Road Hazard: Subprime Loan Delinquencies on the Rise
Paralleling the growth in auto loans, in general, subprime loans have been booming, making up about one-fifth of the nearly $1 trillion auto loan market — but are we headed for a bust?
A new survey from MagnifyMoney.com suggests the rising number of subprime auto loans is also leading to historic new highs in delinquencies and losses.
Indeed, the report from MagnifyMoney suggests the current climate for subprime auto lending is dangerously similar to the scenario surrounding the subprime mortgage market from the prior decade — in terms of shaky underwriting and substandard background checks.
For example, MagnifyMoney's survey (which queried 673 American automobile owners who took out loans) revealed almost two-thirds (64.4%) of auto loan borrowers let the dealer find them a loan, rather than finding one for themselves; more than one-half (52.1%) of auto loan borrowers never had their income verified when applying for the loan; and an overwhelming majority (82.6%) of auto loan borrowers who took out long-term loans (that is, with terms in excess of five years) did so in order to have lower monthly payments. The other 18% or so took out the lengthy loans due to pressure from the dealers themselves.
Subprime Meltdown Revisited?
Nick Clements, founder of MagnifyMoney, sees similarities to the subprime housing market of the 2000s — practices that led to the near collapse of the U.S. economy.
Clements posits that with respect to automobile dealers of today and the mortgage brokers of the 2000s, there are risks that they could play the same role.
"The interest of auto dealers are not always aligned with the interest of their customers," he said. "[Auto] dealers resemble the mortgage brokers, making money on the sale of cars and the dealer discount from lenders. Verification requirements are minimal. Complexity is increasing and the opportunity to commit fraud becomes more widespread."
Back in the 2000s, Clements cited, mortgage brokers generated sky-high commissions on loans they booked — they made the money from the outset and did not suffer the consequences if the loans went bad later. "The brokers had a high incentive to book as many loans as possible, regardless of the credit risk," Clements commented, with many not always verifying a borrower's income or credit score.
Similarly, auto dealerships, make money when they sell cars, and they make commissions ("dealer discounts") when they sell auto financing, he explained.
Now, auto finance companies are seeking to win the auto dealer's business, leading many of them to weaken the credit criteria and relax income verification measures. "The dealer networks, which control the customer and the volume, have a lot of power over banks and finance companies hungry for volume," Clements noted. "If a bank asks too many questions, the dealer can easily move to the next easiest lender."
But not everyone is convinced there are similarities between the contemporary subprime auto loan market and the subprime mortgage market of the 2000s. A report from Liberty Street Economics, citing data from the New York Federal Reserve, countered that the volume of subprime mortgages outstanding in 2007 was nearly four times the volume of subprime auto loans outstanding today.
Paul Kirkbride, SVP of CU solutions at CU Direct, noted that while there are some parallels, there are also some significant differences between the two scenarios.
"The mortgage market suffered because lenders set aside the fundamentals of underwriting, meaning a borrower's ability to repay the obligation," he said. "During the mortgage boom, you saw stated income loans and negative-amortizing loans -- not in the credit union space though. I don't think you see this in the subprime auto space today."
Moreover, citing Federal Reserve data, George Hofheimer, chief knowledge officer for Filene Research Institute, said that most subprime auto loan business is currently handled by auto finance companies — credit unions have a "very small" share of this market.
"[Subprime auto loans are not] the bread and butter of most credit unions," Hofheimer commented
Kirkbride agreed. "Credit unions remain conservative with respect to credit quality," he said. He estimates that based on evidence and data from the CUDL network (consisting of more than 1,000 credit union partners across the country) the percentage of (subprime) indirect auto loans handled by credit unions remains in the low single digits.
Pros and Cons of Subprime Auto Loans
But if credit unions can do a better job of it, should they deepen their footprint in the subprime auto loan market?
Hofheimer said the main advantages of offering subprime auto loans comprise: new markets for credit union loan growth, better deals for non-prime consumers, and high-yielding loans for the credit union. The main disadvantages, he suggested, would be entering a relatively unfamiliar market that may not match with credit union expertise, as well as the likelihood higher rates of delinquencies
CU Direct's Kirkbride explained that credit unions have typically steered away from doing subprime auto loans. "I wouldn't say credit unions are reluctant, per se, but rather prudent, which is what you'd expect from a traditional financial institution," he commented. "Due to the inherent risks associated with these loans, anyone making a heavy investment in subprime lending must have a high tolerance for loss, and that simply isn't going to be the case with most credit unions and banks for a number of reasons."
In addition, credit unions have not been seeking to relax their underwriting guidelines in order to generate more loan volumes.
"Credit unions remain diligent, while at the same time, doing their best to serve their communities as a whole," Kirkbride added. "Yes, you can charge more to cover the losses associated with higher risk loans, but that doesn't mean you don't need to verify a borrower's ability to repay the obligation. Affordability is a basic lending fundamental, regardless of credit score."
Kirkbride concedes that credit unions would be able to attract and serve additional members by offering more subprime loans, but given the anticipated higher loss rates and collections costs associated with subprime lending, it's not easy to predict those in advance.
"Anyone entering this space should take it very slow, set prudent board-approved limits relative to their net worth, and be sure to shock the portfolio from time to time, as subprime portfolios are more volatile in a changing economic environment," he stated. "Subprime loans are higher risk. And credit unions currently don't seem to be targeting that segment."
But CUNA Mutual Group believes subprime auto lending presents a good option for some credit unions. At a conference held late last year in Madison, Wis., CUNA Mutual attendees were told that "as auto sales continue to boom, millions of subprime borrowers are entering the market for new vehicles," adding that this presents a "significant growth opportunity" for credit unions to generate new loans.
Steve Hoke, director of loan growth products for CUNA Mutual Group, told the attendees: "If you aren't reaching out to your members and potential members with an auto loan offer at a competitive rate, then you are basically telling them to go elsewhere."
Hoke told Credit Union Journal credit unions can mitigate the inherent risks of offering subprime auto loans by implementing an interest rate structure that's commensurate with that risk. "This requires a thoughtful approach [to] assessing the risk, cost for collections and loan loss provisions," he said. "While interest rate pricing is important, credit unions also need to work to mitigate the risk of collections. This can be accomplished by ensuring the credit union has a proactive process in place to monitor the risk and work early with the member should the member fall behind on payments."
Another tool that works for some credit unions, he added, is the use of GPS devices that gives the credit union a high degree of control over recovery should the need arise.
Hoke noted that with both new and used auto loans on the rise, "we're seeing that financial institutions are lending to borrowers with lower average credit scores than at the end of the Great Recession," adding that Experian's latest quarterly lending report indicated that over the last five or six years the average credit score for borrowers has declined for both new and used vehicle loans.
Looking for ways to minimize the risks associated with subprime auto lending, therefore, has become a priority.
Andrew Downin, innovation director at Filene, said one of the main findings highlighted in a Filene publication called "Accessible Financial Services" suggested credit unions should employ character-based lending techniques when underwriting such loans, including examining the member's relationship with the credit union, repayment history specifically on auto loans, stable employment and residence, verification of all application elements, and the ability to use payroll or other automatic payment to repay the loan.
"Also, our research indicated that a 'hard close' could help mitigate potential loan loss risks," Downin added. "[By] specifically ensuring [that] the member understands all loan elements, discussing resources available should the consumer have repayment problems, and stepping in more quickly with collection efforts, sometimes as early as the first day the loan is late."
These best practices, he said, can help ensure that credit unions are managing the risk of subprime auto loans and set themselves up for success compared to other competitors who may not be as rigorous with their verification methods.
In addition, Downin said offering subprime auto loans, credit unions can help build loyalty in the minds of members, leading to longer-term lifetime profitability. Indeed, he cited that in Filene's Non-Prime Auto Loans pilot, 84% of participating members said the NPAL had made them more loyal to their credit union. "This indicates the benefits to credit unions may extend far beyond one individual auto loan," Downin said.