Used Car Dealers and the Bankers that Finance Them

by Regional Examiner Jeff Bagby, Oklahoma State Banking Department

Good luck is all I've got to say. If you're going to begin or are already funding floor plan lines on used car dealerships, you will need plenty of luck. And I don't even believe in luck.

If it were just a few banks taking hits, it wouldn't be worth the rant. But there's a pattern here. One banker put it well, "It's not a matter of if they will take you, it's when." To be fair, I believe that there are upstanding, honest people who just happen to be in the used car business. But let's face it, this industry draws criminals like bugs to a street light. This is not news to the average American, I understand that. Yet, why do bankers continue to get their hats handed to them?

I was just in a bank - a good bank - that had losses from more than one used car dealer, and a fistful of Suspicious Activity Reports they had already filed on other dealers/customers that had made their mark. The latest involves a dealer who was simply manufacturing fraudulent titles and borrowing against vehicles that did not exist. The bank is mitigating their exposure the old fashioned way. The crook's silent partner in the dealership is extremely wealthy and was willing to make the bank whole once he found out what was going on.

There are spin-off industries arising from the used car business as well. One dealer has been selling cars to extended "family" members, who in turn go from financial institution to financial institution borrowing money to purchase the same car over and over again. Reportedly, the scheme brought down two institutions before the bad guys oozed into surrounding banks. By that time, word was getting around to lenders, which curtailed most available credit.

Very recently, a smaller bank was nearly declared insolvent because a single customer was allowed to kite checks through various accounts both personal and business for an extended period of time. Whether genuine or fabricated, the managing officer of the bank stated that he believed the customer was simply conducting the functions of his business. What was his line of business, you ask? A used car auction company.

Yet another proactive used car dealer regularly purchased cars out of state for his humble lot in a small town. The curious thing was, when examiners occasionally inspected the bank's collateral, there were rarely more than one or two cars on the lot. "Reportedly" he went to all that trouble because the pre-owned vehicles were used as mules for his drug-running business. Who knows? The bank sure didn't.

These are just a sampling of typical horror stories, but there are banks that have floor plan lines on well-meaning borrowers that go up in smoke also. And it's nearly always due to weak supervision. That could be deceptive however. "Weak supervision" implies that the item supervised was actually controllable. Maybe one in ten used car lines stays under control, and the servicing officer retains a clue as to what is on the lot at any one time. AND the collateral matches with the amount borrowed. Which is the overriding problem. The collateral morphs and changes so rapidly, very few if any loan officers have the time and focus to devote the proper supervision to such a line of credit. It's like kids bent on causing trouble. You have to watch them 24/7. Okay, maybe 2/5 is more reasonable when referring to slippery loan customers, but how much are you paying that loan officer to devote 20% of the workweek to properly monitor that customer?

Used car floor plan lines can work. Theoretically. Unfortunately, you need a borrower who is honest and willing to keep you the lender accurately documented and well informed. In addition, the lender must maintain reasonable equity in each vehicle. Equity? Based on what value? Was that market value established before or after the latest buyer won the demolition derby with your collateral? What do you mean they packed up the bank's car and moved to Montana? You can "theoretically" win the $100 million lottery too.

Regulators will not typically tell you to avoid an entire industry when originating loans. And this is no exception. There is some money to be made financing used car sales, but the risks are high. You have to mitigate that risk somehow. As with any lending focus, you must be realistic about the amount of risk you are assuming and to what extent you must go to offset that exposure.

Financing used car sales is perilous. Somewhat like jumping out of an airplane in flight. The very moment you commit physical assets, your risk has greatly increased and your immediate future could get ugly. Whether it is a hard or soft landing is up to you. I suggest you bring a properly prepared parachute (risk reducer).

As it pertains to used cars, whether your parachute is deeper discounts, larger dealer reserves, limits on the number of cars financed per month, or more frequent and detailed inventory reports is your call. But the risk is real and it is good to know you did everything in your power to reduce the potential of a hard landing.

Jeff Bagby is a Regional Examiner with the Oklahoma State Banking Department. He has spent 17 years in bank regulation which includes a wide spectrum of knowledge and experience. In the early part of his career, the banking industry in the central region of the United States endured its most devastating era since the FDIC was established bringing with it numerous bank closures. In addition to writing examination reports and working with bank management, Jeff teaches Loan Officer Seminars aimed at revealing to bank lenders how and what an examiner looks for when reviewing loans.

Jeff received a B.B.A. from the University of Oklahoma in 1985 and is a graduate of the Conn Graduate School of Community Banking.

First published on BankersOnline.com 1/12/05