Overview
A paramount job for institutional investors and risk managers is an accurate assessment of risk. We did NOT rate Tricolor, First Brands, nor Saks; Tricolor’s bonds were rated at or near “AA” and subsequently cut to “CCC”. Our rating track record continues to be superb. We write this installment to hopefully assist in identifying some early indicators of problems.
Note, typically when there is a debacle like Tricolor, the market overreacts, thereby presenting opportunities, provided proper analysis can be conducted. Note that no number of warranties provide comfort if the transaction is flawed from the onset. In this case, fraud was the symptom, NOT the underlying problem.
Flawed from the Start
In our view, the Tricolor business model was fundamentally flawed, and it was just a matter of time before it became apparent.
Furthermore, the longer the “discovery time,” the greater the losses, as there were no “fixes” to the broken model. In essence, the business of loaning money to subprime borrowers was flawed in the sense that not enough money could be charged, and the cost of recovering depreciating assets more than offset the amount lent. Hence, as time progressed, the greater the losses. Nonetheless, we will provide suggestions for recognizing the flaws early.
Best Practices
There are several approaches to prevent the fraud component of Tricolor:
- Control of cash (lockbox + reconciliations) - an independent party (i.e., not the sponsor) should manage cash. The independent party should provide reports to the trustee with regular (daily) reconciliation of servicer-reported collections vs. bank statements.
- Control of collateral - the lender or an independent party should initiate (at a minimum, verify) and where applicable take custody of pledged assets (leases, loans, and UCCs) and provide reports to the trustee. Periodic matching of unique identifiers (loan IDs, VINs/titles, UCC filings) across all borrowing bases and facilities.
- Global collateral reviews - collateral reporting checks against all facilities. Data integrity tests: anomaly detection (duplicate VINs/IDs, impossible dates, payment pattern outliers) plus exception reporting tied to repurchase remedies.
- Representation and warranty enforcement - rapid breach notices, repurchase demands, and triggers if exceptions exceed thresholds.
Addressing Tricolor Flaws
Regarding the specifics for Tricolor, below is a listing of the “red flags” that should have provided an early warning:
- Underlying Customers - the lender targeted undocumented immigrants and others without Social Security numbers. All credit is dependent on a level of trust, and if a person does not have or does not provide a Social Security number, then a normal conclusion is that the source of income is questionable and probably irregular.It begs the question of whether such borrowers can support any level of lending. Yes, there is collateral provided, but the cost of recovery and the deterioration of the value of the collateral probably represent a significant portion of the original loan.
- Double Pledging of Assets - Tricolor provided the same collateral to multiple lenders.
- Assuming the UCCs (Uniform Commercial Code filings) were in Tricolor’s or an affiliate’s name, perhaps the only way to prevent such multiple hypothecations would be a transfer of such filings to an independent (trustable) third party. A verification of such transfers prior to any significant financing would be needed. Lastly, it would be necessary to reconcile the schedules of the possessed chattel paper for leases and loans with those listed in the UCC filings.
- Pledging of Dubious Assets - Tricolor reportedly falsely represented that loans were performing. The fraud was discovered when one of the lenders questioned why the account balances were not declining if customers were supposedly paying down their loans. (Of course they were not; the loans were not performing.) An independent servicer would be able to assess and provide such assurances.
- Unreconcilable Accounts - Tricolor supposedly received payments from customers but did not record corresponding reductions in outstanding balances.
- False Accounting - If, as reported, Tricolor double pledged assets, then the money should have been reflected in its accounts. For example, if a $20K loan is transferred once to its structured finance unit for $20K and subsequently to a bank for an 80% advance rate, thereby generating an additional $16K, then a total of $36K should have been received and recorded by the company. Perhaps expenses absorbed a large portion of that cash, but there should have been some red flags. Alternatively, if Tricolor received advance rates of less than 50% from each lender, there should also be a red flag via the ratio of advances compared to assets, assuming the loan assets remained on the books.
- Delayed Audits - per paragraph 16 of the indictment, as of July 22, 2021, the audit firm was conducting an audit of the prior year’s financials. From our perspective, a material delay in any audit is a major red flag.
Conclusion
While anyone can make mistakes, sophisticated institutional investors and risk managers should be wary of accepting failure from fraud. As was the case with Enron, WorldCom, Lehman Brothers and many others, fraud was simply masking fundamental problems. Tricolor probably never should have been accepted into the institutional markets. Hopefully this installment helps in recognizing problems early.
Additional Reading
There is likely to be substantial analysis on corrections to the Tricolor fiasco. Below is a summary of suggestions from:
Cadwalader:
Over the past five years, Tricolor has been among the fastest-growing auto lenders in the United States, quadrupling in size.
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Morgan Lewis:
Fraud is not a fad. Publilius Syrus, in the first century B.C., noted that "[i]t is a fraud to borrow what we are unable to pay."
Read More
American Bar Association:
Over the past five years, Tricolor has been among the fastest-growing auto lenders in the United States, quadrupling in size.
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Private Debt Investor:
The recent collapses of Tricolor and First Brands weren't just corporate failures...an industry that had forgotten how to ask uncomfortable questions.
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Mondaq:
One need only look back to the dozens of actions filed by or on behalf of investors in RMBS to see what could lie ahead without a course correction.
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LGT:
Shortly after Tricolor’s collapse, First Brands Group, a major leveraged-loan issuer and global auto-parts manufacturer, declared bankruptcy in September.
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Structured Finance Association:
Following the bankruptcy of Tricolor Holdings, rating agencies are closely watching...loose underwriting practices may impact outstanding securitizations.
Read More
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