Playing the next stage
There is a common misconception that the credit cycle is this perfectly symmetrical sine wave, where credit continuously ramps up, blows up and then starts all over again. That is certainly how many journalists who cover auto lending perceive things, and why all growth, particularly in subprime, must by definition lead to a crisis. The truth is that the consumer credit markets are almost always growing over time and are only occasionally disrupted by outside forces, such as a recession.
In auto finance there is a natural clearing rate of available capital, vehicles and consumers who want those vehicles. Following a disruption, new money enters the market and lenders begin to grow again. For illustration, refer to the chart titled “Growth of Consumer Credit Outstanding.” This data comes from the G-19 report of the Federal Reserve, and shows the change in the growth rate of consumer loans not including loans collateralized by real estate, which makes it a good proxy for auto loan balances. Values above the zero percent line indicate growth and vice versa, while the red columns indicate recessionary periods.
When growth reaches a saturation point, new lending slows down and competition becomes fierce. It is at this point that many lenders loosen pricing and credit requirements to maintain either a targeted growth rate or volume level. When I use the term “loosen”, I do not mean that they originate toxic portfolios, merely that losses will be marginally higher and yield lower within a range. If the saturation point drags on too long, the market will consolidate either through acquisition or portfolios running off as some investors choose to liquidate.
Some companies fall by the wayside due to mismanaging credit performance, but that is more often the exception than the rule. It is important to note that none of the events leading to a disruption in auto lending came from the industry itself. Going back to the early 1990’s, setbacks were caused by oil, a tech bust, mortgages and a pandemic. Throughout all of those periods, auto loans performed just fine – particularly those loans originated during the setbacks. Lenders tend to cherry pick paper in down times, which leads to credit performance far better than the expected baseline. When growth returns, so do normal levels of delinquency and loss, which brings us to the subject of this article.
We have just come through a very anomalous period – a pandemic on a scale of which has not been seen in more than 100 years. The pandemic imposed a short-lived recession which auto lenders are now just emerging from. Both credit performance and the general economy were quite strong prior to the crisis, which means that the growth cycle for lending might have just been briefly interrupted, not completely reset. This implies that the runway for easy growth before hyper-competition emerges is likely much shorter than the 2011-2013 period (following the Great Recession). The good news is that, due to crisis-level forbearance and government stimulus, credit performed extremely well – even after the increased levels of deferments abated.
The issue for auto lenders at this point is how they make the most out of their current position in the credit cycle. The answer is found in consideration of three issues:
• How to grow and protect yield at the same time,
• How to protect credit performance as losses return to normal (or worse)
• When to respond to normalized used vehicle values
Growing the Portfolio
By the time the vast majority of companies realize it is safe to grow again, larger analytic-driven lenders are already stepping on the gas driving intense competition. Companies who saw closure rates in the five to ten percent range, historically, will see two to three percent closure rates. One of the main reasons for this is that they are holding onto overly conservative collateral protection policies. Presently, dealers are paying through the nose for whatever inventory they can acquire. Their margins are razor thin, and they are sending deals to lenders who allow them to get a win with back-end products.
I have spoken to some who have some kind of moral block at back-end amounts greater than $3,000. Remember, the severity of loss only matters if the consumer defaults. For lenders who embrace credit scoring, they can identify the top tiers of customers with the lowest incidence of default and offer increase back-end on their best customers with little impact on the bottom line. Keep in mind that most of these products are partially refundable if the loan terminates early. While this advice will seem obvious to many, there are still quite a few lenders in non-prime that see credit scores only as a tool to cut volume out. If used properly, credit scoring tools help the lender make surgically precise changes without repricing or restructuring the whole portfolio.
Lenders who proactively help their best dealers win will close far more paper in the present environment. That being said, you can’t just modify your program and expect results to happen on their own. You must have your field reps selling the benefit in order to win more deals as competition increases. Getting in front of your dealer base often with a positive message about how they can make more money is a surefire way to close more quality business, provided they actually see the benefit in your approvals.
Protecting Credit Performance
Credit performance is counter-cyclical. When everyone thinks the market is terrible, performance is fantastic. When everyone else is excited about growth is the time for lenders to be cautious. Investment dollars for auto lending platforms are strategically sidelined when people think we are at the top of the credit cycle (i.e., growth has leveled off and competition is intense). When the market resets, following a contraction, that money floods the market.
Many young lenders, or worse yet – inexperienced lenders – jump into the game and make what the rest of us see as irrational approvals in order to get volume. Some private equity-backed lenders may also feel pressure to deliver a growth story so the investor can eventually exit the transaction. This creates a scenario where established lenders must act rationally and not chase other’s approvals.
When worse quality paper is originated, it can take 12 to 24 months for poor performance to become apparent at the portfolio level. Up until that time, the lender may be lulled into thinking they are making good credit decisions. By the time they realize performance has deteriorated they have at least a year’s worth of toxic paper coming through the pipeline. It is imperative to have reporting and portfolio monitoring that determines early on whether origination quality is worsening.
This reporting should minimally include measures of early payment default and roll rate from current to delinquent for young vintages. In addition, it is important to remember that if credit data is predictive of future performance (hint: it is), then a shift in credit characteristics for each vintage is your first warning that performance will shift. Credit will deteriorate back to a normal, baseline level – but managers must make certain their performance doesn’t shoot past that level. Increased delinquency has the immediate effect of shrinking the borrowing base for lenders utilizing warehouse debt. Those with spikes in delinquency will see their portfolios shrinking while everyone else is growing. Tracking key credit attributes will provide lenders with enough early warning to make changes before performance becomes a problem.
In the current economic environment, where inflation and unemployment are uncertain, lenders must buffer new originations to account for the impact of “effective” metrics. Obviously, one would not employ ineffective metrics. What is meant is that if the cost of food, fuel and other expenses increases 20 percent, a consumer’s debt-to-income ratio might effectively be 45 percent instead of 35. I was fortunate to work for large lenders in my career, where we had the resources to acquire many economic and other data sources to mitigate risk; however, those analytic resources may not be available to many companies. In the case of the latter, be careful to limit advance, PTI and DTI on the lowest tiers as you observe the economic situation shift in a negative way.
Accounting for Used Vehicle Values
What goes up must come down, right? Not necessarily. An inventory shortage caused used vehicle prices to rise 30 percent from 2009 to 2011. For years, analysts kept predicting an LTV cliff that never happened. Prices remained high as many displaced consumers re-entered the market propping up demand. Additionally, experts were predicting a value crash due to millions of off-lease vehicles that were re-entering the market. That never happened either.
At present, there is a chip crisis in auto manufacturing. The average vehicle has more than 1,000 separate microchips in each unit. As autos become more technologically enhanced that number will increase. Recent research suggests the problem could extend another 24 months. I am not suggesting that values, and thus recovery rates, will stay elevated indefinitely – only that it is not an impending crisis.
The key thing for lenders to keep in mind is what repossessed vehicles from today’s originations will be worth at auction time (typically 15 to 18 months out depending on the credit niche). At some point values will drop, and when that starts to happen it is critical to act quickly to adjust credit policy. Once again, the key to mitigating these risks is to track as much data as possible. When it comes to auction values, your company’s portfolio may not have enough examples of each vehicle class to give you a sufficient heads up that change is underway. I strongly recommend that lenders track the reports coming out of the auctions, as well has third party value guides who have rich, and affordable, data for this purpose.
Navigating the Cycle
Well-known author and strategist Idowu Koyenikan said, “Opportunity does not waste time with those who are unprepared.” The coming year presents a number of challenges, but also holds the opportunity to grow your portfolios profitably. The key to navigating these issues resides in the data and how companies act on it. In closing, I recommend lenders consider the following actions:
• Embrace Scoring – many lenders understand their historical loss levels and have very sophisticated pricing and yield models. Those will not help you observe an underlying shift in quality, nor will they help you identify pockets of low risk applicants where you can afford to offer more competitive terms. If you are not utilizing credit scores effectively, your company is surely leaving money on the table and missing profitable volume
• Increase Back-end – Every lender has limitations on what they can offer, but if possible, identify the best quality tiers and allow dealers to make some money. Until the inventory issue subsides, this could be the difference between a 3 percent closure rate and a 6 percent closure rate. This is likely the difference between $400 in expense per closed deal and over $1,000! Don’t burn 100bps in operating expense to mitigate 25bps of net loss risk.
• Track Data – Measure early-pay default (delinquent on one of first 3 payments), roll rate from current to past due within the first 6 months on books and measure key credit attributes. If you do not have the ability to track credit attributes, reach out to a vendor that can help you do so.
• Monitor Auction Values – there are many inexpensive data sources lenders can tap into to do this. Unless you are in the top ten lenders in portfolio size, it is unlikely your company has enough examples of each class and age to rely solely on internal data. Tracking external trends provides the earliest indicator that recoveries are sliding.