Gary K. Judis, CEO of Los Angeles lender Aames Financial Corp., lives in a $3 million home in Beverly Hills and in 1994 took home an annual salary and bonus of $1.2 million. The approximately 6,000 customers who financed their homes through Judis' company have rather different balance sheets. Their credit ratings range from slightly flawed to plain awful [B, C, and D in lender's shorthand]. Most have missed at least one mortgage payment and are often also loaded down with car loans and credit-card debt.
Judis' lofty lifestyle attests to the fact that catering to so-called sub-prime or impaired credit risks can produce super-prime profits. In the year ending June 30, Aames's revenue jumped 52%, to $55 million. The company racked up a gross profit margin of 30%.
Lending to potential deadbeats was once regarded as barely a cut above loan sharking. Now many well-heeled finance companies are targeting this market. "The commercial banks have always sort of thumbed their nose and ignored the sub-prime borrower," says John Heffern, a NatWest Securities Corp. analyst. "That left a tremendous opportunity for smaller finance companies." Says Judis: "What we do has achieved a kind of legitimacy we just didn't have before." The stocks of some of the major players are sizzling. So far this year, Aames, the Money Store, and United Companies Financial are up on average an astonishing 236%.
10% SOLUTION. A variety of trends are driving the growth of the impaired credit business: the recent recession, corporate downsizing, and America's undying love affair with credit. But the alluring profitability derives from the ability of lenders to levy high fees and interest that more than compensate for the risks. In 1994, the annual interest rate on the typical Aames loan was 11.8%, several percentage points higher than the rate for "A" quality loans. Borrowers also have to shell out between 9% and 10% of the total loan value in up-front fees, compared to a recent average of 1.8% for an untainted bank borrower.
Fat profits are now luring traditional mortgage lenders into the sub-prime business. Countrywide Credit Industries, the nation's largest independent mortgage banker, began buying up B and C quality loans from mortgage originators in mid-August. Last September, Florida's Barnett Banks jumped into the fray by acquiring EquiCredit Corp., a sub-prime lender, for $332 million in cash.
Sub-prime auto lenders have also been targeted. In March, KeyCorp said it would pay $305 million for the AutoFinance Group Inc. and is now seeking to break into the highly fragmented, $65 billion-a-year, sub-par home equity lending market. More banks will follow, predicts A. Jay Meyerson, head of KeyCorp consumer lending.
"TIME TO WORRY." Some observers, however, are concerned that these lenders could be in for trouble when the next recession hits. David Olson, a market researcher in Columbia, Md., worries that inflation, which in the past has bailed out many of the riskiest loans, may not do the job next time around. "Whenever there's this much growth and euphoria, it's time to worry," Olson says. Adds Calvin Wong, director of Standard & Poor's Corp.'s asset-backed unit: "We're seeing companies liberalizing their criteria, increasing advance rates, and generally taking on more risk."
Already there is evidence of trouble. In March, Search Capital Group, a sub-prime auto lender in Dallas that went public in December, 1993, was delisted by NASDAQ after losing $26 million in 1994. According to Robert Idzi, the company's new chief financial officer, Search Capital erred by using $90 million raised in 1993 debt and equity offerings to make "a riskier category of loan" for as much as 125% of a car's value.
Judis believes Aames has its risks under control. For one thing, he says, the company lends only 55% of a home's value to risky borrowers. And although Aames's foreclosure rate rose steadily for four years, it plunged in the first nine months of the 1995 fiscal year ended June 30 to under 2%, a drop of more than half from 1994 levels.
Nor is Judis concerned about the prospect of new competitors or of new federal disclosure rules that take effect in October. Some experts fear these rules could raise costs for sub-prime lenders. Responds Judis: "As long as you have a credit system, you'll have people who abuse it." Lucky for him.