Interview Transcript

Disclaimer: This interview is for informational purposes only and should not be relied upon as a basis for investment decisions. In Practise is an independent publisher and all opinions expressed by guests are solely their own opinions and do not reflect the opinion of In Practise.

Can we just walk through the mechanics of a sub-prime loan, originated for Credit Acceptance?

Typically, on a sub-prime loan, there are a couple of components. Traditionally, on that type of loan, the dealer has to have a little bit of a higher mark up than they would on a traditional prime customer. That is because there are going to be some holdback fees from the lender. For example, if I’m a dealership and I own a car for $10,000, traditionally, I might retail that car for $3,000 over my costs. The problem I run into, if I’m a dealer, is that if that’s a sub-prime loan – call it a Credit Acceptance customer – more than likely, the holdback from the loan, the discount, is going to be $3,000 or more. That means I have no profitability there.

I have to build enough margin so that, when I do my markup, I sell the car and Credit Acceptance discounts that loan. In other words, they give me a check less than what the amount financed is, but there is enough markup there so I can still make profit. They have to have a big enough markup on the loan.

A traditional loan might look like this. If there is $10,000 on finance, if I have a $5,000 markup on that loan, I’m retailing that car for $15,000 and I get $1,000. Now I’m financing $14,000 plus taxes, tag, license and so on. Call it roughly $1,500 in taxes, fees and everything else. I’m financing $15,500 out the door. Credit Acceptance is going to discount that and submit a check to the dealer for roughly $12,500.

Are they realistic numbers or should we use some recent numbers? I think the loan value that Credit Acceptance recently has are elevated, because of the used car prices. It’s up to $25,000 and a $10,000, nearly $11,000, advance.

When you are looking at their loan value, that’s total of payments. That is not going to be an amount financed. How much did you say the advance was?

For 2020, the advance was $10,500.

Generally, that represents about 40% to 45% of the total payments, which is that $25,000 number you are referring to. It’s $625 a month, times 60 months. Or $500 a month times 60 months will give you $30,000 total of payments. In that scenario, you are probably still going to have about $15,000 amount financed. The difference between the amount financed and the total of payments is the unearned interest that they are factoring in to the total asset.

For example, just for argument’s sake, let’s take 2020. The consumer loan was $24262, advance was $10656, 59 loan term. That works out, if you take the $24262 loan divided by 59, you get the rough monthly payment.

That’s probably going to be somewhere in the ballpark of around $15,000 amount financed, assuming a 22% interest rate; maybe a little higher than $15,000, the total of payments, the total contract value. The car value itself might be $11,000 but I have to sell the car for, say, $16,000. I take a $2,000 down payment and I’m adding tax, tag and license to the sale price. Out the door, amount financed is approximately $15,000. The $15,000 is the loan amount and it has nothing to do with the value of the car. The value of the car is going to be based on the book. If the consumer were to strike a check today, to pay off that loan, that’s how much they would have to pay.

From the dealer’s perspective, if I’m a selling a car for $15,000, $16,000, and I purchased it at the wholesale value of $10,000, $11,000, $12,000 and I’m earning that 30% gross margin, what do the economics look like for the dealer on day one, using Credit Acceptance?

Generally speaking, the economics, on day one, is going to be around $1,500 to $2,000, in profit. In the averages you are using, $10,656, that is the check that the dealer receives; that is the proceeds they get. They also retain the customer’s down payment. If the down payment is approximately $3,000, the dealer has the total cash in of $13,656.

Is it usually that high? What is the average down payment, as a percentage of the car value?

Around 15%.

If the car is $20,000, it’s roughly $3,000.

Yes; between cash and trade equity, of course. Sometimes, there can be smaller down payments but, with a structure like Credit Acceptance, the smaller the down payment, the more profit the dealer sacrifices. Obviously, the fees are going to be there for Credit Acceptance and they are still going to have their significant holdback. The advance isn’t going to change much. If anything, the advance tends to go down a little bit, percentage wise, as the down payment drops, because it’s based on the risk model. The larger the down payment, the lower the loan to value, the higher the advance rate, generally speaking.

If I’m a dealer on day one, effectively, in terms of my cash flow, I’ve paid out the wholesale price and the recon and fees for the car; I’ve got it on my lot. Let’s just say that’s $12,000, in cash flow, I’ve paid out for the car. You are saying that the cash flow in is the advance rate that Credit Acceptance gives, which is $10,656, plus a down payment?

Correct.

Let’s just say that $10,656 plus $2,500, you are at $13,156, so they’re earning $1,156 on day one?

Correct. That is how they would work. The number one complaint from a dealer is, they feel as if they can’t make the profits they want to make because the holdbacks are so high, from the amount financed versus the advance. Unfortunately, that’s just the necessary cost of doing business in the sub-prime market.

In this example, if I just work through the collections, the monthly payment, on a 59-month term, is $411. Take out the 20% service until Credit Acceptance receives their fees and advance back. If we assume the customer gets to 38, 39 months, the holdback is $4,200. It’s 30% of the original cash flow that they dealer receives.

If they were to pay 100% of the payments back, the dealer would be entitled to $19,409. They've already received $10,656 so that will be $7,800 potential for the dealer, but realistically that's not what they get back. The current collection rate is 65%, so $19,409 times 65% equals what number?

65% of the collection equates to 38 months?

There are also some additional fees built into that. There's a collection fee but also a $599 monthly servicing fee for the portfolio, no matter how many loans they have. Every month the dealer's advance balance will increase by $599 unless they have got rid of that. It goes to the whole portfolio but it's insignificant and amounts to a couple of hundred dollars per loan, over the course of time. Dealers know those numbers don't add up because they average $1,200 to $1,500 in total additional monies received down the line. I know dealers aren't receiving $4,000 on back-end portfolio money, based on feedback I've got from them over the past couple of years. Something doesn't add up with those numbers. We have to do $24,262 times 65%, then take 80% of that, so what does that equal? $12,600?

Why would that be so low? Either the collections are not high enough or the fees are too high?

Correct; if they collect 100%, which they rarely do. They collect 65%, so the real number you're working with is 65% of $24,262, and then you take 80% of that.

80% of that is the $12,616.

$12,616, so if you subtract $12,616 from $10,656, you're at $1,950, then there are other fees such as repo fees, collection letters and the $599 monthly portfolio servicing fee. If 35% of those loans don't pay to fruition, some will be repossessions and others will be legal situations, and those are applied to the portfolio balance because dealers get charged for that. There is $200 to $300 on average per loan in collection fees because the good offsets the bad. If expenses are incurred on a repossession, that gets applied to the advance balance which has to be paid back by the loans which aren't performing.

What are the simple economics of a unit loan?

I used to tell dealers to make whatever they can up front, which is $1,500 to $2,000 up front gross on average. They can make an additional $1,500 in down the line money which is the portfolio money. All in, the economics are $3,500; $2,000 front and $1,500 back. Dealers don't do business unless they've been with CACC for a long time. The back-end is a bonus but they don't realize that benefit until three to five years down the line because the advances have to get paid down. Once they do, they become believers and start feeding the bank, so to speak. They put more loans into the portfolio but most dealers look at how much money they can make today because they are in business and need to be profitable today. Dealers are making a fair up front profit today and some money down the line on deals that have been down the road for several years. You can call it mail box money for the dealership.

The total loan value in this case is $24,262 times the collection rate of 65%, which gets you roughly the cash you will collect which is $15,770. 80% of that holdback gets to the $12,616 because Credit Acceptance receive their advance back first, plus some collection fees, so the cash collected less the advance gives you net right?

Yes, which they call portfolio profit. When I was there, the 80% wasn't a true 80%. It was shown as 80% but after collection fees and the $599 monthly servicing fee, it's closer to 77% to the dealer. That is if the portfolio performs well but some portfolios perform at 60%, and that 5% difference eats into the majority of the dealer's profitability, then they are left with no portfolio money at the end. If their portfolio performs well, they make more money. It all comes out in the wash as average but from a dealer perspective, that's where the coaching comes in to help the dealer maintain his rating with Credit Acceptance.

What is the biggest mistake dealers typically make with their portfolio?

They jam everybody they can because they will all get an approval. They game the system by showing a bigger down payment and jack up the price even more, to yield the same amount financed. For example, if I show $2,000 down and I'm financing $15,000, I could show $4,000 down and still finance $15,000. I simply change the sales price, which tricks the system into thinking I have 25% down instead of 15%, which changes the risk of the deal. Dealers can sometimes drive up their advance that way.

The other way is putting loans on the books with cars with collateral which are bad quality vehicles with some mechanical issues. They haven't had it properly serviced, inspected or reconditioned, then put several bad cars on the road which break down. The number one reason why customers default with Credit Acceptance is not because they don't want to pay their bills, it's because the cars break down at some point. They are already in a sub-prime category and one more bad credit item will not kill them; they simply cannot afford to pay for that car and buy another one when it breaks, because repairs are substantial.

What is the impact when dealers game the system?

The performance goes down significantly and the loan will default sooner. They have a formula which says what we expect the loan to do, but because of the big down payment, instead of it being 65% collection expectation, we think it will be a 68% expectation. If that loan defaults earlier than expected, it impacts the portfolio. Credit Acceptance will make adjustments on future deals for that dealer and their credit rating will slip. The dealer will be advanced less money on deals until their actual performance returns to normal. That is how Credit Acceptance hedges their bets against that type of scenario. If the dealer stops doing business, the portfolio can fall off a cliff. If the dealer continues to add loans to the books and has built a 2% to 5% buffer, they can make up some losses on the back-end and it can level off.

What was the most common way you saw dealers gaming the system?

Inflating the sale price and fluffing the down payment. They get a higher advance and make higher profit today. The other way was simply not properly reconditioning the cars. They put on a bad quality collateral from the get go, and then they will sell a warranty, but when the customer makes a claim, it's determined to be a preexisting condition and the repair isn't covered, so that customer defaults. Dealers are short sighted because they look at how they can make the most profit today, versus the long-term viability of their portfolio.

If a dealer bought the car for $12,000 wholesale and wants to maximize their sale price at $17,000, they get a higher advance percentage of the end loan from Credit Acceptance and take their margin up front, even when the car is worth less?

Yes, that's the main way they game the system, but CACC protects themselves by auditing the loans after they're on the books. They do spot checks and if they catch a dealer doing that, which they often do, they will sanction the dealer with a fine per deal or other consequence for doing that.

How do you persuade them not to do that?

They are not simply using us as a lender; this is a partnership. There is money down the line to be made if they purchase the right quality inventory. If they recondition and set up the customer for success – meaning they clearly communicate their payments terms and all the details of the loan and do a proper delivery – the performance and profitability will take care of itself. If they do bad things, they will hurt their profitability down the line in terms of the portfolio money. Good dealers care about being in business for a long time and Credit Acceptance is not a small fly by night lender. They have been around and are not going anywhere. If they want to do business with one of the top lenders in the country, we can help them make lots of money over time, but they have to take care of us like we take care of them.

When in the cycle is it most common for dealers to game?

The current environment is one which is very likely to be a scenario. Used car values are extremely high and Credit Acceptance and other lenders have not increased their advances in line with the book. If the car books for $13,000, I may have to pay $14,000 or $15,000 for it at the auction because of supply and demand issues. Now I have to figure out a way to maintain my margins and I will do anything I can.

Another scenario is times of economic downturn, where inflation or a recession hits and consumers tend to either have less money down or the dealer could be in financial trouble. If 45 of the 50 cars on their lot are floor planned, they will absorb huge fees and get into trouble, and will do whatever they can to unload that inventory which is costing them more money every day. When a dealer is in a financial pinch, they tend to do things they wouldn't do in a normal situation.

Another scenario could be if I submitted 10 loans to Credit Acceptance or another bank and get paid on those loans, I have to provide titles to those banks for those vehicles, so many dealers do what is called floating. They will float that money and pay off another debt, so when it comes time to do the title work at the end of the month, they have to pay $400,000 for titles but used that money elsewhere.

How much room for error is there in Credit Acceptance's collections estimates?

2% difference on your collection rate, 65% to 63%, can make a huge impact on both theirs and the dealer's numbers, so there's not a lot of room for error. Credit Acceptance are good at taking historical consumer data to figure out what their risk and pricing models look like and correctly predicting how much they will collect on a loan. They will build a buffer in there to cut that down by 1% or 2% so their expectation is 63%. When they collect 65% it outperforms expectations. They are under promising and over delivering. Brand new dealers start off at a lower dealer tier 4, than a dealer who has been with them for a long time and is performing well who has a rating of 1 or 2. New dealers come on as a 4 or a 5 with the difference in each point equating to 2.5% in advance.

Credit Acceptance receives their advance rate first plus the 20% collection fee and portfolio fee. Are their estimations 1% or 2% within the boundary?

They are very good at predicting and following through on those predictions.

Does the dealer holdback give them a buffer if they miss the collections? If 65% collection is the estimate but you only collect 60%, the dealer holdback will be squeezed and Credit Acceptance will collect all their advance rate plus the fees?

Correct, they have to collect 100% of their advance regardless. The time when that comes into play is when the portfolio completely falls off the cliff from 65% to 55%. That could be due to many bad loans or fraud, where dealers submit bad pay stubs or sneak stuff in which creates a false expectation on Credit Acceptance's algorithm and risk formula. For example, if they go from 65% to 60%, they still have to collect 100% of their advance, so that 5% difference gets pushed onto the dealer because CACC still collects 20% of every payment, so 100% of the remaining payments will be applied to the advanced balance. The dealer will not receive anything until that advance balance is down to zero on the portfolio of deals. The dealer may end up never getting anything or they may collect forever to get that advanced balance paid off until they are made whole.

One of the reasons they do so well is that big buffer, which helps Credit Acceptance but if that happens often and dealers don't receive that portfolio money, the whole program becomes less appealing to dealer groups. It is imperative that they be as accurate as possible so that dealers get what is promised to them because the sales pitch is that they will make money today and later. They also pay dealers when they close a book of business or when they do their 100th or 50th deal. They receive an additional advance, kind of like a congratulations, which is an advance on future collections and is typically between 15% and 25% of those expected future collections. If a dealer is expected to have $100,000 in future collections, they could get a $25,000 advance check, which is added to the advances which have to be collected back. That is an additional risk CACC takes on by advancing the dealer that money, assuming they will collect that money down the line.

Is $1,500 to $2,000 back-end enough for dealers or should it be more?

If you ask a dealer, it's never enough. Good dealers who know how to buy and properly recondition cars and figure out the sweet spots. They do not recondition too much or not enough, but put quality vehicles on the road and make slightly more money. Some cars have higher advance rates than others, so they buy a bunch of cars that yield bigger advances because those are what you call the hot car. CACC advances a higher rate on those cars because they tend to perform better. That used to be a Nissan Ultima, then it was SUVs.

If dealers play the game that way and, essentially, stock their shelves with higher margin cars, they can make more money, but many dealers don't take the time to learn those things. CACC tries to help educate them because they want to finance vehicles which also have a better return for them. In the 20 years I've been in sub-prime auto finance, dealers have always complained about grosses not being high enough and the economics not being there and they don't make enough money or the bank makes more money than they do. The fees are too high and their profits aren't high enough and they will go elsewhere for higher profits. The current environment is competitive and their number one competitor is Westlake Financial. There are also other competitors such as smaller banks and finance companies, as well as mom-and-pop shops which open up and try to compete with venture capital or private money.

On our original example of a $16,000 car, $12,000 wholesale gave $4,000 gross profit; how would Westlake approach that advance and loan?

Generally, the advance is comparable, however it will be slightly different. Westlake doesn't require you to have as large a mark up, so their fee will be slightly lower. They have a smaller discount fee because there's no portfolio money; it's a straight discount. Instead of the car you own for $12,000 and sell for $16,000, you can sell it for $14,500 which provides a better deal for the customer, and the net result in check from CACC or Westlake is within a couple of hundred dollars. They take a smaller discount and fee, but finance the same amount or lower so the consumer has the better set up and don't pay as much for the car. The dealer still gets the check and makes the profit they want without putting the customer into a position where they have a bigger payment and a higher amount financed.

Dealers battle at Credit Acceptance with not being able to put the deal together because the fees are too high to absorb. Westlake doesn't require the dealer to mark the car up as much because their fees are lower, but they also don't allow you to make money down the line. If Credit Acceptance's check is $500 to $800 more, they will get the deal, whereas if Westlake's check is higher, they will get it. If Westlake's check is within a couple of hundred bucks, they will also get that deal because they put the consumer into a better spot.

How do you calculate the fees Westlake would charge in our example?

They have a system called DealerCenter which calculates the fees automatically. They are between 6% and 15%, on average, depending on the customer's credit, job or income. It also takes into consideration the quality of the vehicle with a vehicle score which goes into it. They look at the consumer's credit and fraud point score to make an informed decision and provide the dealer with a deal that has as small a fee as possible, while still making sense for them, versus Credit Acceptance who want to make 19% ROI. Westlake's expectation is 10%, so they have a different expectation in terms of how much money they want to make per deal. Westlake looks for smaller margins but higher volumes, versus CACC who never compromise.

If a dealer paid $12,000 wholesale for the car and there's a similar advance rate of $10,500 with a $2,000 down payment from the customer, what would be the optimized fees and price?

For a $12,000 loan with Credit Acceptance you are required to have a $5,000 mark up, whereas Westlake has a $3,500 mark up. If it falls into the average tier, the fee with Westlake will be 8%. They will sell the car for $15,000 whereas with CACC you have to sell the car for $17,000 with up to a 20% holdback on that particular loan. You might end up getting a similar check once everything works out, but you're putting the customer into a better scenario with Westlake. In some cases, it doesn't work out and they submit them to both lenders to see which yields a higher check to the dealer.

Could it be more effective to go with Westlake to have a lower price for the customer to turn it quicker?

That is the battle people at CACC face daily. Dealers' feedback is that they could do more loans through us but we require them to sell the car at a higher price than Westlake. They sell the car for $3,000 less with Westlake whose fees are lower. If their advertised price only has a $3,000 mark up built into it, they cannot make money with Credit Acceptance because their holdback eats into all their profit so their Credit Acceptance check is $9,000, whereas their Westlake check is $10,500. We would show dealers that if they let the system work their deal and sell the car at $17,500 instead of $15,000, our check is bigger. The dealer would say yes, but they have to sell the car now, for $2,500 more than if they chose Westlake, and they are not going to do that to their customer. Some dealers are okay with that, others aren't. Some dealers advertise the prices, others don't. That's the dance you go through with dealers.

Is that fee higher because Credit Acceptance earns a higher return on those loans over a longer period than Westlake?

Yes, they're earning a higher return on those loans. Westlake has lower fees because they run a much more stringent verifications process. For a loan with Westlake Financial, every customer gets interviewed from the bank, prior to the loan. The requirements and documentation are extremely strict with proof of income, residence and even verification of social security numbers in some cases. Credit Acceptance has little to no verification process. Most of the time they don't verify the employment. Their back-end systems give scores which dictate whether employment verification is required.

CACC’s average funding time is less than one day, meaning if I submit the loan today, I will be funded by tomorrow. Westlake's is probably close to two to three days. For dealers who need to cash flow regularly, the speed of receiving funds is imperative. Sometimes they choose Credit Acceptance because they know they get their money tomorrow versus being stuck in verification for three days and they have to interview the customer, verify the employment, social and the documentation. Westlake is good at doing that but end up returning the deal when things don't check out. Credit Acceptance returns almost no deal and take on additional risk providing better service to dealers. Dealers like to do business with CACC because they have the best funding in the business, but because it's the riskiest, they build that into their pricing.

What is Westlake's collection rate relative to CACC?

I don't recall what Westlake's collection rate is but when I was at Western Funding, which is a subsidiary of Westlake with a similar program as Credit Acceptance, we ran at 64%.

Does a similar collection rate and lower fees make dealer's margins better?

Westlake is a private company but I was privy to their profitability, and I still have private stock, the valuation of which more than doubled this year. They made a ton of money and hit it from all angles with their prime, mid-prime and sub-prime programs, floor plan services and technology services such as DealerCenter from Nowcom, which is a technology company they market separately to dealers. They are like a one-stop-shop for all dealer operations, whereas Credit Acceptance is purely a sub-prime finance lender.

What is the biggest challenge for Credit Acceptance to grow their loans beyond the peak volume we've seen over the past few years?

Scalability because there are only so many dealers a specific rep can manage. Credit Acceptance has more dealers so battle with attrition due to poor business practices. They have such a large base of dealers that, in order to continue growing, they have to outrun the attrition from dealers who are being churned off through performance, go out of business or stop using Credit Acceptance because they're unhappy with them.

They have done a good job growing but their loan volume has gone backwards or remained stagnant. They have a ton of sales reps who are managing very small markets, to try to penetrate as much as they can, but that strategy hasn't been successful in terms of growing loan volume. Profits are still there but how much more runway do they have to grow? Profits will continue to grow but they have to diversify. They recently introduced a Gold program which is mid-prime, borderline on prime. They have such a stigma about them for being such a deep sub-prime lender, that dealers don't want to send a prime customer to Credit Acceptance because of their sub-prime association, so they have to diversify because there are only so many sub-prime loans you can do, and many dealers want to do them with you.

The strategy of having a high mark up and a big fee is going away because, in the age of digital retail, dealers advertise everything online, prices, payments and transparency, and in order for their program to work successfully, there has to be built in mark ups and margins, because dealers don't want to be at a competitive disadvantage. If my car, which wholesales at $12,000, is marketed at $17,000 and the guy down the street has his at $14,900, as digital retail picks up that will create road blocks for Credit Acceptance, at least on their portfolio program, unless they diversify. Many dealers will feel they are competitively disadvantaged if they market to a full spectrum of customers.

If I'm the sub-prime used car dealer who sells 30 to 40 cars a month and they are all sub-prime, I don't care, that's not my customer. But if I'm the franchise dealer who they're trying to go after, or the big independent dealer, I need a program which works for their business and marketing strategy, not just Credit Acceptance's. Westlake has grown 20% to 30% year over year because they diversified their program to appeal to every type of dealer. For non-sub-prime dealers, they offer a Titanium Program which could appeal to some of their customers. They also offer a Gold Program which could appeal to customers, so they're able to get into dealers that CACC traditionally wouldn't do business with.

Why did Credit Acceptance lose 8% of their dealers the past few years?

This competitive landscape is unlike it has ever been. They are not able to grow as fast because they have an extremely green sales force. The more senior folks either left or there are too few of them.

Why have they all left? It seems loads of you left over the past few years?

Many of them left because Credit Acceptance changed the pay plan. If you're a rookie, the pay plan is fantastic, but if you were a veteran making $200,000 a year before, the commission structure became a higher base and a lower commission. Some veterans took a big pay cut and sought employment elsewhere. The folks who do not meet KPIs, even though they have good loan volumes, will also be pushed out.

What can Credit Acceptance do to increase sub-prime loan volumes?

They have to sign up more dealers and get a larger percentage of their existing dealer base to do business. Do you know how many active dealers they currently have?

They have 11,400 active dealers doing 23 loans per dealer per year.

When I was there, my dealers averaged 3.5 loans per month per dealer, and 60% of my active dealers were producing on a monthly basis, but it's probably a lot lower today.

How much of that is cyclical and easy money versus competition?

The competition comes in when there's easy money. CACC’s mindset has always been they will accept having lower loan volumes and lower producing dealers. They will continue doing what they do because when the cycle repeats, the money is no longer cheap and the competition recedes, they will be left in the same position as 2008 to 2011 where they were one of the last men standing and cleaned up.

How will Credit Acceptance perform over the next few years?

CACC is at a huge advantage because their money and rates are locked in for a long time. Rates are rising across the board and money will not be as cheap, so it will probably get harder to get money down the line, so some of the competition will recede at some point, although I have been saying that for four years. I don't know when it will happen, but I feel as if we are at the start of a cycle where money is more expensive and will become more scarce. Investors will be less willing to invest money into the sub-prime category, so competitors will slowly go away, and CACC will have a competitive advantage at that point. They can be more conservative and increase their margins and have been very good at timing those cycles.

Their unit volume peaked at 373,000 loans in 2018, and last year was unique at 270,000. What is the upper limit for Credit Acceptance in sub-prime loans?

I don't see it increasing much. During the last three years at Westlake, we watched the CACC numbers closely because our goal was to surpass CACC in terms of total loan volume, which we did in 2020. 2019 they were on pace and 2020 they passed them.

Does that include prime?

Yes, that includes total used car loan volume. I don’t see them increasing too much; there are only so many sub-prime loans out there. The franchised dealerships are where the real exponential growth can happen, because they sell so many more cars. There are only so many smaller, mom-and-pop dealerships that CACC can sign up. You have to start getting some dealers that can do a higher number of deals. You can’t grow by doing two deals, per dealer, per month, per year.