SUB-PRIME TIME

By Adam Zagorin/Washington

Who will win this year's race to become America's highest-paid chief executive? With little more than two months remaining in 1996, the favorite by about 50 Rolls-Royce lengths looks to be Larry Coss, 57, a self-effacing former used-car dealer, whose total compensation as CEO of Green Tree Financial Co. in St. Paul, Minnesota, is streaking toward the $100 million mark. Coss, whose company specializes in financing mobile homes, motorcycles and other big-ticket consumer items, walked away with $65.6 million in salary and bonus last year, leaving better-known titans like Sanford Weill of the Travelers Group and Jack Welch of General Electric in the dust.

Measured by performance, Coss, whose pay consists overwhelmingly of Green Tree stock, may deserve a little extra in his packet: he has managed to boost the company's value at a torrid 83% compound rate over the past five years, making it one of the hottest issues on the New York Stock Exchange and winning encomiums from the likes of Fidelity mutual-fund guru Peter Lynch. Just last week Green Tree reported record earnings of $227.3 million through the third quarter and a stunning 50% increase in its loan volume, to $7.57 billion over the same period last year.

Green Tree represents the rapier edge of a red-hot specialty: the business of making loans to people with damaged credit at interest rates that start at high and extend to very high and nosebleed. Depending on where you sit--whether you are the lender or the borrower--this is either an industry filling an underserved market, or legal usury. Often known as sub-prime finance, the sector is taking off in part because of sophisticated software that allows even onetime deadbeats to get loans approved in minutes over the phone or as they sit in the offices of mortgage brokers or car dealers. An even bigger factor in the explosion: people with lousy credit represent a massive and largely untapped market for new loans. Most of them are working folks who don't qualify for conventional bank financing, perhaps because of a past lapse or a layoff. On average, they are far more likely to default, but they are willing, even eager, to pay up for credit.

In the odd twists of finance, these lesser customers now represent the greater opportunity. Regular bank customers who pay lower rates are no longer borrowing as much as they did. There's a reason: the better-risk customers are tapped out, having run up record levels of debt over the past couple of years in a spending boom. This anomaly, according to Joe Jolson, a leading analyst at Montgomery Securities, is "one of the best-kept secrets on Wall Street."

Was. Competition for down-market customers and the profits they generate is intensifying among big mortgage providers like GE Capital, Norwest Financial, KeyCorp, NationsBank and Chase Manhattan, not to mention heavily advertised smaller outfits like the Money Store (Dial 1-800-LOAN-YES). The total for sub-prime mortgages--a figure that is growing at twice the rate of conventional mortgages--is expected to exceed $120 billion this year. Another blistering market: sub-prime cash for new and used cars. Ford Motor Co.'s Associates Corp.; Mercury Finance, based in Lake Forest, Illinois; Credit Acceptance Corp. of Southfield, Michigan; and other lenders this year will provide at least $70 billion to put people with dented credit behind the wheel.

The search for capital to fuel the industry has sparked some 25 recent initial public stock offerings, many in the past year. Shares in a number of the newly public mortgage and auto-finance companies are up astronomically: Southern Pacific Funding is up 82%, Cityscape Financial has risen 288%, and RAC Financial Group Inc. has appreciated 300%. All of them have launched ipos within the past 12 months. Another shot in the arm has come from major Wall Street underwriters, including Lehman Bros., Alex Brown & Sons and Merrill Lynch, which buy and bundle sub-prime loans, selling them off to investors as asset-backed (mobile homes, for example) securities. The transactions help get risk off lenders' books, as proceeds are plowed back into new loans, and the cycle starts anew.

How is it possible to make so much money handing out billions of dollars to people who are less likely than others to hand it back? Easy: charge a lot more to compensate for the extra risk. Depending on his or her credit rating, a sub-prime customer will often pay between a third and a half more in interest than a more credit-worthy borrower.

On a 30-year mortgage, a sub-prime borrower pays 11% to 15% interest, in contrast to the 7.75% that banks charge their better-risk customers. On a $50,000 loan, that amounts to $118 to $234 in added monthly payments. Often there are extras such as points, which in the sub-prime market can be a charge of up to 7% of the loan value, not to mention the hefty fees that are demanded by brokers. Throw in ostensibly optional insurance to cover debtors in the event of disability, loss of life or unemployment, and the total interest costs can double. Despite these drawbacks, customers rarely balk because they have few alternatives outside of pawnshops, rent-to-own stores, check-cashing chains or guys with ominous nicknames.

Indeed, the sub-prime loan pool often resembles a vast ocean at the dawn of commercial fishing. Among the easiest borrowers to hook are the 20 million to 30 million people, including immigrants, who have no bank account or credit history. They often can't get the time of day from bank lenders, who have had to tighten standards in the wake of the savings-and-loan scandals of the 1980s and must conform to strict credit criteria if they want to resell their loans to government agencies like Fannie Mae (Federal National Mortgage Association).

The past decade has produced an increasing number of consumers who have scraped their bottom on one of the economy's speed bumps. Included are the more than 6 million people who have filed for personal bankruptcy so far in the '90s. Says J. Terrell Brown, CEO of United Cos. Financial Corp., a big sub-prime mortgage company in Baton Rouge, Louisiana, that reported record earnings last week: "Company downsizings, stagnating incomes, death, disability, rolling recessions, divorce--we want to bridge folks through financial hard times and lend based on their credit future, not their past." United, which first sold shares to the public in 1971, was founded right after World War II and specialized in making loans to soldiers returning home.

Once customers are in the door, the successful sub-prime lender keeps them on a tight leash. Within days of missing a payment, the delinquent is contacted to work out a new repayment schedule. If that doesn't work, repossession of car, house or other collateral often follows quickly. And when loans do go bad--in some parts of the industry, losses run 10% or higher even during good times--in-house or outside collection agencies and networks of "repo men" may be called in. Independent bill collectors alone employ an army of 65,000 people, who deploy everything from computerized phone banks for dialing deadbeats to liens and litigation.

CEO Coss founded Green Tree in 1975 to finance trailers and recreational vehicles. Mobile homes remain its biggest business--the company claims 28% of the market--as it diversifies into leasing office products and secured credit cards. Most mobile-home customers are first-time home buyers or retirees with annual incomes of about $26,000; the trailers cost an average of $34,000. Green Tree's break came in the 1980s, when the savings-and-loan crisis drove many thrifts out of the mobile-home market. The company moved quickly into the vacuum. The gamble paid off big when the mobile-home market took off in the early 1990s. Since then, the firm has upgraded its relationship with dealers, establishing 24-hour service centers in St. Paul and Rapid City, South Dakota.

Coss, the company's founder, keeps a low profile. A rider and an aficionado of Thoroughbred horses, he likes to relax on his South Dakota ranch or at another residence in Flagstaff, Arizona.

Making high-cost loans to lower-income borrowers doesn't sound like God's work, and the industry continues to hear criticism that it takes advantage of unsophisticated or desperate customers. "There is a whole segment of lenders who target low-income families and try to trap them in a vicious cycle of debt," complains Congressman Joseph Kennedy, a member of the House Banking Committee, who has pushed successfully for legislation to limit mortgage interest and fees. "It's a strategy that allows them to rake in hefty profits off the misery of others."

The industry has attracted numerous lawsuits around the country filed by customers who claim they have been ripped off. In a case that drew considerable public attention, an Alabama jury found Mercury Finance liable for fraud involving an auto-loan scheme that allegedly netted the firm hundreds of millions of dollars. The collection agencies that work hand in glove with the lenders have also been targeted for harassing or even threatening delinquents.

To the industry and to many economists, it is only logical that risky borrowers should pay more for credit. But those same laws of economics should work for consumers too. If the spectacular growth

of sub-prime continues, it will attract enough new competitors to act as a brake on interest charges. By that time, however, Green Tree's Coss won't be making $100 million. Shareholders recently voted to calculate Coss's pay using a new formula. If the company's performance continues at its current level, that would limit his salary and bonus to the $7 million range. Even at that, he seems like a good credit risk.