Say you're president of a regional bank. You're taking fire from the board to increase earnings per share, but they're not interested in the acquisition sweepstakes. In the past five years, you've put your balance sheet in order and cut as much overhead as possible; there are no more earnings in shrinking the bank. And, your memory being good enough to remember the excitement of the 1980s, you want to stick with your core business - retail lending.

[Expanded Picture]Then, one night, you pass a finance company storefront. The lights are on and customers are waiting to borrow money. Business seems brisk. You remember the B and C loan business is a cash cow - all securitization - with spreads a robust 400-plus basis points. The next day you ask around the bank, and you're unsurprised to discover you turn down more loan applications than you accept. All that money going out the door.

Then you recall that some of your friends have been through tough times as their companies downsized; they had trouble finding work, may have been late making some payments, and when they got jobs, they made less than before. So their credit suffered. But they still had capital expenses and needed to send their kids to college. You consider that making some B and C loans won't hurt your standing with the Community Reinvestment Act people, and begin to think about this market as a way of keeping the board happy.

If you have, you're not alone. Several banks have concluded in the recent past that lending to the subprime market is a good idea, and the past 12 months have witnessed a minor epidemic of bank acquisitions: Barnett Banks acquired EquiCredit Corp. for $332 million last September; KeyCorp grabbed AutoFinance Group Inc. for $316 million in March; and Norwest Corp. bought the Foothill Group for $441 million in May. informed observers expect more deals, although none appeared imminent this summer.

All the acquired companies operate in different sectors of the sub-prime market - home equity, automobile loans, and collateralized commercial lending, respectively - but but all are established firms with seasoned management teams that will remain in place. SunTrust Corp. is widely said to be starting a de novo sub-prime group, but the bank itself has declined comment on what it calls rumors.

Possible targets for future acquisition: The Money Store, Aames Financial Corp., United Financial Corp., Countrywide Credit Industries, Green Tree Financial Corp., and ADVANTA Corp., all of which are active - and profitable - companies with experienced management and good balance sheets.

Banks are smart to look at this market; it's big, and there's room for consolidation. Oppenheimer & Co. estimates that the sub-prime home equity business alone totals some $65 billion per year, and no company commands more than 6% of the market. Add sub-prime auto and other consumer and commercial lending to the mix, and the numbers get a lot bigger: Total assets in the finance company sector were $741.7 billion at year-end 1994, according to the Federal Reserve Board's Flow of Funds Accounts, which represented growth of 21% over the past five years.

The sector also posted a $74.6 billion surplus (assets versus liabilities) at year-end 1994, which is better than U.S.-chartered commercial banks; while bank holding companies were solvent, the commercial bank sector's assets grew 18% in the same period, and was underwater by $129.4 billion at year-end 1994.

[Expanded Picture]The growth of the finance company sector isn't very shocking in light of the underlying social trends fueling it. The cost of basic amenities has soared in recent years -and incomes haven't kept pace (see chart).

Meanwhile, the Bureau of Labor Statistics reports that in the period 1982-92 - the period of the BLS' most recent study in this area - displacement rates for all white-collar workers rose 38.4%, while those for executive, administrative and managerial jobs grew by 88%. Blue-collar displacement fell 28.7% in that period. (The BLS defines a displaced worker as one laid off after being with a company at least three years.)

So there's plenty of potential opportunity for lenders. But experts say this is a business that has to be done right, or not at all, which may well mean turning to experienced professionals to run it for you.

"There are amazing cultural differences [between banks and finance companies!," says Steven Eisman, a finance company analyst with New York's Oppenheimer & Co. "Servicing is very different, the underwriting is very different. They're very entrepreneurial; the best the banks could do is leave them alone in separate subsidiaries [if they acquire one]."

This was the conclusion reached by Barnett Banks Inc., the $38-billion, Jacksonville-based institution. Its recent acquisition of Equi-Credit Credit, which originated about $602 million in home equity loans from 89 offices in 29 states in 1993, is meant to be the kernel of a push into the B and C market, according to Lee Chaplin, Barnett's North Region Executive.

"We decided not to start from scratch, but to acquire a company that has been in business for more that 20 years, with a stable management team," says Chaplin. "We'll provide them with capital, and develop a strategic plan that would take their line to a different delivery channel, and further expand it geographically. And we're building them a new headquarters building. But the core part of their business will continue as it is."

The Norwest Model

Chaplin says Barnett plans to expand its new business through both acquisitions and de novo growth. "Over time, I expect we will have some EquiCredit people integrated into other parts of the Barnett organization, and Barnett people integrated into EquiCredit. We want to, grow [EquiCredit] geographically, and are looking at alternatives as far as distribution channels go. We think that market is a very fragmented market, nationally, and it's a core strategy that we want to build upon."

Barnett, he says, borrowed from another bank's experience in this market when it designed its own strategy. "Norwest is really kind of the model that we were looking at," he says.

Norwest Corp., the 59.3-billion-asset Minneapolis-based banking company, has been in the sub-prime lending business since 1982, when it acquired Des Moines-based Dial Finance Corp. The consumer finance arm that grew from that acquisition, Norwest Financial, earned net income of $222.5 million in 1994 and produced 27.8% of the bank's 1994 earnings per share. Dial's name was changed, but senior management remained intact for years, says Jim Campbell, executive vice president at Norwest.

"From our perspective," says Campbell, running the sub-prime lending business in a separate subsidiary "is the only way to go. You cannot take a business that's been successful, managed away from a bank culture, and convert it and have it continue to be successful.

"You've got to have the professionals that understand how to market (the product), how to process it and ultimately how to produce acceptable returns and manage losses. So underwriting is critical."

Just how different is underwriting in the sub-prime market? "When you're underwriting an A loan, you underwriting the person - does he have a job, is his credit good?" says Oppenheimer's Eisman. "When you do an appraisal, you do it to check that the house is there, to protect yourself against fraud. You're making very high loan-to-value ratios, so if the person loses their job, you're screwed."

"When you underwrite these (sub-prime) loans, on the other hand, you obviously underwrite the borrower to some degree - does he have a job, what's his credit - but you've got to be very careful on the appraisal, because the loan is only going to be as good as the appraisal value is low; as long as the LTV is low, you keep the borrower paying" because the amount of debt at stake is not worth losing a house over.

The same goes for auto lending, says Ruchi Maden, a regional banking analyst at Prudential Securities Inc. "I saw a presentation by an auto finance firm once, and they said that when they do their credit checks, they consider how far away a person's work is, and how important is that car going to be to that person," she says. "They think that should be a better predictor of whether a person is going to keep current on their loan or not (than default tables often relied on by banks)."

Defaults Are Higher

Default rates are nonetheless higher than with A loans. The Money Store, for instance, reports that its home equity loan delinquencies (loans 90 days or more past due) stood at 1.86% in 1994. This compares with delinquencies of 1.40% in bankmade home equity loans - second mortgages and lines of credit - for the same year. And The Money Store focuses on the A- and B market.

But higher default rates aren't necessarily a bad thing, if the loan is properly structured, says Norwest's Campbell. "If you have receivables and inventory and equipment, and you actually have perfected claims, one could make the case that that's the safest lending that exists, because if the, business turns down and you have to liquidate, you have hard assets to liquidate and be repaid."

So how different is this business? Consider The Money Store, the Sacramento, CA-based national firm so familiar to baseball fans, thanks to its aggressive advertising campaign featuring former major league great Jim Palmer.

Founded in Union, NJ, in 1967, The Money Store went public in 1991. It originates home equity loans as well as government-guaranteed Small Business Administration and student loans; it securitizes them, retaining servicing rights. Last year it originated $2.7 billion in loans - almost triple its 1992 originations of $1 billion - and serviced a portfolio that has grown to $5.8 billion, from $2.9 billion in 1992.

Income before taxes in the same period grew from $18.8 million to $53 million. This year it expanded into sub-prime car loans. From August 1993 to August 1994, the stock rose from $16 to $60 per share. (where it ws a year later).

Don't look for a bank to land The Money Store: The founding Turtletaub family seems intent on keeping control, and covenants in the firm's note agreements make it very difficult for outsiders to wrest control without triggering a default.

Underwriting is the key to operations in the sub-prime market, agrees Marc Turtletaub, the company's CEO. "It's very different from A lending," he says. "The first thing is to be comfortable with the risk; two, how to understand it and to price to it; and three, know how to structure loans so that you mitigate the risk as much as possible."

"It's difficult to have one person do many things," he says. "We have people who specialize in auto loans, and they don't touch mortgages; and we have people who specialize in the sub-prime home equity business who won't touch a student loan."

Also important, he says, is to maintain geographic and economic diversification. "We tend to be concerned about places that are ebullient, like Washington State and Colorado have been over the past couple of years, where there's a lot of demand," says Turtletaub. "We're less concerned about places like Southern California, where we've been very prudent for four years now, and our loan-to-values are very reasonable, because the appraisals are done on houses with depreciated values today.

"Also, I think it's critical to understand economic trends, not just regionally, but also in specific, local ways; what's happening in Boeing, and how many Boeing employees you have on your book. You've got to watch your concentrations. You should be prudent in lending to individuals, but also, understand the broader risks."

Finally, suggests Turtletaub, tone down your expectations. "I think the risks in this business are that people get too aggressive. You have to bear in mind that this is a sub-prime credit, and you have to be aware of the key barometers of repayment. That's something we keep our eye on, that we don't do anything that's overly aggressive."


Andrew Reinbach is a freelance financial writer based in Shrewsbury, N.J.

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