As Inventor of Subprime Car Loans Exits, Critics Smell a Lemon
As Inventor of Subprime Car Loans Exits, Critics Smell a Lemon
When Don Foss was inducted into his industry’s hall of fame in 2015, he was adamant he wasn’t retiring. Addressing a Las Vegas audience of easy-credit used-car dealers who lauded him for creating the subprime auto-loan business, he said, “I’m just getting embarked.”
Last summer, however, the 72-year-old billionaire sold Carite Corp., a chain of used-car dealerships that he founded in 2011. In January he stepped down as chairman of Credit Acceptance Corp., the company he began in one thousand nine hundred seventy two that pioneered extending auto loans to customers with rock-bottom credit scores or none at all. A month after he left, he sold a big chunk of his Credit Acceptance shares for $128 million.
The company didn’t say why Foss sold his shares and declined to comment. Foss didn’t react to requests for comment. But his exit coincides with rough times for subprime auto lenders in general and Credit Acceptance in particular. Brief sellers — investors who bet that a security will fall in price — have become intrigued by the idea that a bubble is forming in subprime auto lending. Bearish bets on Credit Acceptance have risen to about forty eight percent of the shares tradeable by public investors, making it the third-most-shorted stock on the Russell one thousand Index of large and midsize companies.
The subprime auto industry’s reputation has been under attack for decades. Consumer advocates say it takes advantage of consumers who have nowhere else to turn, often charging interest rates higher than twenty percent.
Credit Acceptance notes in its filings that it is frequently the subject of consumer lawsuits and regulatory investigations over its loan-making and collection practices. Claims of predatory practices have dogged the industry for many years. Credit Acceptance typically counters that it abides by the terms of the contracts signed by its customers. In February, it disclosed that the Federal Trade Commission was investigating its use of devices that disable vehicles remotely when payments are missed. It said it was cooperating with the inquiry.
Investors looked past all that. Credit Acceptance’s share price more than doubled over the past five years. But now some number crunchers see signs of trouble in its shifting business model. After profiting handsomely from a strategy that emphasized sharing loan risk with dealers, Credit Acceptance is lending more on its own, enlargening its exposure to defaults.
“The shift is unhealthy,” says Ben Weinger, portfolio manager of hedge fund 3-Sigma Value LP, which has bet against Credit Acceptance shares. “The entire genius of this company is the risk-sharing program. That is what makes Credit Acceptance unique.”
Sharing Risk
Foss introduced the risk-sharing system, which the company calls the portfolio program, in the late 1980s. The son of a used-car salesman, Foss opened his very first lot in 1967. He appealed to customers in Detroit with cheesy TV commercials promising effortless credit. Later he founded Credit Acceptance to treat financing and collections for his growing network of dealerships, and then expanded to working with other dealers.
In the portfolio program, when a cash-strapped customer wants to buy a car, Credit Acceptance will advance the dealer about forty percent of the total value of the loan. That is typically enough to cover the cost of the car to the dealer plus a petite profit. Once that part has been repaid, Credit Acceptance shares any remaining payments with the dealer. The company is shielded from much of the credit risk, because its advance is secured by the car. It can repossess the vehicle while pursuing the defaulting customer in court.
“It was a growth juggernaut,” recalls Richard Beckman, who was Credit Acceptance president in the 1990s and remembers Foss as a hard-nosed businessman. Foss has a $1.Trio billion fortune, according to the Bloomberg Billionaires Index. He’s still the largest shareholder in Credit Acceptance with a $700 million stake.
Shifting Model
The program’s success attracted competitors, making it firmer for Credit Acceptance to draw dealers to its program. So, three years after Foss stepped down as chief executive officer in 2002, the company added another program in an attempt to maintain loan volume. Under the so-called purchase program, Credit Acceptance began to buy some loans outright. The dealers got more money upfront while Credit Acceptance kept all the payments. Since then, the purchase program has constituted about ten percent of the loans the company has issued, on average.
But that ratio soared last year, with the purchase program making up twenty one percent of fresh loans in 2016. The number of purchase loans underwritten enlargened eighty eight percent even as the risk-sharing portfolio program dipped 0.Two percent. A quarter of its $Four.Five billion loan book now comprises loans it possesses outright, up from sixteen percent at the end of 2015.
Detractors contend this shift means Credit Acceptance is more vulnerable to the woes of an industry fighting with a combination of declining used-car values, which make it tighter to recoup losses by repossessing vehicles, and higher delinquencies. This year, Wells Fargo & Co. and JPMorgan Pursue & Co. have backed away from making fresh subprime auto loans themselves, tightening standards and reducing loan volume. Still, big banks have continued packaging loans that finance companies then securitize and sell to investors.
Brief Sellers
Credit Acceptance expects to collect sixty five percent of the value of loans it has made so far this year, according to its filings, which is lower than its recovery rates over the last two decades but still better than the rates reported by its peers. That decline is contributing to the brief sellers’ argument that the Southfield, Michigan-based company’s share price is too high.
Credit Acceptance has a higher market value relative to a measure of its net assets than its largest rivals — five times that of Ally Financial Inc. and four times that of Santander Consumer USA Holdings Inc. Steve Eisman, made famous in Michael Lewis’s book “The Big Brief” for his bet on the mortgage crash, said in March that he was worried about the U.S. subprime-auto market.
Some supporters of the company say that Credit Acceptance is merely being targeted by investors looking for a way to get on that bandwagon and that the company’s practice in subprime lending will enable it to rail out any downturn and benefit as competitors exit.
“Right now there’s a big brief interest, as everyone wants to play this theme of the auto lender bubble, but Credit Acceptance is the absolute wrong vehicle for this,” says Randy Heck, a general playmate at Goodnow Investment Group LLC, who has possessed shares in Credit Acceptance for nineteen years.
Credit Acceptance has said in filings that the switch in its product mix is largely a result of enlargened competition. It says that even the higher-risk purchase loans have been profitable ever since they were very first suggested in 2005. Still, the company concedes that the switch isn’t welcome. “We recognize that if collections fall brief of our forecast, the influence on profitability will be much greater with purchase loans than with portfolio loans,” CEO Brett Roberts wrote in his letter to shareholders last month.
Complicating matters is Credit Acceptance’s broad disclosures on the condition of its portfolio, which doesn’t include some specifics on defaults and delinquencies. That makes it difficult for analysts and investors to dig into the underlying spectacle of its loan book. “The accounting we go after is the required accounting,” Chief Financial Officer Ken Booth said on a November earnings call when asked about the company’s disclosure practices.
Lost Influence
Through it all, Foss’s influence has waned. Last summer, Credit Acceptance compelled him to sell Carite, a dealership chain that leases cars to customers with powerless credit, to avoid potential conflicts of interest, Credit Acceptance filings showcase. An 18-page shareholder agreement accompanying his January retirement from the chairmanship noted that for the next ten years, Foss had agreed to vote his Credit Acceptance shares in accordance with the board.
The arrangement places Foss in an unacquainted role, unclothing him of influence over his creation just as it faces fresh risks, while depriving him of the dealership business that was supposed to be his next act. People in the industry don’t see him taking a back seat just yet. Ken Shilson, president and founder of the National Alliance of Buy Here, Pay Here Dealers, says “My sense is he’s got a lot of miles left on his tires.”
— With assistance by Neil Weinberg, Matt Scully, and Anders Melin