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Male Speaker: Broadcasting live from the Business Radio X Studios in Atlanta, Georgia it’s time for Capital Club Radio, brought to you by Flock Specialty Finance.

Michael: Good afternoon. This is Michael Flock, Chairman and CEO of Flock Specialty Finance. I'm delighted to be here this afternoon with Ken Shilson. Ken is the icon of the subprime auto finance industry. He has a very interesting, colorful, and successful story for us this afternoon. Ken is well known for being the founder of NABD, which is the National Alliance of Buy Here Pay Here Dealers, the largest trade association in the used car dealer space at 10,000 members.

Ken is a CPA and serves as President of the Subprime Analytics and Profit Max Consulting Companies. They provide subprime portfolio analysis services and custom credit scoring solutions. Subprime has state-of-the-art data mining and extraction technology, which identifies loss trends and areas for underwriting improvement. Profit Max integrates with Subprime Analytics to provide a web-based custom credit scoring solution.

Ken delivers due diligence services for banks and financial institutions that provide capital to the subprime auto industry. He has helped pioneer an IRS approved tax strategy for Buy Here, Pay Here dealers regarding the use of a related finance company. He’s authored many articles on accounting, tax, and other matters related to this industry, and he has been a speaker at numerous national automotive conferences and conventions.

So we’re really honored and thrilled to get Ken here. It took us about a year to get his schedule in sync with ours. He’s in demand in this industry and I'm just so honored that he made time to see us this afternoon.

Ken; let’s just start with how you got into this space. Not many of us when we go to school, I dare say, think “I'm going to grow up and be a used car dealer.” How did you go from accounting to used cars? What was the evolution? How did this all happen?

Ken: First of all, Michael, pleasure to be with you here today and thanks for the great introduction. You didn’t mention my golf game so you must have seen me play, I guess.

Michael: No, but you’re a scratch golfer and I'm a rookie.

Ken: First of all, when I started my CPA firm in the early ‘80s, I wanted to find a niche market to serve. And I found that within the different marketplaces, the auto finance business is one of the largest industries out there. When I did some research, it seemed like everyone in my profession was gravitating to the new car franchise business. They all wanted to serve franchise new car dealers; nobody wanted to take the used car space. So I wanted to be a contrarian because I thought it would be easier to build my practice, and that turned out to be exactly right.

The used car industry was really underserved at the time. It gave me an opportunity to build a niche market for my CPA practice.

Michael: So it’s underserved and I also think it probably was very fragmented, is that right?

Ken: It really was. When I first started to focus on subprime auto finance, I found that there was a huge disconnect in the market. The capital providers seemed to be skeptical of whether it was a good business to lend to. The operators in the business didn’t really understand how to partner with a capital provider. So really through the years, I've been able to help bring those two together. I've been able to bring Wall Street and the capital markets to Main Street, so to speak. So I’m glad that we’ve finally found a partnership there. And today, capital is really flowing into this marketplace.

Michael: Right, and that’s exactly how we met you, I think, because we’re capital providers and we like large, fragmented, underserved or even ill served markets. And for our listeners’ benefit, that’s how we met Ken. We are interested in partnering with Ken – we are partnering with Ken, both in the charged off financing market as well as the originations of subprime loans. So that’s exactly how we met with you. What’s your vision, going forward, for these companies that you manage? Not just NABD but also Subprime and Profit Max?

Ken: I think that first of all, the auto finance business has just reached over $1 trillion in outstanding (loans?) - it’s a huge marketplace. And we estimate that the subprime, deep subprime buy here, pay here space is about $100 billion outstanding. So it’s a large market and a large opportunity. Right now, because of the last two years, it’s become very competitive.

But I'm starting to see some of the competition ease up. I think there’s a great opportunity going forward for the independent dealer to get some of the customers back that they’ve lost to competition. As well as get the vehicles back that have been involved in some of these big Wall Street securitizations that have taken place in the last couple of years. So I think there’s a great opportunity for independent dealers to really thrive in the future.

Michael: What’s causing this trend?

Ken: Wall Street. When the subprime mortgage business kind of dried up and fell apart, Wall Street began to look for other opportunities to package up asset-backed collateral. They moved over into the auto finance space because money is so cheap and investors are seeking higher yields than they can get with other types of investments. The subprime auto finance business, if done right, offers one of the highest yielding alternatives that are out there.

So it was a natural for Wall Street to package up these auto bonds, securitized and collateralized by automobiles or vehicles, and then lay those off to investors who perceived that the risk and reward justifies investing in it. And certainly that’s been the case. Some of these transactions have been $100 million, $150 million, $200 million… and we’ve seen a huge marketplace for this in 2014 and 2015.

Michael: So you’re suggesting that the yields are better in the independent market?

Ken: I think that what’s happened is, a lot of the money flowed into independent finance companies; people who were not in the business saw an opportunity to invest in the business but hadn’t had a lot of experience in dealing with the deep subprime customer. Not all the securitizations are bad; many of them are mixed in terms of higher credit quality with lower credit quality.

What’s happened in the lower credit quality space… it takes a lot of experience, it takes a lot of training, and it takes a lot of expertise to make that deep subprime portfolio work. And I'm not sure that the securitization market has quite focused on the experience and collection expertise that’s needed to pull that all off.

Michael: How would you characterize the difference between subprime and deep subprime?

Ken: Great. Generally speaking, subprime is consumers that have a credit bureau score of 600 or less. And deep subprime is 500 or less. So 501 to 600 would be subprime customers, and under 500 would be deep subprime. Deep subprime is often referred to as working with the unbankable consumer because they typically aren’t able to find a traditional loan from a bank or a credit union. So they have limited financing opportunities.

Michael: And that’s where the independent financers have the greatest share?

Ken: The two biggest players in that deep subprime market are independent owner-operators and finance companies like you were saying earlier - who don’t own their own lots but are providing financing to operate.

Michael: Who are some examples of that?

Ken: There are several that I can think of. Santander has been one of the most aggressive lenders into the subprime market. But in the deep subprime you’ll see people like Capital One, Ally, even Wells Fargo has provided capital to that deep subprime market.

Michael: Even Wells?

Ken: Wells tends to gravitate more to loaning to finance companies who then re-loan out to independent dealers. So those are three of the bigger ones.

Michael: We all keep hearing about and reading about the big bubble building in auto. We’ve heard that it’s not as bad as the bubble in mortgage several years ago but it’s going to be a bubble and at some point in the next 12 months it’s going to burst. Do you share that view? And if so, why?

Ken: I don't think it’s going to be like the subprime mortgage bubble. First of all, there are several significant differences. In the mortgage business, when they securitized mortgage properties, they basically expected the underlying value of the property to appreciate in value as part of the return. But in an auto bond securitization, the collateral is projected to depreciate. They’ve also built in other protections since the subprime mortgage finance securitization business.

So there are additional reserves and other protections built into the auto bond market. So I think where the problems lie are in that deep subprime securitize portfolios where they were overly aggressive in trying to gain market. Where they went deeper in the credit spectrum, where they just tried to sell more new cars by selling them to lower credit score customers, or credit unions decided to expand their portfolio so they were very aggressive. So it’s really that deep subprime tranches that are experiencing the problems.

Michael: Is that due also to the fact that we’ve heard that many of them make their money on the markup of the car?

Ken: Yes, that’s absolutely right. In the deeper subprime space, typically the higher the financing rate, and usually there’s a higher markup with the vehicle, as well. And simply because those customers have had bad credit histories and have very limited credit alternative so it stands to reason that they’d have to pay a premium because of their poor credit history.

Michael: And I guess that the dilemma may be that they’re paying a premium with a higher markup but on an asset that’s depreciating. Is that correct?

Ken: That’s right. I think another thing that differentiates the independent dealer from the finance company is that a dealer will keep the car running during the life of the contract. In other words, he’s providing a transportation solution. If the car breaks down, they’ll finance the repair or help the customer get the repair done so that the vehicle keeps running.

Typically, in a securitization market, there’s no provision for that after the warranty wears off. In addition, finance companies don’t typically like to finance repairs. So the independent operator is really doing a different type of financing than what we’ve seen in the aggressive underwriting in the securitization market.

Michael: Talk to us a little bit about the three companies that you are president of: Subprime Analytics, Profit Max and then NABD. What’s your management philosophy and vision for them, and what are the benefits that you bring to the clients in those companies?

Ken: In looking at the subprime auto finance space, success is measured by keeping the vehicle sold and the contract performing over the entire life of the contract. In order to do that, you have to know how to manage risk. You have to know how to underwrite a customer properly, you have to know how to collect properly, and most importantly, you need a lot of experience and training to do it right. You have to start with the right business model.

It’s got to be cash efficient. In other words, like any other investment, you want to maximize your return on whatever money you put in. so that means you’ve got to start with a reasonable investment that’s going to have an opportunity to return itself over the term of the contract and keep that contract out there.

So I developed Subprime Analytics so that I could monitor and measure performance in these portfolios and help identify adjustments that have to be made over the life of the contract, and help the operator get a cash efficient business model to start off with; one that’s going to be successful and keep him on track over the term of the loans. And that’s proved to be the case.

I've done almost $16 billion worth of analysis in Subprime Analytics; I think I have the largest database in the country on this type of paper. What we’ve learned is what works and what doesn’t work. So I'm able to share that information with owner/operators and with capital providers to do it right and be successful. Because it is a very capital-intensive business.

At NABD, I realized back in the late 1980s that no one was really focusing or serving or training that segment of the industry. We had other trade groups out there that really weren’t differentiating with the needs of the deep subprime space. So I decided to start NABD where we could not only focus on it, but promote the interest of the self finance industry. So those are really the two organizations.

I think over time, we’ve built more than 13,000 members in NABD, which shows the growth and progress that we’ve made. And in Subprime Analytics, as I said, over 1.5 million loans have been analyzed with over $16 billion worth of analysis; a great deal of information there that’s very valuable to the industry.

Michael: When you talk about the consulting services of Subprime Analytics, do you also, by definition, just include Profit Max with that? How has the integration of those databases enriched the solution that you’re providing your customers?

Ken: At Profit Max, typically when we do an analysis of a portfolio, we find ways that the portfolio could be improved. We identify specific areas of improvement. Operators would want a credit scoring solution to help them implement those changes in their underwriting. So I ended up actually licensing Profit Max from my first customer who developed a web-based solution for it and it’s been very successful.

It’s helped several operators get on track. I think that what it does do is it provides a great deal of customer information. We’re able to gather information about the customers where Subprime Analytics would focus on the vehicles, the deal structure, and any other financing products that are in the financing itself. So they complement each other very well.

Michael: You used the term state-of-the-art data mining. Can you give me some examples of how you provide that?

Ken: I think that one of the challenges has been, where do you get the data to analyze it. And it’s generally stored in the dealer management software systems in about six or seven major software packages that serve the deep subprime and the subprime auto finance industry. Over the years, I've developed a data extract with all of those dealer software providers to send me the data in exactly the form that I need.

So that means our customers don’t have to do anything except just authorize the extraction. We get the data. They don’t have to handle it; they don’t have to do anything with it. Then we will go in and analyze it and identify any data exceptions before we run the analysis; give the customer a chance to correct those.

Michael: So it makes it a lot easier to use.

Ken: Absolutely.

Michael: You don’t have to be an IT geek to use this, like I am and you are.

Ken: Yes, you don’t have to have an IT department to do this; all you have to do is authorize your software provider to give us the data extract.

Michael: Terrific. Another issue that faces subprime auto finance, and it’s an issue that we face in financing companies that provide subprime credit and those who sell charged off debt - compliance regulation. There’s been a lot of political controversy, I think, in this subprime auto space particularly as it relates to this issue of different races. I think people in our government said some of the credit scoring is racist. Is that a hot issue in the auto industry with subprime auto finance?

Ken: There have really been two areas of focus so far in the compliance area as related to the subprime auto finance business. One has been discrimination; profiling and basically excluding certain races from financing opportunities. I think the second of it has been there’s a concept called disparate impact, which the regulators have focused on. Meaning that if you’re out of step with the rest of the industry or what others are doing, then you become a target to be singled out and be put under the microscope.

Michael: As a capital provider or as a used car dealer?

Ken: Both. Sometimes those distinctions are made by complaints from consumers but other times they just are discovered by simple investigations that are conducted by the regulators. When they’re spotted, again if you’re out of step with the rest of the industry, you stand to really be challenged about that; why are you doing this? Why are you charging premiums? Why are you marking these vehicles up above what your competition is doing? There has been some case law on that in the last couple of years.

Michael: So then what advice would you give providers in this space who are listening today as well as used car dealers? How do you manage this?

Ken: If you’re loaning to somebody who’s in this space, you need to insist that they have a compliance management system. It starts with a chief compliance officer to oversee it. But then it goes way beyond that. And the regulators have proposed certain contents of a compliance management system which is really a series of checks and balances to make sure that a compliance function is in place at every dealership.

Lastly, if you have a consumer complaint, the regulators are looking for an internal solution by that operator or by that capital provider; how are they dealing with consumer complaints? Are they solving them fairly and expeditiously? If not, why not? And they have policies and procedures to deal with those types of things. So, in summary, a compliance officer, a compliance management system and a complaint management protocol process to deal with these types of complaints.

Michael: Do your companies provide guidance in this area?

Ken: One of the main things we do at Subprime Analytics is to compare a dealer’s business model with their peers so that they can understand if they are doing something differently than their peers and if they’re going to stand out. If they’re charging too high of an interest rate, if they’re marking the vehicle up too heavily, if the term is different, if they’re being maybe too tight on certain areas or discriminating amongst consumers; we help identify those things so that they can correct them before they have a regulatory problem. I think that’s extremely important.

Also, we’re checking the validity of the data so that if there are errors or omissions in the data, we help them catch that before it becomes a regulatory problem. So those are the main things that Subprime Analytics can do on the compliance end.

Michael: Does NABD have some compliance programs or seminars or webinars?

Ken: Absolutely. In our national training conferences. We typically have two major ones a year; one in May, always in Las Vegas and then in the fall that we move it around the East Coast. We have the top attorneys in the United States come in and update us on all the regulatory developments. We just had a director of the Federal Trade Commission speak at our last show to talk about what their concerns are about the industry.

So we’re helping dealers and operators and capital providers understand what the issues are out there so that they can work through those issues. We make them aware of industry developments. We give them a chance to interact with the regulators.

The other thing is as a special interest group, NABD works closely with other trade associations like National Auto Dealers Association, National Independent Auto Dealers Associations and various state associations to help represent the industry positively in regulatory matters.

Michael: And I think you’re also partnering with a group in our industry, the Debt Buyers Association. Is any of this overlapping?

Ken: Absolutely. We have a great deal of respect for the compliance program and the educational programs that the Debt Buyers Association have provided. I know you’re very active and Flock is a major participant in the Debt Buyers Association; a really quality organization. And we’ve just become an educational partner for them. Meaning that if you’re a debt buyer, you can come to one of our conferences and get credit towards their educational requirements in certification by attending one of our events. We hope to reciprocate by participating in their events, as well.

Michael: Ken, let’s shift the discussion a little bit to you as an entrepreneur. Many of our listeners are entrepreneurs, and they all like to hear success stories and stories about the ups and downs of how businesses are built and grow. Could you share with us a little bit more about your thoughts on what you have learned along the actually many decades that you’ve been in this industry, managing as the founder of NABD and also Subprime Analytics?

Ken: I think the first thing, as I mentioned earlier, both with NABD and Subprime Analytics, it’s important to find a niche. It’s important to find a niche that’s different in that you can develop and grow in. That’s what I did both with NABD and Subprime Analytics. But I think the second thing comes from both my family background and my educational training, and also being a CPA; how very, very important it is to have good financial management in any business that you’re doing. You must have good accounting. You must be able to estimate the capital needs that you’re going to have and raise that capital in order to implement any business plan.

You’ve heard the saying, “People don’t plan to fail; they fail to plan.” Part of that planning has to come with looking at the capital and looking at the financial resources and the financial management. That’s absolutely essential in the subprime auto finance base because the most successful auto finance operators have a good financial management function and a good chief financial officer.

Michael: Because those are the two common denominators you see in this space?

Ken: Absolutely.

Michael: And you’ve applied them, I assume, to your work with your own companies?

Ken: No question about it. I think managing the financial affairs of any business is a job in itself. When an entrepreneur has an idea, he has to be able to evaluate the cost of implementing that idea and the impact that it’s going to have on his business. That’s where a good financial person comes in.

Michael: Growing up, I know you’ve told me that your dad was one of your heroes. Did you learn any of this from him? I remember you told me when we first met that he recommended this book which I have here, The Richest Man in Babylon, by George Clason. The success secrets of the ancients, the most inspiring book on wealth ever written. Could you comment on what you learned from your dad and how he inspired and taught you?

Ken: You’re absolutely right; my dad was my hero and most importantly, aside from loving him, I had tremendous respect for him; the way he not only was successful in business but also successful in his own personal life. He instilled upon me the importance of prudent financial management. He taught me that money is not there to be squandered; it’s there to be preserved. Wealth is there to be preserved.

And again, good financial management does that. When I was just 12 years old, I asked him some questions about why we weren’t spending more money as a family, he suggested I read The Richest Man in Babylon. He said it was the greatest financial book ever written. And I have to agree with him. I would encourage everyone to read this book. I think the message is let the money be a slave to you; not you be a slave to making money.

Michael: As I read the book, there are a couple principles in there I was going to ask you about. One was “little caution than a great regret.”

Ken: Absolutely. I think again, good financial management comes with healthy, professional skepticism about whether the idea is really going to work and what the financial impact of it is going to be. So that’s what I was alluding to earlier. I think that’s what that message is.

Michael: Yes, sound underwriting.

Ken: Yes.

Michael: The second principle that applies is, “We cannot afford to be without adequate protection.” So, that speaks to what… collateral and insurance?

Ken: That’s exactly right. In other words, you wouldn’t have a beautiful home without some protection around it. You might have a fence, you might have a security system; you might do other things to protect your homestead. And the same thing is true in building a good business. You build a sound business and then you build some protection around it to keep it successful.

Michael: The last one, which I love is, “Where there is determination the way can be found.” Your life, to the average person, looks like everything has gone as planned, it’s gone in a straight line; you’ve done very well for yourself. But tell us, have there been moments of adversity when things didn’t go the way they were planned and you had to try to use a little determination or perseverance to get through it?

Ken: Absolutely. We all have challenges in our lives and certainly mine has been no exception. I've found that life and business is a journey; it’s a long distance run and you’re going to run into obstacles. And it’s really how you deal with those obstacles.

Michael: Can you give us a few examples and stories? People love stories; they speak volumes.

Ken: First of all, when you leave college and you have a good educational background, you’re not an entrepreneur. You’re still trying to learn how to apply those educational principles successfully to be a good businessman. And then as you start a business entrepreneurially, you have capital challenges, you have people challenges; how do you manage people? How do you grow your business? Marketing becomes very important. These are all skills that you have to develop. They’re not necessarily God-given. So that’s where the determination comes in; you have to constantly thrive to do your best.

But I want to share with you, Michael, something that one of my initial clients taught me in the subprime auto finance business. He said: Ken, if you just treat other people like you would like to be treated yourself; you’ll find that you’ll be successful. And I think that’s some of the best advice I've ever received.

Michael: It’s the golden rule.

Ken: Treat other people fairly like you’d like to be treated yourself. If you always remember that in business, I think you’re going to be better off.

Michael: That’s a great conclusion to this and it’s somewhat paradoxal because people have a view of the used car dealer space as something less than to be desired. Do you think that’s a fair characterization? The symbolism in people’s minds of used car dealers that they don’t treat people the way they want to be treated; is that fair or not?

Ken: Certainly, I think when I first started working in this space, I had the same perception. But my perception now is totally different. Over the last 18 or 19 years that I've been working with this industry, I’ve found them to be some of the best people and the best businesspeople I've ever worked with. Sure, there are some bad apples in the barrel but that’s true in any industry.

I think one of the good things that’s going to come out of this compliance scrutiny that we have right now is causing us to focus more on the consumer and building a stronger bond with the consumer, and treating people fairly and handling their complaints. That’s going to help us be more successful in the long term as we work our way through it. I think those relationships, all relationships, are very important in business.

Michael: I think what you just said also applies to the collection industry at large. It’s got sort of an unfair negative stigma associated with it. There are bad apples, and there are some good things that the compliance initiatives that the government launched have achieved.

Ken: There is, and there will be more coming. I think part of that is that the press tends to focus on the negative and therefore people get that perceptions.

Michael: The headlines sell. That’s exactly right. Ken, what are you reading these days? What’s on your nightstand?

Ken: It takes so much effort just to keep up with what’s going on in the subprime auto finance business that I have to read constantly all the automotive publications. I'm constantly on the internet looking at what’s going on in the securitization market. I work with two investment research firms out of Wall Street so I’m constantly talking with Wall Street firms about the industry and what’s going on. So that keeps me very, very busy. It’s hard to keep up with it. There’s so much information flowing out there right now.

And of course from a compliance standpoint, because of my role in the industry, I've got to keep up with all the regulatory and legal developments so I’m constantly reading about cases that have come up, about regulatory complaints, and working with investigations. I do expert witness testimony so I'm having to keep up with developments there. So there’s no shortage of things to read, that’s for sure.

Michael: And of course your golf game, are you still keeping up?

Ken: My golf game has suffered, definitely, from all the stress. But I still enjoy getting out and playing, Michael, and it’s a great release for me and I really do enjoy it.

Michael: Speaking of relationships, and you’re the master of many of them, I've learned that golf is one of the channels for developing wonderful relationships. I guess when I look back on our time together this afternoon, some of the things I see here in terms of your common denominators of success and I've tried to connect the dots, is that you’ve got to have sound financial management. You’ve got to know what you’re getting into. You’ve got to have good protection. And at the same time, part of that is the analytical data that you use to get there. And then of course the relationships, and you’ve built that with NABD; now 13,000 members.

So it’s relationships, it’s data, it’s analytics, it’s good collateral; kind of sound business management. Which in the end makes it easier for you to adhere to your golden rule. You want to, at the same time, make money but you also want to treat people the way you want to be treated. So I think it’s a wonderful conclusion to our conversation this afternoon, Ken, and I thank you for your time here in Atlanta. Are there any words or conclusions you’d like to share with our listeners?

Ken: I'd just like to thank you, Michael, for the time today. I think this has been great and your summary was spot on. I think the only other thing to add is when you set up a plan and you implement it, you need to monitor it. You need to make sure that it’s working the way you think it is. That’s where the analysis and the back testing and the validation and all the things I learned as a financial person and a CPA becomes so important.

So I encourage everybody. I hope everyone will be successful, build great relationships, and I want the auto finance business to continue to grow. And buy here, pay her is extremely important in this country; I want to see it succeed. It provides transportation to millions of Americans who otherwise wouldn’t have it. We’re car dependent so I want to continue to help it succeed.

Michael: Our nation is car dependent, and certainly those folks in the subprime segment are very car dependent. So I think actually what you’re offering is also a form of public service.

Ken: We hope so, and we’re trying to get the regulators to better understand the importance of this type of financing to millions of Americans. I think we’re starting to get through; I really think we’re making some progress.

Michael: Thank you, Ken. I really appreciate what you’re doing for this industry. I think you’ve provided incredible thought leadership and an integrity of a financial solution that seems that it can work for the subprime markets, which is wonderful. I want to give you two invitations. One, we’ve got to get that golf game in this year, and I want a lesson from you; you’re a scratch golfer. Secondly, I want to invite you back in six to 12 months to see if this inflection point, this bubble in auto finance actually hit and what our listeners in the future can do about it.

Ken: It would be my pleasure to do both of those things, Michael. So thank you very much and I always enjoy visiting with you. I want to say how important capital is to our industry and Flock does a great job of providing it. So thank you for your support and partnership.

Ken: Thank you for your partnership, Ken.

Ken: Thank you.

Michael: Good afternoon.

Ken: Okay, thank you.

Male Speaker: This show is brought to you by Flock Specialty Finance. To learn more, please visit .

Duration: 39 minutes

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