The wobbly world of subprime auto finance got another unexpected jolt when First Merchants Acceptance Corp. became the second lender this year to restate earnings and fire top executives due to phony accounting.
On Wednesday night the Deerfield, Ill.-based lender announced it had discovered "irregularities involving unauthorized entries" in the company's financial records. The company also disclosed that its president and other top executives had been fired, and said its 1996 earnings statement would have to be revised. It expects to report a first-quarter loss.
On Thursday afternoon, company officials said the fired employees had altered records to make it appear as if customers were more current on their payments than they actually were.
First Merchants is a relatively small player in subprime lending, but its disclosures, only a few months after Mercury Finance Co. made a similar announcement, caused some to suggest similar problems may be endemic to the business.
The new co-chief executive, Richard J. Uhl, said the situation was well in hand at First Merchants.
"There are no more events to be uncovered. The board believes there was no criminal activity. There is no indication assets were moved or falsely created," he said. "The people responsible have left the company."
First Merchants shares lost half their value in Thursday's trading, tumbling $3.375 to $3.25.
Analysts are accustomed to bizarre news from subprime auto lending, but acknowledged they were stunned by the latest fiasco.
"This comes as a great shock," said Reilly Tierney, analyst at Duff & Phelps Credit Rating Co. "This may have a greater impact on the industry than Mercury did."
Mercury opened the lid on subprime auto lending's problems when in January it disclosed that accounting fraud caused it to overstate earnings for four consecutive years. The company fired its top executives and is now under federal investigation.
Wall Street dismissed the incident as an isolated case that did not speak to the nature of the subprime lending business.
But with executives seen doctoring the books at another company, that analysis may no longer hold up, Mr. Tierney said.
In light of the alleged fraud, First Merchants' board announced it fired president and chief executive Mitchell C. Kahn, who used to work at Mercury. Also fired were chief information officer Thomas R. Ehmann, vice president for strategic planning Paul Van Eyl, and one other employee.
The company said it would revise previously reported 1996 earnings downward from $1.56 per share. In a statement, it said restated net earnings "should remain at a level of at least $1.00 per share." It added that first-quarter results will be delayed but the company expects to report losses of between $1.60 and $2.00 per share.
Observers had suspected that First Merchants was in trouble ever since the company's treasurer, Brian Hake, left without explanation two weeks ago. Reached at his home, Mr. Hake refused to comment on reasons for his departure.
And analysts say they had been unable to contact a newly appointed chief financial officer. On April 9, First Merchants announced it would report a first-quarter loss, and its stock dropped 19%.
First Merchant chief financial officer Norman Smagley said the company's securitizations were affected by the fraud, but insisted investors will get paid.
The deals are insured against default by Financial Security Assurance and serviced by Harris Trust and Savings Bank.
The company securitized $530 million worth of receivables in 1996 and in March sold another $106.7 million of securities backed by installment contract receivables.
The troubles at First Merchants and other subprime auto lenders illustrate the difficulties turning a profit by making loans to people with bad credit for an item that depreciates over time. And it is unlikely to get any easier, says Karen Petrou of ISD/Shaw, a Washington consultancy.
"With better credit-scoring techniques and enforcement of fair-lending practices, more and more people who once relied on subprime lenders can now go to banks," she said. "It's adverse selection-subprime lenders are forced to serve the worst credit risks that are left behind."