Capital Club Radio Interview with Kenneth Shilson
Male Speaker:Broadcasting live from the Business Radio X Studios in Atlanta, Georgia it’s time for Capital Club Radio, brought to you by Flock Specialty Finance.
Michael:Good afternoon. This is Michael Flock, Chairman and CEO of Flock Specialty Finance. I'm delighted to be here this afternoon with Ken Shilson. Ken is the icon of the subprime auto finance industry. He has a very interesting, colorful, and successful story for us this afternoon. Ken is well known for being the founder of NABD, which is the National Alliance of Buy Here Pay Here Dealers, the largest trade association in the used car dealer space at 10,000 members.
Ken is a CPA and serves as President of the Subprime Analytics and Profit Max Consulting Companies. They provide subprime portfolio analysis services and custom credit scoring solutions. Subprime has state-of-the-art data mining and extraction technology, which identifies loss trends and areas for underwriting improvement. Profit Max integrates with Subprime Analytics to provide a web-based custom credit scoring solution.
Ken delivers due diligence services for banks and financial institutions that provide capital to the subprime auto industry. He has helped pioneer an IRS approved tax strategy for Buy Here, Pay Here dealers regarding the use of a related finance company. He’s authored many articles on accounting, tax, and other matters related to this industry, and he has been a speaker at numerous national automotive conferences and conventions.
So we’re really honored and thrilled to get Ken here. It took us about a year to get his schedule in sync with ours. He’s in demand in this industry and I'm just so honored that he made time to see us this afternoon.
Ken; let’s just start with how you got into this space. Not many of us when we go to school, I dare say, think “I'm going to grow up and be a used car dealer.” How did you go from accounting to used cars? What was the evolution? How did this all happen?
Ken:First of all, Michael, pleasure to be with you here today and thanks for the great introduction. You didn’t mention my golf game so you must have seen me play, I guess.
Michael:No, but you’re a scratch golfer and I'm a rookie.
Ken:First of all, when I started my CPA firm in the early ‘80s, I wanted to find a niche market to serve. And I found that within the different marketplaces, the auto finance business is one of the largest industries out there. When I did some research, it seemed like everyone in my profession was gravitating to the new car franchise business. They all wanted to serve franchise new car dealers; nobody wanted to take the used car space. So I wanted to be a contrarian because I thought it would be easier to build my practice, and that turned out to be exactly right.
The used car industry was really underserved at the time. It gave me an opportunity to build a niche market for my CPA practice.
Michael:So it’s underserved and I also think it probably was very fragmented, is that right?
Ken:It really was. When I first started to focus on subprime auto finance, I found that there was a huge disconnect in the market. The capital providers seemed to be skeptical of whether it was a good business to lend to. The operators in the business didn’t really understand how to partner with a capital provider. So really through the years, I've been able to help bring those two together. I've been able to bring Wall Street and the capital markets to Main Street, so to speak. So I’m glad that we’ve finally found a partnership there. And today, capital is really flowing into this marketplace.
Michael:Right, and that’s exactly how we met you, I think, because we’re capital providers and we like large, fragmented, underserved or even ill served markets. And for our listeners’ benefit, that’s how we met Ken. We are interested in partnering with Ken – we are partnering with Ken, both in the charged off financing market as well as the originations of subprime loans. So that’s exactly how we met with you. What’s your vision, going forward, for these companies that you manage? Not just NABD but also Subprime and Profit Max?
Ken:I think that first of all, the auto finance business has just reached over $1 trillion in outstanding (loans?) - it’s a huge marketplace. And we estimate that the subprime, deep subprime buy here, pay here space is about $100 billion outstanding. So it’s a large market and a large opportunity. Right now, because of the last two years, it’s become very competitive.
But I'm starting to see some of the competition ease up. I think there’s a great opportunity going forward for the independent dealer to get some of the customers back that they’ve lost to competition. As well as get the vehicles back that have been involved in some of these big Wall Street securitizations that have taken place in the last couple of years. So I think there’s a great opportunity for independent dealers to really thrive in the future.
Michael:What’s causing this trend?
Ken:Wall Street. When the subprime mortgage business kind of dried up and fell apart, Wall Street began to look for other opportunities to package up asset-backed collateral. They moved over into the auto finance space because money is so cheap and investors are seeking higher yields than they can get with other types of investments. The subprime auto finance business, if done right, offers one of the highest yielding alternatives that are out there.
So it was a natural for Wall Street to package up these auto bonds, securitized and collateralized by automobiles or vehicles, and then lay those off to investors who perceived that the risk and reward justifies investing in it. And certainly that’s been the case. Some of these transactions have been $100 million, $150 million, $200 million… and we’ve seen a huge marketplace for this in 2014 and 2015.
Michael:So you’re suggesting that the yields are better in the independent market?
Ken:I think that what’s happened is, a lot of the money flowed into independent finance companies; people who were not in the business saw an opportunity to invest in the business but hadn’t had a lot of experience in dealing with the deep subprime customer. Not all the securitizations are bad; many of them are mixed in terms of higher credit quality with lower credit quality.
What’s happened in the lower credit quality space… it takes a lot of experience, it takes a lot of training, and it takes a lot of expertise to make that deep subprime portfolio work. And I'm not sure that the securitization market has quite focused on the experience and collection expertise that’s needed to pull that all off.
Michael:How would you characterize the difference between subprime and deep subprime?
Ken:Great. Generally speaking, subprime is consumers that have a credit bureau score of 600 or less. And deep subprime is 500 or less. So 501 to 600 would be subprime customers, and under 500 would be deep subprime. Deep subprime is often referred to as working with the unbankable consumer because they typically aren’t able to find a traditional loan from a bank or a credit union. So they have limited financing opportunities.
Michael:And that’s where the independent financers have the greatest share?
Ken:The two biggest players in that deep subprime market are independent owner-operators and finance companies like you were saying earlier - who don’t own their own lots but are providing financing to operate.
Michael:Who are some examples of that?
Ken:There are several that I can think of. Santander has been one of the most aggressive lenders into the subprime market. But in the deep subprime you’ll see people like Capital One, Ally, even Wells Fargo has provided capital to that deep subprime market.
Michael:Even Wells?
Ken:Wells tends to gravitate more to loaning to finance companies who then re-loan out to independent dealers. So those are three of the bigger ones.
Michael:We all keep hearing about and reading about the big bubble building in auto. We’ve heard that it’s not as bad as the bubble in mortgage several years ago but it’s going to be a bubble and at some point in the next 12 months it’s going to burst. Do you share that view? And if so, why?
Ken:I don't think it’s going to be like the subprime mortgage bubble. First of all, there are several significant differences. In the mortgage business, when they securitized mortgage properties, they basically expected the underlying value of the property to appreciate in value as part of the return. But in an auto bond securitization, the collateral is projected to depreciate. They’ve also built in other protections since the subprime mortgage finance securitization business.
So there are additional reserves and other protections built into the auto bond market. So I think where the problemslie are in that deep subprime securitize portfolios where they were overly aggressive in trying to gain market. Where they went deeper in the credit spectrum, where they just tried to sell more new cars by selling them to lower credit score customers, or credit unions decided to expand their portfolio so they were very aggressive. So it’s really that deep subprime tranches that are experiencing the problems.
Michael:Is that due also to the fact that we’ve heard that many of them make their money on the markup of the car?
Ken:Yes, that’s absolutely right. In the deeper subprime space, typically the higher the financing rate, and usually there’s a higher markup with the vehicle, as well. And simply because those customers have had bad credit histories and have very limited credit alternative so it stands to reason that they’d have to pay a premium because of their poor credit history.
Michael:And I guess that the dilemma may be that they’re paying a premium with a higher markup but on an asset that’s depreciating. Is that correct?
Ken:That’s right. I think another thing that differentiates the independent dealer from the finance company is that a dealer will keep the car running during the life of the contract. In other words, he’s providing a transportation solution. If the car breaks down, they’ll finance the repair or help the customer get the repair done so that the vehicle keeps running.
Typically, in a securitization market, there’s no provision for that after the warranty wears off. In addition, finance companies don’t typically like to finance repairs. So the independent operator is really doing a different type of financing than what we’ve seen in the aggressive underwriting in the securitization market.
Michael:Talk to us a little bit about the three companies that you are president of: Subprime Analytics, Profit Max and then NABD. What’s your management philosophy and vision for them, and what are the benefits that you bring to the clients in those companies?
Ken:In looking at the subprime auto finance space, success is measured by keeping the vehicle sold and the contract performing over the entire life of the contract. In order to do that, you have to know how to manage risk. You have to know how to underwrite a customer properly, you have to know how to collect properly, and most importantly, you need a lot of experience and training to do it right. You have to start with the right business model.
It’s got to be cash efficient. In other words, like any other investment, you want to maximize your return on whatever money you put in. so that means you’ve got to start with a reasonable investment that’s going to have an opportunity to return itself over the term of the contract and keep that contract out there.
So I developed Subprime Analytics so that I could monitor and measure performance in these portfolios and help identify adjustments that have to be made over the life of the contract, and help the operator get a cash efficient business model to start off with; one that’s going to be successful and keep him on track over the term of the loans. And that’s proved to be the case.
I've done almost $16 billion worth of analysis in Subprime Analytics; I think I have the largest database in the country on this type of paper. What we’ve learned is what works and what doesn’t work. So I'm able to share that information with owner/operators and with capital providers to do it right and be successful. Because it is a very capital-intensive business.
At NABD, I realized back in the late 1980s that no one was really focusing or serving or training that segment of the industry. We had other trade groups out there that really weren’t differentiating with the needs of the deep subprime space. So I decided to start NABD where we could not only focus on it, but promote the interest of the self finance industry. So those are really the two organizations.
I think over time, we’ve built more than 13,000 members in NABD, which shows the growth and progress that we’ve made. And in Subprime Analytics, as I said, over 1.5 million loans have been analyzed with over $16 billion worth of analysis; a great deal of information there that’s very valuable to the industry.
Michael:When you talk about the consulting services of Subprime Analytics, do you also, by definition, just include Profit Max with that? How has the integration of those databases enriched the solution that you’re providing your customers?
Ken:At Profit Max, typically when we do an analysis of a portfolio, we find ways that the portfolio could be improved. We identify specific areas of improvement. Operators would want a credit scoring solution to help them implement those changes in their underwriting. So I ended up actually licensing Profit Max from my first customer who developed a web-based solution for it and it’s been very successful.
It’s helped several operators get on track. I think that what it does do is it provides a great deal of customer information. We’re able to gather information about the customers where Subprime Analytics would focus on the vehicles, the deal structure, and any other financing products that are in the financing itself. So they complement each other very well.
Michael:You used the term state-of-the-art data mining. Can you give me some examples of how you provide that?
Ken:I think that one of the challenges has been, where do you get the data to analyze it. And it’s generally stored in the dealer management software systems in about six or seven major software packages that serve the deep subprime and the subprime auto finance industry. Over the years, I've developed a data extract with all of those dealer software providers to send me the data in exactly the form that I need.
So that means our customers don’t have to do anything except just authorize the extraction. We get the data. They don’t have to handle it; they don’t have to do anything with it. Then we will go in and analyze it and identify any data exceptions before we run the analysis; give the customer a chance to correct those.
Michael:So it makes it a lot easier to use.
Ken:Absolutely.
Michael:You don’t have to be an IT geek to use this, like I am and you are.
Ken:Yes, you don’t have to have an IT department to do this; all you have to do is authorize your software provider to give us the data extract.
Michael:Terrific. Another issue that faces subprime auto finance, and it’s an issue that we face in financing companies that provide subprime credit and those who sell charged off debt - compliance regulation. There’s been a lot of political controversy, I think, in this subprime auto space particularly as it relates to this issue of different races. I think people in our government said some of the credit scoring is racist. Is that a hot issue in the auto industry with subprime auto finance?
Ken:There have really been two areas of focus so far in the compliance area as related to the subprime auto finance business. One has been discrimination; profiling and basically excluding certain races from financing opportunities. I think the second of it has been there’s a concept called disparate impact, which the regulators have focused on. Meaning that if you’re out of step with the rest of the industry or what others are doing, then you become a target to be singled out and be put under the microscope.
Michael:As a capital provider or as a used car dealer?
Ken:Both. Sometimes those distinctions are made by complaints from consumers but other times they just are discovered by simple investigations that are conducted by the regulators. When they’re spotted, again if you’re out of step with the rest of the industry, you stand to really be challenged about that; why are you doing this? Why are you charging premiums? Why are you marking these vehicles up above what your competition is doing? There has been some case law on that in the last couple of years.