From the January issue: 2018 was a strong year for auto finance as delinquency rates dropped, the economy grew, and consumer demand remained high.
However, the new year finds lenders and analysts bracing for an economic slowdown. But that’s not the only worry. New-car purchases are lagging, according to Manheim’s November data, which has new-vehicle sales down 0.7% year over year. On top of that, rising tariffs and higher interest rates could stymie growth in 2019.
“In some ways, it’s a house of cards,” said Jessica Caldwell, executive director of industry analysis for Edmunds. “As access to cheap and easy credit grows scarce, many buyers may be forced into the used market, or even be priced out of a purchase completely. If, for some reason, the economy suddenly collapses or if tariffs are enacted and raise prices even more dramatically, things could take a turn very quickly.”
Lenders that will thrive in the new year will be the ones that are prepared.
“The worst position [a lender] could be in is being surprised, not having a plan, and trying to improvise when confronted with an issue,” Marcelo Brutti, chief risk officer at Hyundai Capital America, told Auto Finance News. “Our job is to monitor all of [the risk factors] and make sure that those we can manage have discipline. We have to understand the potential economic cycle and be ready for it to protect the captive, the OEMs, dealers, and the reputation of the brand.”
Industrywide, lenders are starting to bump up subprime volume, extend loan terms, and increase technology investments, particularly in data and analytics that allow lenders to better track performance.
The Subprime Sector
Following a pullback from the subprime sector in the past few years, originations to credit-challenged borrowers are expected to account for 16.5% of loans in 2019, compared with 15.1% in 2018, according to TransUnion’s 2019 consumer credit forecast. Positive economic trends and opportunities to boost profits are spurring growth in subprime, Brian Landau, senior vice president and auto line of business leader at TransUnion, told AFN. Specifically, lenders feel more confident going back to subprime because of macroeconomic performance like stabilizing delinquencies and a low unemployment rate, he said. The 60-day delinquency rate is anticipated to stay flat at 1.44% through 2019. “The auto market is starting to recalibrate itself after the pullbacks in [2016 and 2017],” Landau said. However, the competition for subprime loans will likely increase. “If [one lender] is going to tap into subprime consumers, so are other lenders,” Landau said. “The profit is in subprime, and lenders have to make money.”
With affordability in question and subprime originations expected to climb, it’s important for lenders to come up with strategies to avoid delinquencies, David Gemperle, a partner at Nisen & Elliott LLC, told AFN. A loan extension is a common tool for keeping delinquencies in check.
However, extensions done wrong can result in liability, Gemperle said. “Loan extensions are a short-term solution that has potential consequences and higher losses down the line,” he said.
The problem is that some lenders will do what is necessary to avoid repossession and higher defaults. “If lenders don’t do loan extensions, then they have a repo,” Micky Watts, senior vice president of indirect lending at Anderson Brothers Bank, told AFN. “When [lenders] are looking at an $8,000 to $10,000 loss, loan extensions make sense.”
However, extensions are inherently risky because the longer a loan is on the books, the tougher it becomes to pay down and the greater the risk of negative equity. “Longer loan terms will only expedite that situation,” said Anil Goyal, Black Book’s executive vice president of operations.
To that end, lenders need to understand that not all used vehicles depreciate at the same rate, and there are opportunities to leverage residual forecasts in the underwriting process to evaluate which cars are better suited for loan extensions, Goyal added.
“[Loan extensions] could be poison for the industry,” Joe Cioffi, chair of the insolvency, creditors’ rights, and financial products practice group at Davis & Gilbert, told AFN. A red flag to watch out for is an unreasonable reliance on loan extensions being used to offset what would be higher monthly payments.
“When lenders are thinking of strategies, it’s important to think: ‘What about the long-term risks associated with that?’” Gemperle said. The longer the loan term, the greater the chances a borrower will face financial hurdles.
Lenders also have to be careful to explain the effect of an extension to the borrower and to ensure that programs pass compliance, Gemperle said. For instance, in November 2018, Santander Consumer USA finalized an agreement with the Consumer Financial Protection Bureau to pay a $2.5 million fine and more than $9 million in restitution after allegations that it misled consumers regarding loan extensions. Santander told consumers that loan extensions would move monthly payments to the end of their loans but failed to explain to consumers how or when the accumulated interest would be repaid, according to the CFPB’s claims.
Santander agreed to settle without admitting or denying the CFPB’s claims.
Another situation with folded lender Honor Finance, which handed over its portfolio to Westlake Financial Services in August 2018, was primarily due to poor practices regarding loan extensions.
“Honor granted an extraordinarily high number of payment extensions to borrowers,” Cioffi said. Although Honor took the practice to a dangerous level, it is common in the industry. “So much so, that S&P Global Ratings is recommending that going forward investors monitor the level of extensions in their deals,” Cioffi added.
Extensions can also increase risk, Cioffi said, because extensions are requested by financially troubled borrowers and allow interest to accrue during the deferral period — something borrowers do not always understand — ultimately increasing the amount to be repaid.
Technology: Data and Analytics
One analyst argues that with the technology and data available for lenders today, there is no excuse for flawed loan extension practices. “The data to decide on loan extensions is more sophisticated than ever before,” said Lou Loquasto, the auto vertical leader at Equifax.
Lenders should be able to use the technology available today to properly vet loan extensions, but each borrower situation is different.
Indeed, tech is playing a bigger role in financing as buyers increasingly look for lenders to provide digital options for communication and payment. Nissan Motor Acceptance Corp. and Toyota Financial Services, for instance, are meeting their customers’ expectations with new web portals, text communications, and mobile apps.
And a number of lenders are partnering with tech companies to make loan applications and servicing more attractive.
BMO Harris Bank, for instance, in December 2018 started to accept online auto loan applications in California through a newly inked partnership with AutoGravity. Earlier this year, Infiniti Financial Services, Kelley Blue Book, Santander Consumer USA, and TD Auto Finance also partnered with the auto marketplace.
AutoGravity’s platform connects car shoppers with lenders and dealers. It provides prequalified finance offers from partnered dealerships listed on the AutoGravity site. Buyers can use their computer or smartphone to browse local inventory for new or used vehicles, shop by monthly payment amount, and apply for financing directly through the platform.
Technology innovations have made access to credit easier for consumers, as well, with alternate ways lenders can evaluate potential borrowers besides traditional Fico scores.
However, “the issue can actually be too much available credit given rising interest rates,” Cioffi said. “Alternatives to Fico that take into consideration bank accounts and check payments will make even more credit available.”
There’s a risk with greater accessibility to credit, and lenders need to be wary. “Consumers can get the false impression that if a lender is willing to make the loan, then they must be able to afford it,” Cioffi said.
With industry apprehension that a market slowdown is near, it is critical for lenders to understand that the next few years will be a risky time to grow the loan business through expansion of criteria. But data and analytics, combined with the proper investments in IT, can help lenders manage their businesses.
The key is to implement an IT strategy that supports its future business model. Alternatively, if a lender is pursuing the wrong business model, then its IT infrastructure will be of little help.
“Where you’re investing your money today might not be correlated with the business model that might be the right model in the future,” Brutti said. “As a captive or as a bank, we’ll try different things, and we’re all trying to figure it out.”
The question is: What is going to be the business model in the future? With subscription services, autonomous vehicles, electric vehicles, carsharing, direct lending — it’s vital for lenders to be prepared for the future of financing.
“We don’t see anything disruptive in the short term,” Brutti said. “We see these potential products in the future, and it’s an opportunity cost. If you don’t do it, somebody else will do it. There is more risk in not doing anything than in trying something. Whoever else does it, it will take that business away from you [in regard to] profitability, customers relationship, loyalty, and potentially sales — that will be one of the risks for 2019.”
“If there’s a threat to the business model, decide how you address it,” Brutti added. “You can do it on your own, and you can pick a partner, you can do a pilot. Then learn how to mitigate risks for each factor.”