Last week the Securities and Exchange Commission filed suit against the principals behind the DriveUSA used car superstores accusing them of by running their company as a huge Ponzi scheme. The lawsuit explains how their greed apparently drove them to defraud their investors out of tens of millions of dollars. It also shed some like on the murky dealings of the sub-prime auto industry that preys on people with poor credit.
Sub-Prime Dealers Are No Bargain
Dealers that make loans to people with poor credit typically sell them lousy cars for way more than they are worth. They buy worn out cars at an auction for $1,000 each, clean them up a bit, and sell them for $3,000. The buyers agree to make monthly payments, at very high interest rates, but the dealers don’t not want to wait for the loan payments – they want cash. (They also know people will stop paying the loans once their cars break down and need expensive repairs.) So the dealers sell the loans to a sub-prime lenders like Inofin or Mid-Atlantic Finance. According to paragraphs 26 – 31 of the SEC lawsuit, Inofin bought loans by giving dealers an up-front payment of only 68% of the loan amounts.
Here is how that math can work when a dealer sells a $1,000 car to a customer for for $3,500 ($500 down + $3,000 loan).
$ 500 Customer #1′s Down Payment
$ 2,040 Lender Pays Dealer for $3,000 Loan Customer #1 Signed
- $ 1,000 Dealers’ Cost For the Car
$ 1,540 Dealer Profit
Selling The Same Car Again and Again
When a customer stops making payments, the lender makes the dealer ‘buy’ the loan back by paying the lender however much is still owed on the loan. But the dealer can still make money by taking the car back and reselling it to its next victim . . I mean ‘customer.’
For example, if Customer #1 stops paying the loan after paying only $1,500, the dealer ‘buys’ the loan back from the lender, repossesses the car, cleans it up again, and resells it. Here is how that math can work if the dealer resells the car to Customer #2 for only $3,000 with $500 down and a $2,500 loan:
$1,540 Dealer Profit From Sale to Customer #1
- $1,500 Dealer Pays Lender to ‘Buy’ back Customer #1’s Loan
+ 500 Second Down Payment
+ $1,700 Second Lender Pays Dealer for $3,000 Loan Customer #2 Signed
$2,240 Dealer Profit