A death march disguised as a consolidation wave appears about to sweep the subprime auto lending business.
Monday night, First Merchants Acceptance Corp., a Deerfield, Ill., company, joined the growing ranks of subprime auto lenders looking for buyers when it announced it had retained Salomon Brothers Inc.
But while First Merchants six months ago might have snared bids from a host of eager banks or finance companies, recent scandals over bogus accounting at two companies and a rash of unexpected losses at others have raised serious questions about the viability and honesty of many players.
As a result, observers said, consolidation in subprime auto lending won't mean companies being sold. Instead, they'll wither on the vine.
"This will be a very strange consolidation," said Oppenheimer & Co. analyst Steve Eisman. "Companies won't be bought. They'll just die."
Market sources said nine companies that make car loans to people with substandard credit are currently for sale. This is a stunning turnaround from only a year ago, when Wall Street had just completed taking about 25 such lenders public and was aggressively touting them as growth stocks.
But a series of bizarre events have tarnished the once golden image of this business.
In January, industry leader Mercury Finance Co. fired top executives, charging accounting fraud. In short order, Jayhawk Acceptance Corp. filed for bankruptcy, and a string of other lenders started reporting unexpected losses. Two weeks ago, First Merchants also fired top executives, alleging they had doctored the books.
These hammer blows have caused investors to turn their backs on virtually the entire sector, wiping out hundreds of millions of dollars in market value. The events have also made banks skittish about financing these companies, which buy installment contracts from car dealers, according to Duff & Phelps Credit Rating Co. analyst Reilly Tierney.
And while industry consolidation has generally served investors in bank stocks well, it is unlikely to deliver the same benefits for investors in subprime auto lenders, said Thomas Blum, managing director at the financial institutions group of Bear, Stearns & Co.
"It's not like combining banks or thrifts, where you have a deposit base you can build on and there are obvious cost takeouts," he said. "I don't see cost savings in subprime auto-in fact, I see initially higher costs in combining companies because most of them are run pretty efficiently already. It's never been difficult to get new loans, so there's no franchise value in that. What you want are seasoned salespeople, and there's no guarantee you'll retain them in a merger."
As a result, he said, smaller companies like First Merchants "are really going to struggle." First Merchants executives were not available to comment.
That said, the history of consolidation in this field is not hopeless. Barnett Banks Inc.'s purchase of Oxford Resources Corp. is going smoothly, analysts said, and KeyCorp has done well by Key AutoFinance.
But now, with turmoil in the subprime auto sector, with companies revising their accounting systems to boost loss reserves and making less optimistic earnings projections, it's hard to tell who's got a good business and who hasn't, said Mr. Tierney of Duff & Phelps.
"Credit Acceptance and AmeriCredit are considered the best," he said, "but it's hard to see why they're materially better than anyone else right now."
Last Friday, shares of Credit Acceptance Corp., Southfield, Mich., dropped 35% in value, though the company had reported solid earnings, because of concerns over loan origination volume. "It's a sign of how paranoid the market is now," said one observer.
First Merchants was also one of the more respected companies in its field, explaining why its recent disclosure of apparent accounting fraud came as such a shock to the investor community.
Like its competitors' stocks, its shares plunged after it released bad news. And so the company called on Salomon, which had managed the $800 million of securitizations that help fund the company, to guide it through the crisis.
First Merchants turned to Salomon because getting additional funding to continue operations could prove difficult and because it may not be able to secure financing from anyone but the New York investment bank.
"First Merchants is an important client for Salomon," Mr. Tierney said. "But it's still going to be rough going for First Merchants. Although their securities are wrapped (insured against default), a lot of portfolio managers are going to be saying, 'Why buy this when I could buy something else that's equally safe?'"
Meanwhile, the company will remain afloat while it tries to rebuild its business or sell to another company. Oppenheimer's Mr. Eisman said he finds the latter scenario unlikely. "I don't think First Merchants is sellable," he said. "No one knows what credit quality is in there."
In what now seems like another era, Salomon advised Mercury Finance on selling 16% of its stock to BankBoston Corp., which was eager to expand its presence in subprime auto lending. That deal has since been terminated.
Ultimately, Bear Stearns' Mr. Blum sees the small independent firms like First Merchants disappearing as larger, less specialized companies come to the fore.
"Companies like the Money Store, Household Finance, and GE Capital are all building their subprime areas," Mr. Blum said. "There's a large business out there that will continue to be done."
