New accounting rules could cause more financial headaches for subprime auto lenders, by forcing them to restate how much it costs to collect loans.
The rules could hurt companies that have assumed low servicing costs, said Katrina Blecher, an analyst at Gruntal & Co. Alternatively, the rules could benefit companies that have assumed high servicing costs.
Either way, Ms. Blecher said, the impact is unlikely to be felt until the fourth quarter, when lenders hire outside auditors to prepare their annual reports.
"You might see some hits to earnings," she said in Chicago last week at a subprime auto lending conference sponsored by Executive Enterprises.
The rules, which were prepared by the Financial Accounting Standards Board and took effect Jan. 1, were designed to add consistency to a form of accounting called "gain on sale."
Subprime auto lenders use this method when they sell loans to investors in the form of securities and then book the profits right away.
This accounting has come under sharp criticism, even within the industry, for leading to overly optimistic earnings reports. (See article on page 26.) Estimated collection costs strongly effect the profits booked.
To promote consistency, the FASB issued a rule requiring companies to determine "adequate market compensation" for loan servicing, said FASB practicing fellow Scott Marcello. This means that companies or their accountants will have to figure out the going market rate for loan servicing and adjust the books accordingly.
These adjustments to servicing costs may cause some earnings surprises in a sector that has already provided plenty.
While the rules may force companies to use less aggressive assumptions when they securitize loans, the securitization band wagon seems not to have slowed down.
Preparing a securitization is not cheap-about $800,000 in investment banking and legal fees for a $60 million deal, according to Fahnestock & Co. managing director David Pullman. (See chart.)
But it is still the easiest way for subprime auto lenders to fund themselves.
Nevertheless, Ms. Blecher warned that securitization is "without a doubt the potential blowup point in this industry."
So far no investors in subprime auto securities have lost principal, because they have been protected by bond insurance.
But if more deals go bad, Ms. Blecher warned, bond insurers will become reluctant to guarantee deals, and investors could get burned the way those in mortgage-backed securities did in 1994 and 1995.
To prevent this, she urged subprime auto lenders to clean up their acts and avoid accounting tricks.
"If you're collecting a check and it bounces, don't redeposit the check a day before the quarter ends so your accountant can report the account is current at the end of the quarter," she said. "Don't do that anymore."