Subprime Mortgage Lessons from the Used Car Lot

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Includes: AIG, CFC, IMPM
by: Michael Steinberg

When American International Group’s (NYSE:AIG) former CEO Hank Greenberg said publicly that he was not responsible for the huge write downs of bad assets placed on the books during his reign, I only partially agree. Greenberg’s point was that a company should not just sit on assets when the market changes; assets need to be actively managed. He blames the current management for not hedging.

Subprime loans pay a premium for a specific reason; they require extra care. Here’s where Greenberg and I part company. The care required is not managing the mathematical odds of default rates and recoveries. The extra care required is in nurturing the borrowers with the proper balance between carrots and sticks to keep the loans profitable.

The Impac Mortgage Holdings (NYSEMKT:IMH) conference call was quite interesting in that regard. Impac went through an excruciating period of consolidation and is starting its rebuilding phase. Investors certainly needed an iron stomach to continue buying when the stock bottomed at 20 cents. Impac said that early buyers of distressed mortgages stood little chance of success because they did not control the servicing rights.

Impac is in the process of purchasing a small servicing platform, before buying any distressed assets. Heavily discounted distressed mortgages are only a good value if they can be reworked into profitable loans. Investors cannot systematically rework loans if they do not control the servicing. As important, investors cannot nurture their borrowers if an independent servicer stands in the way.

The interest of investors and servicers are far from aligned. Countrywide (CFC) has shown that it is far more interested in collecting all kinds fees and penalties than working out distressed mortgages.

The new breed of distressed mortgage funds seems to be the “free market” solution that both Treasury Secretary Paulson and Federal Reserve Chairman Bernanke could feel comfortable with. These funds are buying delinquent mortgages with the intent of borrower workouts. Deeply discounted mortgages can still be profitable with lower payments. Time will tell how successful these new funds will be without controlling the service rights.

Providing financing for used cars in the rural southern states can be just as challenging as providing subprime mortgages. The key difference is there is never any hope for appreciation of a used car. Auto loans are almost always underwater from the start, so dealers are using new technology to track their riskiest customer’s collateral. The Financial TimesAmerican dream boosts used-car dealers” reports the dealers are starting to install a remote operated starter-disabling device to discipline borrowers to pay, and global positioning systems to find vehicles in need of repossession.

While the regulations for managing auto and mortgage debt differ, the mortgage industry can learn from the auto loan industry. Given the inherent high risk of all auto loans, these lenders must be on the cutting edge of managing their customers.

Disclosure: Author is long CFC and IMH.

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