NORFOLK, Va. -- The executives of TFC Enterprises Inc. have worked hard to get where they are today, but luck played a role as well.

"I think we went public just in the nick of time," says president and chief executive George R. Kouri.

TFC, which stands for "The Finance Company," raised $50 million in December 1993, just two months before the Federal Reserve began raising interest rates and the stock market headed south.

Now, with its capital safely in hand, TFC seems well positioned to ride out an environment of rising interest rates and roiling financial markets.

"Given the fact that they've got the strongest capital base in their history, they've got a great shot at growing very rapidly with minimal dilution to current shareholders," says Joe Feshbach, a stock analyst with Stockbridge Partners Inc. in Palo Alto, Calif.

TFC is one of a handful of finance companies that specialize in lending to used car buyers with substandard credit -- borrowers shunned by most banks.

This market is estimated at between $30 billion and $70 billion a year. But the only true national player is Northbrook, Ill.-based Mercury Finance Co., whose share price has risen eightfold since the company's April 1989 spinoff from First Illinois Corp.

TFC and several other companies went public during the last three years hoping to capture some of the Mercury magic. "A lot of people made a lot of money in Mercury, and I'm sure that helps," says Charles M. Johnston, TFC's chief financial officer.


But TFC's own investors may have to wait a while to enjoy Mercury-like returns. The stock, which went public at $11.50 a share, traded as high as $14.75 in February, but lately has fallen back into the $8 a share range.

Market conditions explain part of this, since rising interest rates put pressure on the margins of TFC and other finance companies.

Investors also seem to be nervous about the sheer volume of recent IPOs in the subprime auto category, which also includes First Merchants Acceptance Corp., Eagle Finance; Search Capital Group, Regional Acceptance Corp., Americredit Inc., Consumers Portfolio Services Inc., and Credit Acceptance Corp.

"There's a perception out there that this business is very easy, that's there's very little barrier to entry and anybody can do it," says analyst David Stumpf, with Wheat First Butcher Singer in Richmond.

Some well-publicized snafus don't help. Search Capital, which went public about the same time as TFC, saw its stock price plunge into penny stock territory after reporting a disastrous second quarter.

Mercury, the industry model, got sideswiped in August by a $50 million punitive damages judgment handed down by an Alabama jury in a case involving a $4,000 car loan.

Mercury expects the judgment to be reversed on appeal. But the case reminded consumer finance companies, once again, of their vulnerability to enterprising plaintiffs attorneys.

Mr. Kouri insists that TFC, which charges an average 22% annual percentage rate on its loans, doesn't face "material litigation of any kind." But just to be on the safe side, the company closed down its operations in Alabama in the wake of the Mercury fiasco.

"We have plenty of opportunities to grow our company," Mr. Kouri says. "If the climate in Alabama is such that that can happen, we just don't need to be there right now." Excluding Alabama, TFC now operates in 14 states around the country, with its strongest presence on the East Coast.

In contrast to Mercury, which operates a network of small branches spread out across the country, TFC utilizes the "service center" concept. It purchases loans from auto dealers and then monitors and collects on that paper from three highly automated regional centers, in Norfolk, Jacksonville, Fla., and Dallas.

The oldest center, in Norfolk, employs 160. Jacksonville has 100 employees and Dallas, the newest office, 80. The company is now scouting out the possibility of establishing a fourth service center in San Diego, to cover the West Coast.

Housing so many workers in one place allows TFC to put expensive technology in each center and underwrite bulk purchases of receivables, such as the $12.8 million portfolio it bought in October from a dealer in Austin, Tex., in its largest purchase to date.

Another difference between TFC and Mercury is the type of paper they buy. Mercury goes after "C"-rated loans, which are below bank quality but still higher than the bottom level "D" paper purchased by Credit Acceptance. TFC falls somewhere in between -- taking both "C" and "D" paper.

It is, in fact, rare for players in the subprime auto lending market to compete directly against each other, since there are so many gradations of auto paper. And when such competition does occur, it's only in selected markets.

Bank competition is not a factor at all for TFC, although credit unions can get aggressive for short periods of time. "It's not unusual for a credit union to jump in with both feet and then wake up five to six months later saying, 'Oh, God, what have I done?'" Mr. Kouri says.

TFC also sets itself apart from Mercury by working exclusively with nonfranchised dealers, or those not connected to an auto maker. This is where Mr. Kouri sees his greatest opportunity for future growth.

"The nice thing about servicing the independent dealer," he says, "is that on a national basis, they really don't have anyone vying for their business.

"A lot of the independent dealers have been forced historically to finance their own receivables. They haven't had a consistent lender to buy their paper. We see that as our niche market."

With all their differences, TFC and Mercury both began in the same way: servicing military borrowers. TFC traces its own origins back to the early 1970s, when Mr. Kouri and Robert S. Raley Jr., the TFC chairman, worked for Major Finance, a consumer finance company in the Washington, D.C. area.

It was Mr. Raley, then Major's chief operating officer, who hired Mr. Kouri as a management trainee in 1972. Mr. Kouri, then 23, had zero financial experience, having graduated from Marist College in Poughkeepsie, N.Y., with a degree in American studies.

But Mr. Kouri caught on quickly. While at Major Finance, he and Mr. Raley helped pioneer the "allotment" method of lending to enlisted military personnel.

Under this system, a serviceman's installment payments are deducted from his paycheck and sent to a cooperating bank, which then disburses the funds to the appropriate lenders.

The two men left Major Finance in 1977 to found TFC in Alexandria, Va. They later moved to Norfolk in order to be close to the country's largest naval base.

The allotment system has the virtue of transforming the previously uncreditworthy soldier or sailor into a bankable risk.

"We recognized that market wanted cars, stereos, beer, and women -- or actually, women, cars, stereos and beer -- and they had a great amount of disposable income with no other obligations," Mr. Kouri says.

But even with automatic payroll deductions, one giant risk remains, that the customer might prematurely leave the service.

Over the years, Mr. Kouri and Mr. Raley developed a system for underwriting military loans that involves intensive investigation of the customer, including the procurement of what TFC employees term a "good boy letter" from the commanding officer.

TFC, like other finance companies, also maintains a relentless collecting staff who will track down scofflaws and seek to garnishee their wages many years after a loan default. An automated dialing system helps facilitate this onerous task.

TFC continues to emphasize military customers, but sees the civilian market as having greater opportunity for growth.

Mr. Kouri estimates that incoming receivables now are roughly split between military and civilian. Total receivables reached $125 million in the third quarter, up 34% from $93 million a year earlier.

For most of its existence, TFC has been plagued by a capital deficiency, which limited its ability to grow. In 1988, Mr. Raley and Mr. Kouri sold the company to Chicago Holdings Inc., a private leveraged buyout group.

The idea was for Chicago Holdings to inject the needed capital and for TFC managers to keep running the company day-to-day. But disagreements over strategy quickly developed and the TFC executive group bought back the company in 1990.

It wasn't until Wheat First took it public in December 1993 that TFC finally solved its capital problem.

Going forward, the biggest risk on TFC's horizon probably has to do with interest rates. TFC can raise the rates it charges customers, who tend to focus more on their monthly payments than the listed annual percentage rate anyway.

But a rising cost of funds can still squeeze TFC's net interest margin, which is expected to fall to 18.41% by yearend, from 20.25% in the first quarter.

Late last year, TFC negotiated an increase in its line of credit with General Electric Capital Corp. from $80 million to $120 million. And in June, GE agreed to lower the spread TFC pays over the London interbank offered rate by 125 basis points, helping keep funding costs level despite rising rates. TFC paid an average 8.6% on interest bearing liabilities in the third quarter, compared to 8.8% in the second.

In addition, TFC has had an interest rate ceiling agreement in place on a major portion of its borrowings that activates when Libor reaches certain levels. Mr. Johnston, the chief financial officer, said TFC is now working on two other facilities to increase its funding capacity beyond the single line from GE Capital.

"We have some risk, but it's not unlimited," he says. "There's a point at which our risk is capped out."

At TFC, Loss Reserve Is Just a Third Line of Defense

There's big difference in the way TFC Enterprises Inc. and other finance companies guard against loan losses, compared to standard banking practice.

At a bank, the second line of defense against default, following the actual underwriting process, is the loan-loss provision. Banks set aside a certain amount of money each quarter to cover their anticipated losses.

TFC does that too, but uses the set-aside only after emptying something known as the "nonrefundable dealer reserve."

When TFC purchases a pool of loans from an auto dealer, it scrutinizes each credit individually, agreeing to accept only those that meet its standards.

Then, since the risk is so high with these borrowers, TFC purchases the acceptable loans at a huge discount, usually about 20% of principal amount.

It puts aside an amount equal to the discount in a separate account to cover losses from that particular loan pool. Once the pool is paid down, whatever is left of the dealer reserve is taken into earnings as interest revenue.

Only if there is a shortfall in the dealer reserve does TFC have to draw upon its loan-losss provision to cover chargeoffs.

"What we're trying to do is buy the paper in such a way that the dealer absorbs the losses" or most of the losses, says Charles M. Johnston, TFC's chief financial officer.

The effectiveness of the system can be judged from the fact that TFC's current loanloss provision is a mere $453,000, which covers $125 million in net receivables.

Use of the dealer reserve, which is similar to the way in which credit card companies discount their merchant receivables, is common in the subprime auto lending business.

But that hasn't prevented it from attracting fire from plaintiffs attorneys, who say failure to disclose the discount is unfair to borrowers.

Mercury Finance Co., the industry's largest and most visible player, recently sustained a $50 million punitive damages judgment in Alabama over a $4,000 car loan.

The jury in the case decided that Mercury's failure to disclose the discount violated state lending laws.

Mercury vigorously disputes that conclusion and intends to appeal to the Alabama Supreme Court.

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