Commentary: Hard Answers For The Crisis In Easy Credit

In the past few weeks, Wall Street has been reeling from the sudden and seemingly unexpected collapse in the subprime auto lending industry. Onetime investor darlings like Mercury Finance Co. and Jayhawk Acceptance Corp., which cater to people with lousy credit histories, have shocked the Street with news of accounting irregularities and bankruptcy filings, while other erstwhile high-flyers have reported rising loan losses. Stock prices in the sector have fallen sharply, and some lenders may be looking at huge losses.

Who's to blame? Most obvious is Wall Street itself. By uncritically feeding the subprime sector with vast amounts of capital through securitizations and some 30 recent initial public offerings, investment banks contributed to a speculative bubble that was bound to burst. Yet despite abundant signs of overheated competition in an industry already fraught with risk, hardly anybody sounded a warning until the damage was done.

But don't just blame Wall Street. The auto-lending fiasco also points out the need to take a hard look at accounting standards that leave glaring loopholes. And stricter financial disclosure guidelines are needed to avoid misleading investors.

GUESSWORK. Let's start with accounting. Many subprime auto lenders rely on the magic of securitization: Lend millions of dollars, then find a friendly investment bank to package up the loans and sell them. After a securitization, the company books an instant paper profit, based on a complex formula that takes into account such variables as estimated loan losses and the discounted value of future cash flows. In essence, these companies post earnings based on little more than an educated guess about how much cash will flow in over three or four years. Even companies like Mercury that don't securitize make similar guesses.

Trouble is, in such a volatile and risky industry, the guesswork is much more art than science. Whenever accounting standards leave that much room for interpretation, you can be sure somebody will be overoptimistic--or unscrupulous. When loan defaults soared, the only way for many companies to show continued profit growth was to originate ever more loans. This led to a vicious cycle in which loan companies cut prices and approved ever-riskier clients, leading to more defaults and a need for ever-faster growth.

For a subprime example, just look at Aegis Consumer Funding Group Inc., based in Jersey City, N.J. Using securitization, Aegis has tripled its size in each of the last two years, and now has more than $645 million in loans outstanding. Net profits were up eightfold in the year ended June 30, 1996, to $9.3 million. By tying bonuses to pretax profits, executives raked in some fat paychecks: The top five managers got an eye-popping $4.6 million in salary and bonus last year. Yet the profits were only on paper. Aegis loaned to a bunch of dud customers, repossessions and losses soared, and the company was unable to make a $4.2 million note payment due last October. Now, according to its Sept. 30 financial filings, it may have to "materially curtail operations" unless it gets additional capital soon. Aegis executives declined comment.

The Financial Accounting Standards Board has tweaked its rules on this type of accounting. But it's time for a sweeping look. "This way of doing it doesn't make any sense," says Howard Schilit, an accounting consultant. "If the money is coming in 1999, the company has no business booking revenue in 1996. It's a recipe for all kinds of abuses." At a minimum, the Securities & Exchange Commission and the Big Six accounting firms should more closely scrutine assumptions underlying financial statements.

Another problem has been inconsistent reporting standards. Many subprime companies have been able to mask problems by reporting delinquency and loan loss rates as a percentage of overall loans. When a company is growing quickly, those rates inevitably appear misleadingly small at best. A far better method is the so-called "static pool" analysis, which discloses delinquency and loss rates for loans originated in a particular month or quarter. That would allow much easier comparison between companies--and spotlight problems much sooner.

Subprime loans aren't inherently bad. They allow people on society's fringes or those who have hit a financially rocky patch to drive a car or foot other bills. But it's time to shed a bright light on the sector to make sure investors don't become roadkill.

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