Underwriting, Metrics, and Credit Scoring That Reduce Losses

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1 Underwriting, Metrics, and Credit Scoring That Reduce Losses Presentation to Innovate 2012 Monday, September 17, 2012 Part One Ken Shilson, CPA President, Subprime Analytics Booth # North Loop West Suite 270 Houston, TX Phone: Fax:

2 Electronic Loss Analysis Loss trends were determined by Subprime Analytics, who performed electronic portfolio analysis of over 1 million subprime deals aggregating approximately $10 billion to identify loss rates, patterns, and where industry losses come from!

3 About BHPH Underwriting: Success in BHPH Underwriting is best achieved by 1.) avoiding trial and error mistakes that can cost you millions of dollars and 2.) learning from your losses, not repeating them! Ken Shilson, CPA President / Founder National Alliance of Buy Here, Pay Here Dealers (NABD) The More You Learn, the More You will Earn!

4 The Ten Important BHPH Underwriting Fundamentals 1. The installment receivable portfolio represents an operator s most important financial asset because it provides the cash flow needed to sustain and grow the operations. BHPH really is the finance business and not about just selling vehicles!

5 The Ten Important BHPH Underwriting Fundamentals 2. In BHPH, selling a vehicle is the easy part! Collecting the contract is the real challenge. Therefore, the sales and underwriting process must be used to determine a prospective customer s ability to repay the amount financed.

6 The Ten Important BHPH Underwriting Fundamentals 3. Asset quality is more important to success than size. Bigger is not always better. Portfolio growth is generally constrained by capital availability. You must have a business plan which matches your growth plans with the capital available to fund it.

7 The Ten Important BHPH Underwriting Fundamentals 4. The best portfolios are built over time, not overnight, using a consistent underwriting approach which is best developed by correlating the underwriting characteristics of the customers, the vehicles, and the deal structures with historical loss rates. Learn from your losses, don t repeat them!

8 The Three Key Elements of BHPH Deals: 1. The Customer! 2. The Vehicle! 3. The Deal Structure!

9 Learn From Your Losses! Analyzing Your Portfolio Helps You Avoid Trial and Error Mistakes.

10 The Ten Important BHPH Underwriting Fundamentals 5. The definition of good underwriting is properly matching the customer with the vehicle they can afford and not necessarily the one the customer picks out.

11 What is A Reasonable Mark-Up?

12 Markup Considerations 1. Should be based upon the cost of the vehicle. 2. Consider how long the vehicle will run. 3. Don t increase the selling price to where the contract term exceeds the vehicle life.

13 The Ten Important BHPH Underwriting Fundamentals 6. There is an inherent conflict between the sales and underwriting departments. These functions must be separated, and customer stipulations verified independently from sales prior to finalizing each vehicle sale.

14 The Ten Important BHPH Underwriting Fundamentals 7. Centralized underwriting does not assure positive performance it only assures consistency. Good underwriting involves the careful analysis of customer stipulations, a customer s credit bureau ratings, and an evaluation of a customer s ability to repay.

15 What to Consider When Underwriting Prospective Customers What factors make up the customer s stability and ability to pay? There are at least 15 factors to look at including: Credit Bureau Score Rent Amount Repossessions Prior Auto Credit Job Time Age Phone Job Type Residency Net Pay Current Mortgage Time at Residence Debt to Net Pay Bankruptcy Outstanding Debt

16 What to Consider When Underwriting Prospective Customers Credit Bureau Score: Although most of our customers credit bureau scores are low, it is still an excellent indicator of default and how the customer will pay. In addition, you can glean lots of information from their credit bureau. You can obtain alternative credit data when traditional credit info is unavailable.

17 Losses Based on Credit Bureau Scores Default Rate Unscored 45.3% % % % % *Opportunity, or mistake?? Average Loan Default Rate 28.4%! Source: Subprime Analytics

18 What to Consider When Underwriting Prospective Customers Age of Customer: First you must make sure the customer is 18 years or older. If they are not you can t sell them a vehicle.

19 What to Consider When Underwriting Prospective Customers Type of Phone: The type of phone a customer has is an indicator of the stability of the customer. We do our collecting by phone, so this is important. If we can t reach a customer we can t collect from them. Landline Cell Phone Go Phone No Phone

20 What to Consider When Underwriting Prospective Customers Type of Residence: The type of residence a customer has is an indicator of the stability and ability of the customer to pay. There is a difference between owning a House and owning a Mobile Home for stability. Own House Buying House Rent/Lease House Own Mobile Home Buying Mobile Home Rent/Lease Mobile Home Government Housing Lives with Someone

21 What to Consider When Underwriting Prospective Customers Length of Residency: The time the customer has been at their residence is an indicator of stability. Is this customer hard to find or a possible skip? Do they move frequently? Are they new to the area? These are all indicators of skip risk.

22 What to Consider When Underwriting Prospective Customers Rent or Mortgage Amount: How much rent or mortgage does the customer have to pay each month? What percentage of their net pay?

23 What to Consider When Underwriting Prospective Customers Type of Job: The type of job the customer has is an indicator of ability to pay. Is it a job that if they lose their current job they can go get another similar one? Does the job pay enough for the customer to make payments to you? Is the job stable?

24 What to Consider When Underwriting Prospective Customers Net Pay: This is what the customer brings home each pay period after all deductions. This is the money the customer has to pay their bills with. Do not look at gross; they don t pay their bills out of gross pay.

25 What to Consider When Underwriting Prospective Customers Debt to Net Pay: This is the customer s living expenses and monthly debt payments compared to their net pay. Is there enough money for customer to make payments? Does the customer have some wiggle room in case of unexpected expenses or problems?

26 What to Consider When Underwriting Prospective Customers Bankruptcy: Is the customer in a current bankruptcy? Has the customer ever filed bankruptcy in the past? If so, how many? Was it discharged or dismissed?

27 What to Consider When Underwriting Prospective Customers Auto Repossession: Has the customer had an auto repossession? If so, how many? How long ago? Why?

28 What to Consider When Underwriting Prospective Customers Prior Auto Credit: How has the customer handled their auto credit in the past? Although they might not pay their medical bills or utility bills, they may pay their auto payments. The manner in which they handle their past auto payment is an indicator on how they will pay you.

29 What to Consider When Underwriting Prospective Customers Current Mortgage: If the customer has a mortgage, how are they paying that mortgage? Are they struggling to make payments on time? Are they past due now? This is one of the key factors in customers filing bankruptcy.

30 What to Consider When Underwriting Prospective Customers Amount of Revolving Credit and Collection Items: The amount of debt a customer has, including collection items, is important. This will let you know how much money they have outgoing. You have to make sure they have enough income to cover their debt.

31 What to Consider When Underwriting Prospective Customers What factors make a good deal structure? There are 5 factors to consider: 1. Down Payment 2. Mileage of Vehicle 3. Cost of Vehicle 4. Term of Loan 5. Payment Amount

32 What to Consider When Underwriting Prospective Customers Down Payment: The amount of down payment helps you limit your risk. Do you look at dollars down? Look at down payment as % of ACV of the vehicle, this is a better indicator of risk than just dollars down. Do you use deferred downpayments?

33 What to Consider When Underwriting Prospective Customers Mileage of Vehicle: We all understand that the customer is not going to pay if the vehicle is not running. So you must look at the vehicle mileage to make sure the term of loan is not too long. The vehicle should run the length of the contract. The higher the mileage of the vehicle the shorter your term must be.

34 What to Consider When Underwriting Prospective Customers Cost or ACV of Vehicle: As with the mileage of a vehicle, cost or ACV of vehicle should help you determine term of contract. The cheaper the cost of the vehicle, the shorter the term should be.

35 What to Consider When Underwriting Prospective Customers Term of Loan: The term of the loan is one of the most important factors in the deal structure. You must get the term correct. The vehicle must run the length of the contract. Don t set your terms too long or you will create repossessions.

36 What to Consider When Underwriting Prospective Customers Payment Amount: Just like term, the payment amount is an important factor in the deal structure. The payment must be one that the customer can pay. If you set your payment too low then your term will be too long, but if you set your payment too high then you will create a repossession.

37 What to Consider When Underwriting Prospective Customers Where do you get the information needed to create your own score card? By Studying YOUR losses.

38 Can You Really Learn Anything by Studying Losses? Data mining and extraction technology enables us to "drill down" into your portfolio data to evaluate your underwriting practices, the vehicles you are selling, and the customers who are buying your vehicles ( touch your losses )! Computerized analysis is the most effective way to analyze portfolio s performance! This type of analysis allows us to identify loss characteristics, trends and loss patterns. (Continued)

39 Can You Really Learn Anything by Studying Losses? (Continued) In this way, you learn to avoid repeating underwriting mistakes which cost you millions! You can correlate credit scores with actual loss rates to determine if your credit scoring model is working.

40 Loss Stratifications Generic Credit Scoring System Summary: Percentage Repo Deals Repo All Repo Records >= Lower Limit < Upper Limit Records Records To All Records Blank 15,524 63, % , % ,696 28, % ,381 7, % , % , %

41 Loss Stratifications Profit Max Credit Scoring System Summary: Percentage Repo Deals Repo All Repo Records >= Lower Limit < Upper Limit Records Records To All Records < (126) (125) % (125) 8 1,347 10, % , % , % , % Totals 1,956 15, %

42 What Profit Max Does Provides web-based credit scoring system designed for you Scores customers with little or no credit file Helps standardize underwriting, even for multiple locations Subprime Analytics integration allows correlation of credit scores with your actual loss results

43 The Ten Important BHPH Underwriting Fundamentals 8. Changes in the local economic environment can impact repayment performance more than changes in the national economy. Therefore, underwriting must be monitored periodically and adjusted accordingly. Significant changes in your underwriting model should be avoided. Consistent underwriting policies should be followed.

44 Analyzing Customer Stipulations Analysis of customer info is needed to effectively manage portfolio risk! Verification of income, debt and expenses is critical to good underwriting. Using technology is the only efficient way to gather and analyze customer information. The more you learn about your customers, the more you will earn! Take the CASH approach to underwriting!

45 What Do Good Underwriters Do? Verify Customer Capacity Verify Customer Ability to pay Verify Customer Stability Verify Customer History

46 The Ten Important BHPH Underwriting Fundamentals 9. Your underwriting (business model) should be developed with a thorough understanding of local economic conditions like income levels, employment statistics, customer demographics, etc. There are many different approaches to successful BHPH underwriting not just one way.

47 The Ten Important BHPH Underwriting Fundamentals 10. Good underwriting is essential to good collections. Bad underwriting equals bad debts! However, some losses must be anticipated because BHPH customers typically lack financial capacity.

48 Underwriting, Metrics, and Credit Scoring That Reduce Losses This concludes Part One. Visit Booth #132 and Join Me for Part Two! Ken Shilson, CPA President, Subprime Analytics Booth # North Loop West Suite 270 Houston, TX Phone: Fax:

49 Underwriting, Metrics, and Credit Scoring That Reduce Losses Presentation to Innovate 2012 Monday, September 17, 2012 Part Two Ken Shilson, CPA President, Subprime Analytics Booth # North Loop West Suite 270 Houston, TX Phone: Fax:

50 Part One Recap 1. The 10 Important BHPH Underwriting Fundamentals! 2. What to Consider When Underwriting Prospective Customers! If you missed it, Visit Booth #132!

51 If you re not using analytics today, you re going to have a hard time borrowing money tomorrow. -Rick Potter, President, CAR Financial Source: Subprime Auto Finance News, December 2008

52 Why Develop Portfolio Performance Metrics? The economics of the buy here, pay here industry have changed dramatically over the last several years. Today, operators are putting more money on the street with each sale! As a result, you can t afford to make underwriting mistakes which cost you millions of dollars. You must learn from your losses, not repeat them! The more you learn, the more you will earn!

53 How Should You Charge Off Bad Debts? Charge off bad debts consistently over a loss confirmation period. Value vehicle recoveries at their ACV. Recognize losses as they occur, don t defer them! Losses don t get smaller with time! Maximize recoveries and recognize them when realized.

54 Example What is Static Pool Loss Analysis? Inception Performance Since Inception Origination Units Booked Dollars Loss Units Loss Dollars Static Month Per Period Booked To Date To Date Pool Jan $623, $227, % Feb $563, $219, % Mar $395, $146, % Apr $326, $109, % May $534, $139, % Jun $571, $148, % Jul $648, $145, % Aug $392, $64, % Sep $435, $40, % Oct $652, $62, % Nov $422, $21, % Dec $761, $51, % Total for Year 742 $6,327, $1,376, % ANNUALIZED DEFAULT RATE 55.66%

55 Example What is Loss to Liquidation? Inception Performance Since Inception Origination Month Units Booked Per Period Dollars Booked Dollars Liquidated Loss Units Per Period Loss Dollars Per Period Losses to Liquidation Jan $623,527 $552, $227, % Feb $563,609 $474, $219, % Mar $395,740 $339, $146, % Apr $326,029 $223, $109, % May $534,163 $346, $139, % Jun $571,195 $395, $148, % Jul $648,549 $394, $145, % Aug $392,917 $190, $64, % Sep $435,502 $194, $40, % Oct $652,717 $289, $62, % Nov $422,052 $171, $21, % Dec $761,749 $188, $51, % Total for Year 742 $6,327,749 $3,760, $1,376, % ANNUALIZED DEFAULT RATE 55.66%

56 What Can You Learn By Using Performance Metrics? 1) How much of your financing profit you really collect. 2) You can project your future losses. 3) How your portfolio performance compares with your peers, with your prior results and to identify important trends. 4) You can use to forecast future cash flow. (Continued)

57 What Can You Learn By Using Performance Metrics? 5) Use to calculate the return on your portfolio investment. 6) Information needed to build a credit scoring system. 7) Use to estimate the value of your portfolio or the LOC advance rate it will support.

58 What Are Loss Curves And Why Are They Important? Loss curves graph loss trends to help you identify meaningful patterns and trends. They are needed to project future losses. Loss curves can be used to measure severity in dollars or frequency in units.

59 Static Pool Net Loss (Dollars) By Period Measures Severity Net Loss $4,000, $3,500, $3,000, $2,500, $2,000, $1,500, $1,000, $500, $0.00 t=1 t=3 t=5 t=7 t=9 t=11 t=13 t=15 t=17 t=19 t=21 t=23 t=25 t=27 t=29 Months Since Origination

60 Static Pool Defaults By Period Measures Frequency Accounts Charged Off t=1 t=3 t=5 t=7 t=9 t=11 t=13 t=15 t=17 t=19 t=21 t=23 t=25 t=27 t=29 t=31 t=33 Months Since Origination

61 In Order to Succeed in BHPH You Must Avoid the Ten Fatal Underwriting Pitfalls!

62 Ten Fatal BHPH Underwriting Mistakes You Must Avoid To Be Successful! Based upon analysis of over $10 billion in BHPH loans by:

63 Mistake 1: Not determining that your installment contracts and documents are compliant with all the applicable laws and regulations. (Making legal and regulatory mistakes can bring you down!)

64 Mistake 2: Improper deal structure: not properly matching the customer, the vehicle, and the deal structure when granting credit. (Selling a customer the vehicle they want instead of the one they can afford!)

65 Mistake 3: Not running a credit bureau report prior when granting credit. (Initially saving a few dollars ends up costing you millions!)

66 Mistake 4: Emphasizing sales growth over good underwriting. (Growing too fast can be fatal!)

67 Mistake 5: Not independently (separate from the sales function) verifying stipulations or customer applicant information. (There is an inherent conflict of interests between sales and good underwriting practices!)

68 Mistake 6: Not learning from your losses! (Making trial and error mistakes can cost you millions!)

69 Mistake 7: Modifying or extending the term of the loan in order to meet the customer s payment requirements. (In BHPH, time is your enemy!)

70 Mistake 8: Letting a large down payment (like a tax refund) make the deal instead of making the deal better! (Confusing down payment with repayment!)

71 Mistake 9: Not properly managing portfolio risk by adapting to changes in economic conditions. (Dealer education, reading and networking are your best defenses here!)

72 Mistake 10: Not monitoring or using credit scoring or deal stipulations to make underwriting decisions more consistently. (Frequent changes in underwriting policies and practices can be very costly!

73 Where to Get More Specialized BHPH Training?

74 NAT IONAL ALLIANCE OF B U Y H E RE, PAY H ER E DE A L E R S

75 NAT IONAL ALLIANCE OF B U Y H E RE, PAY H ER E DE A L E R S

76 Questions At this time you are welcome to ask questions on anything covered in this presentation Kenneth B. Shilson, CPA Subprime Analytics 2180 North Loop W., Ste. 270 Houston, TX VISIT BOOTH #132!

National Alliance of Buy Here, Pay Here Dealers (NABD) 2180 North Loop West, Suite 260 Houston, Texas

BUY HERE, PAY HERE INDUSTRY BENCHMARKS/TRENDS - 2010 - CONTRIBUTORS: www.bhphinfo.com www.sgcaccounting.com www.ncm20.com www.subanalytics.com www.subanalytics.com National Alliance of Buy Here, Pay Here