The Changing Landscape of Indirect Automobile … - banks that prequalify auto loans

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The Changing Landscape
of Indirect Automobile Lending
any traditional aspects of indirect type of borrower and loan they will
auto lending have changed owing accept by providing dealers with under-
to significant competitive pres- writing and interest rate guidelines. In
Msures exerted by the captive finance most cases, a dealership's finance
companies (captives) of automobile manager gathers credit information from
manufacturers. In response, many banks prospective buyers, completes loan appli-
have loosened underwriting standards cations, and forwards the documents to
and relaxed procedures to become more the bank for approval. Historically, auto
"borrower friendly" to compete with the financing has been perceived as a low-
financial concessions of competitors. As risk form of lending, with risk spread
a result, some banks operating in this among a large volume of small-balance,
highly competitive market with weak collateralized loans. However, recent
controls and lax automobile loan under- instances of weak indirect auto lending
writing programs have been adversely programs have indicated insufficient
affected. Banks with stronger programs collateral values and marginal to defi-
remain susceptible to diminishing collat- cient borrower repayment capacity,
eral values as loan terms continue to be resulting in substantial financial adver-
extended over longer periods. sity for the lender.
Traditionally, Federal regulatory agencies Anecdotal evidence suggests that
and bank internal loan review depart- increased competition is influencing indi-
ments have relied on a delinquency- rect auto lending programs. Heightened
based approach to evaluate automobile competition has prompted banks to offer
loan portfolios. This approach has served lower interest rates, lengthen amortiza-
regulators and bankers well, but recent tion periods, and scale down payment
automobile financing trends may require requirements. In some cases, competi-
a more in-depth analysis when loan and tion has prompted banks to grant lend-
collateral values are not correlated, ing authority to the dealer in order to
vehicles are financed multiple times, or expedite the approval process for loans
losses are deferred and embedded in that fall within bank-approved guidelines.
loan balances. Banks sometimes permit credit arrange-
This article discusses how heightened ments outside underwriting guidelines if
competition, weak underwriting stan- the dealer signs a recourse agreement
dards, and lax auto lending controls can stating that it will repurchase such loans
harm a bank's asset quality, earnings, if they become delinquent. Recourse
and capital. Two case studies identify agreements vary, and some expire after
warning signs and highlight best prac- a certain period of time has passed or a
tices that will strengthen automobile certain number of payments have been
lending programs. Consumer compli- made. Today's indirect automobile lend-
ance risks associated with indirect auto ing practices represent unique challenges
lending are considered, along with to bank management and supervisors.
controls to mitigate those risks.
Automobile Finance Market
Trends in Indirect Auto Conditions
Lending Structure In recent years, automobile manufac-
Banks develop indirect automobile turers have responded to overproduction
lending programs by establishing rela- by offering special rebate and financing
tionships with automobile dealers. offers to stimulate consumer demand.
Insured financial institutions define the The manufacturers' primary objective is
29
Supervisory Insights Summer 2005
Auto Lending
continued from pg. 29
to reduce inventory; pricing and financ- equity, a situation in which the loan
ing are secondary concerns. This goal balance exceeds the vehicle's value.
conflicts with that of other lenders, J.D. Power and Associates estimates that
whose primary goal is to earn a fair approximately 38 percent of new car
return for a limited amount of risk. buyers have negative equity at trade-in,
Manufacturers use their captives to intro- compared to 25 percent two years ago.3
duce special financing offers. Captives,
such as General Motors Acceptance
Corporation, Ford Motor Credit, and Impact on the Banking
Toyota Motor Credit, dominate the Industry
industry, with 56 percent of the automo- Vehicle financing trends reflect a
bile financing market in 2003.1 Banks, general weakening in overall underwrit-
credit unions, and other finance compa- ing standards, leaving automobile loan
nies comprise the remaining market. portfolios increasingly vulnerable to an
To spur demand, manufacturers have economic downturn. To date, weaker
introduced large cash-back rebates, loan underwriting has not translated into
while their captives offered zero- and widespread asset quality problems in the
low-rate, no-money-down financing for banking industry. The relatively low
longer periods. The Consumer Bankers interest rate environment and a healthy
Association's (CBA) 2004 Automobile economy have contributed to improved
Finance Study reflects an annual automobile loan loss and delinquency
increase of 6 percent for the average rates. According to a Moody's report,
automobile loan balance, while the aver- the October 2004 auto loan net loss rate
age amount financed grew to represent fell from 1.22 percent in October 2003
99 percent of invoice for new cars and to 0.93 percent in October 2004, and
96 percent of wholesale value for used account balances more than 60 days
cars. To compensate for the larger loan late declined from 0.56 percent to 0.46
balances, loan amortization periods have percent.4 The Moody's report also indi-
lengthened to keep monthly payments cated that the net loss rate and delin-
low and vehicles affordable. Federal quency rate had fallen for 17 and 18
Reserve Bank data show the average consecutive months, respectively, on a
new car loan maturity increasing from year-over-year basis. These positive indus-
53 months to 62.5 months between try trends reflect the strengthening U.S.
1999 and fourth quarter 2003 as more economy. However, these trends may
consumers selected a 72-month loan mask the actual risk inherent in automo-
product. An article in the American bile loan portfolios. The 2004 CBA Auto-
Banker indicates that the terms of auto- mobile Finance Study states that the
mobile loans are increasing, with some average net loss per unit increased 10
banks offering eight-year loans.2 percent since the prior year, a statistic
Initial vehicle depreciation rates gener- that may suggest more borrower-friendly
ally exceed loan amortization rates for underwriting standards at the same time
credits with lengthy amortization peri- the incidence of negative equity value of
ods. Increased loan balances, low down collateral is on the rise. The case studies
payment requirements, and lengthy in this article reflect the impact these
amortization periods create negative high charge-off rates can have on an
1Deutsche Bank, "U.S. Autos: A Triple Threat," February 20, 2004.
2"Driven into Making More Used-Car Loans," American Banker, April 15, 2005.
3"Owing More on an Auto Than It's Worth as a Trade-In," New York Times, March 27, 2004.
4Moody's Reports: Prime Auto Net Loss and Delinquency Rates Continue to Improve in October 2004.
30
Supervisory Insights Summer 2005
institution's capital and earnings, follow- repayment will occur regardless of repay-
ing loan defaults. Rising market interest ment status. Many internal loan reviews
rates or a general economic downturn have adopted a similar approach. Tradi-
could affect marginal borrowers' repay- tional application of this approach
ment capacities and may eventually assumes that borrowers initially had
subject the banking industry to increas- adequate repayment capacities or that
ing losses. the collateral values cover loan balances.
Large cash-back incentives depress Closer scrutiny is required when auto
used car values, resulting in lower repos- loan portfolios have not been underwrit-
session values. At the same time, favor- ten in a traditional fashion. Examiners
able consumer financing terms may have the latitude to deviate from the
heighten risk and shrink profitability. It prescribed classification guidelines when
has become more difficult for banks to historical delinquency and charge-off
compete safely in a market dominated by trends warrant such action. In cases
captives, which establish lending criteria where underwriting standards are weak
that are influenced by manufacturing and present unreasonable credit risk,
decisions rather than the risk/return examiners may also classify entire portfo-
trade-off of each financial transaction. In lios or portfolio segments. Similarly,
some cases, banks' attempts to remain bank management should consider a
competitive with captives have resulted more in-depth transaction-based review
in portfolios characterized by lower inter- if traditional formulas are not capturing
est rates, extended loan amortization insufficient collateral values or the
periods, and weaker borrowers. These performance of less financially substan-
underwriting trends suggest that some tial borrowers.
banks' automobile loan portfolios may
require closer internal review and regula- Case Studies: When Indirect
tory scrutiny. Auto Lending Went Awry
A number of banks have developed
Regulatory and Industry heightened risk profiles while attempting
Approach to Retail Credit to maintain or increase market share in
To evaluate a large volume of small- automobile financing. These case studies
balance loans efficiently and consis- show the pitfalls banks may face when
tently, the FDIC, the Comptroller of the they compete in this market without
Currency, the Federal Reserve Board, appropriate lending policies, procedures,
and the Office of Thrift Supervision internal controls, and oversight.
adopted the Uniform Retail Credit Bank A
Classification and Account Manage-
ment Policy.5 The policy provides Bank A opened in the second quarter
general guidance for assessing and of Year 1 with an indirect automobile
adversely classifying retail credit based lending program managed by one loan
on delinquency status. Auto loans, officer. By the end of Year 2, indirect
considered closed-end credit, that are automobile loans represented 58 percent
delinquent for 90 cumulative days are of total assets and 370 percent of Tier 1
classified Substandard; those at least capital; the delinquency rate was rela-
120 days delinquent are classified Loss. tively low at 1.91 percent. Bank A also
Examiners are charged with ensuring reported a 0.30 percent return on assets,
that banks adhere to this policy, unless despite its relatively small size and recent
5Federal Financial Institutions Examination Council, Uniform Retail Credit Classification and Account Management
Policy, 65 Fed. Reg. 36903 (June 12, 2000).
31
Supervisory Insights Summer 2005


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