’05 Impala is now able to compete head-on with it in the used car market for the same customer and the same monthly payment.

This is good news for those of us who buy the older used car for cash and keep it until it croaks. As time goes on, the price of older used cars should come down. We may finally find ourselves with a good daily driver at a reasonable purchase price.  Instead of having to pay a price premium that comes from independent car dealers trying to finance these exact same older vehicles to their customers.

The debtors who actually buy a newer vehicle won’t have it so easy. The term for their ride will likely migrate away from the shorter three year notes, to barnacle-keeping seven year agreements.

 

The risk that goes along with a long-term deal for that indebted customer is far higher than what most of you would expect.

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That bad credit customer will usually go to a dealership that finances their own vehicles. As a guy who does this for a living, I can tell you that making sure the car can ‘make the note’ is critically important to my bottom line.

I get parts for about 40% off what the public is charged and my mechanics typically make $15 to $20 an hour. What that means is that I can afford to perform the required maintenance on a vehicle in advance of it being due, and my cost for doing this usually comes to less than a single monthly payment.

In a three year period most car owners will experience perhaps one major maintenance experience (which I will already cover), and various times where routine maintenance will be required. The independent shop down the road from me will perform oil changes for all my customers for $20 and if there is a minor issue at hand, I can often have them catch it before it becomes a major issue.

In the last five years I have never lost a deal to a blown engine, a bad transmission, or any other mechanical issue.

As someone who finances cars for a shorter length of time, I also have far less default risk when it comes to my customers. Most folks will keep their jobs on average for 4.6 years according to the Department of Labor Statistics. So you may wind up with one, maybe two job changes on average.

A substantial number of my customers will keep the same employer over those three years. So my net risk of a default due to employment issues and overall vehicle condition isn’t that high.

Take that same customer I currently finance and keep them for a seven year period with a company that will sell that note to a Wall Street firm. Now the risk changes quite a bit.

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The majority of Americans will leave their job at some point in the ownership experience. As for the car, chances are that the major maintenance needs have already not been performed on a three year old car when that customer is given the keys.

Will that customer remember to actually do it? Will they be able to afford to pay what it takes to get that work done?

These may seem like silly questions to those of you here who are the ‘keepers’ of their cars. However a fairly large number of folks simply get in their car, fill it with gas, and go. They don’t pay attention to the maintenance needs of their vehicles until something expensive takes place and if that something can be deferred, they will likely keep riding the car out until their money situation is healthy enough to handle it.

That’s the issue. Keepers are into preservation and low maintenance costs, which is why they keep up with their cars. The traders and perpetual debtors among us see maintenance as a thing to avoid.

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If you would like a personal taste of this, go to the nearest public auction and feel free to count all the vehicles that had their major issues recently serviced. Or visit an independent mechanic shop and ask them what percentage of their customers go past the recommended intervals for major maintenance.

I am willing to bet that the number will be north of 50%, and the ones who do follow the maintenance regimen are far more likely to be long-term owners of their vehicles.

The risk of the finance company that wrote the note won’t be that much for one simple reason.

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They will sell the note as part of an asset backed security to another company, which will then likely sell it to a Wall Street firm, who will then find an investment fund that is willing to buy high risk asset-backed securities.

The risk will be exported. It’s too bad that the vehicle will likely have a shorter and harder life in the process. When it comes to maintenance, most customers with bad credit simply don’t economize for it. If something goes bad on that vehicle, the only one that will have a stake in a successful repair of that vehicle will be an ‘institution’ that will be thousands of miles away, and will likely have tens of thousands of vehicles in their portfolio.

Picture Courtesy of Capital One Auto Finance - An Issuer Of SubPrime Financing To New Car Dealers

Picture Courtesy of Capital One Auto Finance – An Issuer Of SubPrime Financing To New Car Dealers

There is a lesson to be learned here.  If the guy who is financing the eight year old car for three years could make more money by financing the three year old car for seven years, he would have already done it.

The fact that nobody in this business did this with high risk customers until now, means two things.

1) Either late model cars just experienced a quantum leap in improvement when it comes to overall quality.

2) Or the industry will likely have a little bit more of this type of financing until something bad happens.

By then, you will have broke customer with a broken down asset that is worth a small fraction of the remaining balance.

Does this sound familiar?