Redefining risk management: 4 takeaways from the Auto Finance Risk Summit

A global pandemic, changing consumer habits and the rise in digital lending has redefined risk management across the auto finance industry. Consumer preferences are driving the digital revolution and other changes across every aspect of auto finance, and risk management is no exception. Lenders must closely watch how outside economic factors impact consumer spending because their customers’ financial health, and where they choose to spend their money, largely determines how lenders tackle risk. “We’re paying close attention to customer spending and consumer purchasing patterns coming out of the pandemic,” said Ally Financial ’s Mike Goyer , senior vice president of consumer asset management. “We’ve seen customer deposits increasing and people being more vigilant with their money, and where they spend their money. Will that continue post pandemic? Or will things kind of go back to ‘normal’ pre-pandemic levels?” While the auto finance industry has benefited from strong vehicle demand and an increase in digital adoption, not all consumers have recovered equally. Affordability led a list of auto lenders’ top four concerns highlighted during the recent Auto Finance Risk Summit , followed by looming increases in net charge-off rates, the need to adapt new technology to manage risk, and changing compliance regulations. 1. Heightened affordability concerns Vehicle affordability will continue to decrease during the next year given rising average transaction prices, low incentive levels, and the eventual end to government stimulus and unemployment support, Mike Brisson , senior economist at Moody’s Analytics , said during the Summit. The U.S. light vehicle SAAR in April reached 18.5 million units, setting a record for the highest monthly selling rate in 16 years, and coming above the initial forecast of 17.6 million units, according to a J.P. Morgan research note. The SAAR increased 3% from March 2021, and 112% year over year, factoring the same number of selling days as April 2020. “The auto market has been hot; this is the highest number since 2005, and the highest April of all time,” Brisson said. “18 million is outstanding for where we were, coming off of 22 million jobs lost during the past year.” Still, strong demand, combined with the semiconductor chip shortage, continues to hamper supply. “We've seen OEMs announcing the pullback in production, and now it's starting to be shown in the numbers. This is a major risk to vehicle sales and to used-vehicle prices,” Brisson said, noting that the hope is production will catch up in the third or fourth quarter of this year. “You have dealers who are going into the wholesale auctions … they're bidding against rental car agencies that are trying to get units on their lots to be able to ramp up for the summer because they can't get units from the OEMs,” Brisson added. “All of this is playing into prices that are shooting up astronomically over the past couple of months.” Used-vehicle values were volatile in 2020, a trend likely to continue this year, Eric Ibara , director of residual value risk at Kelley Blue Book , said. After bottoming out in April 2020, the Manheim Used Vehicle Value Index soared to a record high of 149.3 in June 2020, and hit new records for the next two months before stabilizing in August 2020. Starting in February 2021, the Index hit new records monthly, landing finally at 194.0 in April, an 8.3% increase on a sequential basis. On the new-vehicle side, the average MSRP reached $41,950 in April 2021, with four out of ten consumers willing to pay an average 12% above the retail price, according to Kelley Blue Book. New-vehicle supply stood at less than 2 million units across the U.S. in April, a 42% decrease YoY, according to Cox Automotive . Elevated vehicle values are good for consumers in the short term, but pose looming origination risks, said Landon Starr , chief risk officer at subprime lender Arivo Acceptance . “If someone buys a car at an extremely elevated value, that puts them in a very difficult situation as far as being able to pay that down in accordance to the depreciation curve that we may see six to 12 months,” he said. Forecasting experts agree that used-vehicle values are likely to stay elevated above pre-pandemic levels for at least the next few years, though it is unclear where they will finally land. 2. Looming portfolio risks Portfolio risk management has become even more challenging for auto lenders as delinquencies and net charge-off rates remain down due to pandemic-related consumer assistance. While customers have benefited from deferral programs and government stimulus, eventually those programs will end, and delinquency rates will tick up to more normal levels, said Bart Barry , managing director for auto originations risk management at Chase Auto . Chase Auto’s first quarter 2021 30-day delinquency rate sat at 0.42% of auto loans, a decrease of 47 basis points (bps) YoY. The net charge-off rate for auto loans also decreased 16 bps YoY to 0.16%, according to the bank’s earnings report. “The U.S. consumer has been heavily supported by external factors; mortgage extensions are still going on,” Barry said. “With the extensions of government support, the expectation is that you'll have a large enough economic recovery that will occur by the time some of those things run out. But either way, you're going to get to a point where you expect rates to rise.” Ally Financial, too, is preparing for potential increases in charge-offs , Ally Financial’s Goyer said. “We're keeping our head down and staying focused on disciplined underwriting,” he said. “On the backside of the business, we’re staying focused on how we service our customers and make sure we give them every opportunity to perform and manage their account online. We're going to continue to stay focused on digital efforts.” One of the biggest challenges to managing portfolio risk and having disciplined underwriting practices is in forecasting and modeling, said Kris Pritchard , general manager of residual and dealer risk at Toyota Financial Services . “Nobody has a forecast model that says in two years from now I'm expecting a $1 trillion government support program,” Pritchard said. “One of the bigger challenges we face is how do you read your models? How do you account for what happened during a pandemic?” While customers have been paying their auto loans at positive rates, defaults are likely down the road, Barry said. “The hope is all these [assistance] programs will last through the point where people will be able to return to an employed status,” he said, noting that the challenges of constrained inventory, increasing vehicle prices, inflation and rising interest rates remain. 3. Mitigating risk through technology In the digital age, auto lenders must get creative to mitigate risk. Many have turned to automation, alternative data and artificial intelligence to improve their underwriting strategies. “The things that we can control is how well our oversight really can detect risk, and how we can do monitoring and testing more efficiently,” said Meredith Garland-Hannifan , chief compliance officer at Exeter Finance . “You harness the power of data monitoring, instead of hand-by-hand old school testing.” Arivo Acceptance, for one, leaned on automated data acquisition to verify borrowers’ income and employment status, and thus their ability to repay, as a way to help mitigate origination risk during the COVID-19 pandemic, Starr said. “One of the big things to keep in mind is that what you originated during the COVID downturn, and those type of dynamics, is now what’s part of what’s performing in your portfolio — in the same way that what you originate now is going to be your portfolio performance in 12 to 18 months,” Starr said. Sandy, Utah-based Arivo, founded in 2017, has a managed portfolio of around $325 million as of March 2021. “When it comes to focusing on what you can control, it's your originations pipeline. It's how you're building and how you're constructing your portfolio right now that's going to dictate a lot of your performance in the future,” Starr said. Managing risk in today’s environment requires lenders to move beyond traditional risk metrics. Tricolor Auto Acceptance , for example, looks beyond the typical credit metrics to include behavioral economic trends and external data sources, said Nick Brown , chief risk officer for the subprime lender. “Signaling exists in all forms of data, and the farther you move outside of the mainstream in terms of the product or the population, the more those alternative data sources are going to prove valuable to you,” Brown said. For the best results, when it comes to using alternative data and automation, lenders must ensure their algorithms are accurate and compliant, said Armando Hidalgo , direct of servicing at Platinum Auto Finance . “As a compliance piece, you also want to hold your data provider accountable,” he said. “You've got to do your due diligence and inspect what you expect. If something doesn't seem right, look at it.” 4. Navigating changing regulation Compliance is always a key concern for any lender, but the 2020 election and recent state-level actions have made staying on top of changing state and federal regulations even more challenging. Fair lending and racial equity are under a microscope across the lending community, especially if Rohit Chopra , Consumer Financial Protection Bureau director nominee, takes the helm, said John Redding , partner at Alston & Bird . Chopra “has been a strong advocate of personal liability during his tenure at the FTC,” Redding noted. “We've seen in five of the last eight orders that have come out with respect to the current administration under acting Director [Dave] Uejio , that personal liability has been part of those. I think that's another area that we will want to be particularly careful in and paying attention to.” Meanwhile, the Illinois 36% “all-in” rate cap, or Predatory Loan Prevention Act, enacted March 23, could present challenges to the industry if other states and the federal government implement similar statutes, said Ken Rojc , managing partner at Nisen & Elliott . The Illinois State Legislature’s bill imposes the 36% cap on consumer loans, in line with the U.S. military APR calculation required under federal law, which includes any ancillary products financed on the note. “It’s important for creditors to revisit their policies as to what cases ancillary products are going to be allowed to be financed and at what price, because they there could be limitations on the ability to finance those products,” Rojc said. Lenders who are found to be in violation of the statute will have the loan considered void and be subject to a $10,000 fine. While banks and credit unions are exempt, subprime lenders are likely to be most affected by the statute, Rojc said. Despite the need to manage risk, auto lenders prioritized consumers’ well-being during the pandemic, a move that helped drive much of the change across the industry that continues today. “We all became very human first,” Arivo’s Starr said, adding that he saw this across the company’s collections and loss mitigations teams. “These are no longer just customers or numbers. There's this heightened level of empathy and understanding of the difficulties that brought a lot of innovation to the environment,” he added.

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