The Used-Car, Bad-Loan Road To Riches: Or Ruin

By the time Doyle resurfaced a week later, Mercury Finance had already been forced to admit that its profits were less than half what it had reported - $ 56.7 million.

It said Doyle had disappeared. Doyles re-appearance came when his lawyer revealed that he was cooperating with federal law enforcement officials. He denounced the charade at Mercury Finance.

This incident proved to be the trigger for a sweeping loss of confidence in the entire sub-prime sector.

Share prices of the main players fell by up to 30 per cent, several suffered downgradings of their credit from rating agencies, and there were huge sales of their bonds on the capital markets.

 

A period of swift growth has, at least temporarily, been halted.

It is difficult to track the size of the industry, as there are almost 100,000 car retailers in the US, but Scott Willkomm, a director of Prudential Securities in New York, estimates the total value of sub-prime car loans outstanding at between $50 billion and $75 billion.

About 25 sub-prime lenders have floated on the market in the last two years. All of them are now under much closer scrutiny. According to Willkomm: There were opportunistic types who saw a lot of money being made. They say fools rush in, and thats clearly what happened. Its not dissimilar to what happened in savings and loans in the late 1980s. Mercurys difficulties created such attention because it had led the move into sub-prime credit in the late 1980s, and had spawned many imitators.

The sub-prime industry really grew because a lot of companies saw how much money Mercury was making, said Richard Schmidt, who covers the sector for rating agency Standard & Poors. They jumped on the bandwagon.

Wall Street was prepared to offer them cheap money by buying bonds backed by the companys loans. This was a key factor in the sectors growth as the alternative - borrowing from banks at venture capital rates - would have been prohibitively expensive.

The capital markets were attracted to the fledgling sector because of its apparent immunity to economic recession.

You could arguably say that the sub-prime borrower is in permanent recession, said Schmidt. Its almost like they are under water already so the waves dont hurt them too much. Willkomm cautioned, however, that Wall Street may have taken this argument too far.

Their incomes are not necessarily particularly low. What distinguishes the sector instead is the previous aversion that its customers have shown to repaying debts. Their key defining characteristic is a bad credit history - generally a personal bankruptcy or a repossession in their past.

This means that the skills required to survive in the sector are different from any other consumer credit industry.

Its not just a question of lending money to a formula, said Schmidt. Its a whole mind-set. Companies which can repossess their assets swiftly, reliably and cheaply will perform best.

He added: You dont send out a friendly reminder after 20 days. You send a monthly invoice, and back it with a phone call. And you have to be willing to take back the collateral much quicker. Mercury Finances story has continued to unfold over the last two weeks.

Once its shares re-opened on the New York stock exchange, they dropped $13, or 87 per cent, to $1 7 /8 on huge volume, lopping more than $2.2 billion off its market value. This week brought news of a class action lawsuit brought by shareholders alleging that corporate insiders sold 545,000 shares of Mercury Finance common stock at artificially inflated prices and reaped proceeds in excess of $6.7 million.

The suit further alleged that Mercury Finance chief executive John Brincat, who has already agreed to stand aside in favour of William Brandt, an external expert in corporate recoveries, was paid millions of dollars in cash bonuses that were tied directly to the companys falsely reported earnings.

Several potential buyers are known to be eyeing the company, and commercial banks, in particular, now seem to see an opportunity to buy into the sector when prices are favourable.

The day after Mercury announced that its profits had been overstated, Jayhawk Acceptance, a Dallas-based sub-prime lender, announced that it was taking a $15.5 million charge on last years accounts because it was unable to recover advances it had made to certain lenders.

Last week Jayhawk filed for bankruptcy protection after the bankers who held the companys revolving credit agreement declared the company to be in default. Again, there is speculation that some investors may be willing to take the company on.

Both Mercury and Jayhawk were looking to expand away from used cars, and in recent months had briefed Wall Street on their intention to move into financing the costs of plastic surgery.

Analysts seemed sceptical.

What happens if someone defaults? asked one.

They repossess someones nose?