Profit on subprime is just too juicy to resist.
We called them ‘note lots.’ People with terrible credit could go buy an old beater there. Ideally, it worked like this: you walked in with $500 cash. The dealer showed you a ‘cream puff’ he’d bought for $500. You didn’t like the car, but you’d been turned down everywhere. The dealer made you a ‘great deal’ for $2,000. He’d already recoup his cost. Everything else was profit. You signed a note for $1,500 with 21% APR and drove off with the car.
Three months later, the brakes shot craps. You had them fixed, thereby using up the money for your monthly payment. Five days after the payment was due, the dealer called and asked for it in cash, to be handed to him. You promised. On day seven, he sent the repo man. He’d sell the same car to the next guy under the same conditions. Even if he couldn’t recover the car, he was still ahead. Because there is one ancient truth in the car business: you can make the most money on people with bad credit.
The opportunity was just too good. Soon, reputable new-car dealers got involved, calling it ‘special financing’ before the word ‘subprime’ was born, and some of them got into trouble over it, but what the heck [for the inside scoop, read my book, TESTOSTERONE PIT, an edgy, raunchy, and funny novel about car salesmen, their customers, managers, and the shenanigans at a large Ford dealership; it’s so cheap it’s almost free].
Over the years, the process moved up-market, became more sophisticated. Now deadbeats can even buy new cars, and the biggest banks are involved, and everyone is happy: manufactures because it moves the iron; dealers because they’re making a ton; and lenders, oh my!
The interest is juicy, if not usurious. They get to package these loans into asset-backed securities and sell them to mutual funds in your portfolio, and everyone is extracting money along the way. Finance companies pop up to focus on auto subprime because banks can be a little squeamish when it comes to the dirty underbelly of the business. However, banks have no problem lending to these finance companies to fund their subprime loans, and the money flows, and it all adds to retail sales, manufacturing, industrial production, a million other closely watched metrics, and GDP. And everyone is happy.
Well, not everyone.
This post was published at Wolf Street on October 13, 2014.