Recreating Chrysler Capital

Nearly 10 years after Chrysler LLC came to the government seeking a $12.5 billion bailout in the midst of the financial crisis, and eight years after Cerberus Capital Management sold Chrysler Financial to TD Bank, the OEM may finally get back its captive finance arm, the company announced in late May.

A lot has changed since those bleak days following the recession. Fiat bought the U.S. brand to form Fiat Chrysler Automobiles, General Motors spun off its financial arm General Motors Acceptance Corp. to form Ally Financial Inc., and Santander Consumer USA emerged as one of the largest subprime lenders in the industry. Meanwhile, the economy is booming as the U.S. nears full employment, with the unemployment rate at 3.8% in May, according to the Bureau of Labor Statistics.

Yet, the auto bailout from the financial crisis continues to reverberate through the industry, as FCA prepares to buy Chrysler Capital from Santander. Analysts are contemplating the fate of the OEM’s primary lending partner, the wisdom of the timing – as many economists believe a mild recession is on the horizon – the effectiveness of private-label bank partnerships, and the state of subprime lending, generally.

The announcement is part of a larger strategic push by FCA’s Chief Executive Sergio Marchionne, who plans to promote Jeep- and Ram-branded SUVs, as well as Maserati luxury cars, in favor of some of its legacy name brands such as Fiat, Dodge, and Chrysler.

Sales have been strong for FCA despite an industry-wide decline. In fact, in May the company sold 214,294 vehicles — its highest sales month dating back to July 2005. However, the OEM’s subvented lending partner Santander has failed to meet volume goals.

As of March 31, Santander recorded a 28% penetration rate for Chrysler Capital loans — up from 23% in the prior-year period but below the April target of 65% set by the original agreement between the companies.

Moreover, Ally Financial is actually funding a greater dollar volume of Chrysler retail installment contracts than Santander. In the first quarter, Ally originated $2.5 billion of loans for Chrysler vehicles, while Santander originated $1.9 billion.

“We do not have a preferred lender relationship with FCA today,” Doug Timmerman, Ally’s newly appointed president of auto finance, told Auto Finance News. “Our business comes from dealers, who are independent business owners, and it’s earned through competition. Our culture is based on personal relationships with dealers. FCA dealers are important to Ally, and we plan to continue supporting them as we do today and as we have done historically over many credit cycles with our industry-leading products, services, and expert team.”

Ally used to have a subvented program with FCA back when both companies were owned by the government. The partnership lasted from 2009 to 2013, but the roots of that relationship linger on today.

© Can Stock Photo / meepoohyaphoto

However, add in leasing and the narrative flips again. Santander originated $2.1 billion worth of leases in the first quarter, the majority of which were for Chrysler vehicles. That brings Santander’s total Chrysler Capital originations up to $4 billion — 61% more than Ally.

Still, the fact that Ally remains a competitive secondary option to Santander is emblematic of the overall relationship.

Santander’s contract with FCA was signed for a 10-year period, however, it includes a termination provision if the lender fails to meet origination goals within the first five years. For those counting, the halfway mark occurs this year, according to regulatory filings.

“The 10-year contract remains in effect, and we continue to operate under that,” Scott Powell, president and chief executive of Santander Consumer, said during a June 1 investor call. “There is no ability to unilaterally terminate that contract. Separate from that contract, we have this equity option agreement, which does give [FCA] the right to buy Chrysler Capital from us at fair value, which would effectively terminate the existing agreement, but we are not in discussions about whether we’re performing under the contract or not.”

Santander attempted to repair the relationship last year ahead of the deadline. Rich Morrin was named president of Chrysler Capital and auto relationships for Santander in October 2017 and was meant to assuage FCA’s concerns about the relationship, given his tenure as chief operating officer.

“FCA is a very important relationship for SC, and the team and I are focused on identifying opportunities to assist FCA in selling more vehicles and to utilize incentive spending more efficiently,” Morrin told AFN earlier this year.

In part, it worked. Santander Consumer originated $1.9 billion in Chrysler Capital retail loans in the first quarter — a 24% increase year over year, according to earnings. But it seems those efforts will not be enough.

Santander declined to comment for this story.

Although FCA could still build its captive from the ground up, Jack Micenko, bank and auto finance analyst with Susquehanna Financial Group, anticipates the manufacturer will move quickly to purchase the Chrysler Capital portfolio.

He estimates the portfolio is worth a conservative $1.2 billion, even though Santander Consumer holds $40 billion in outstandings, about $15 billion of which is related to Chrysler, he told AFN.

“It’s the least risky part of the portfolio that FCA would acquire under the umbrella of what is Chrysler Capital, but it’s also lower yield, because higher risk is higher yields,” he told AFN. “Santander will retain all the subprime business if this deal were to go through, and we’ve heard FCA say, ‘We don’t want to do subprime in the future,’ so presumably some sort of relationship for the subprime assets would continue.”

The Chrysler Capital portfolio would provide FCA with $500 million to $800 million in incremental pretax earnings within four years, according to Bloomberg. Should the OEM start a captive from scratch, the company predicts $100 million in incremental profits in the same period.

But profits aren’t the only reason for wanting to buy the portfolio from Santander. There’s also the value of brand loyalty that retaining the lease customers would bring FCA.

“Why would Chrysler want the loans? It gives them an earnings stream from day one, and they will be more profitable sooner,” Micenko said. “Two-thirds of the assets are leases, which gives [FCA] a better ability to control the collateral, control used-vehicle residual values into their brands, and retain customers into new leases.”

The Problem With Bank Partners

The underlying issue this deal underscores is, why are banks unable to provide the volume that OEMs like FCA need?

Several sources explained to AFN there is an inherent tension between a bank’s risk expectations and an OEM’s desire to sell cars.

“[When it works with an OEM] the lender is just there to push more cars,” said Ian Anderson, president and chief executive of Westlake Financial Services. “It really exists to sell more cars, and the autonomy of the lender is controlled by the manufacturer. You’ll see Chrysler Capital, if it’s owned by FCA, be more aggressive than even Santander was.”

Some banks are able to make this balancing act work. For example, Bank of America originates for Volvo and worked with the OEM this year to form a subscription program. U.S. Bank doesn’t partner with any specific OEMs but has managed to grow an $18 billion lease by beating its competition in the open market.

Chase Auto Finance supports financing programs for Jaguar Land Rover, Subaru, and Mazda, which can make a private-label arrangement work because they would rather invest their capital in other areas of the business than sink funds into maintaining a captive operation, said Jagdeep Dayal, senior vice president and business head of captive finance auto lending at JPMorgan Chase & Co.

“For the large OEMs, it could make sense economically [to form a captive] depending on how they want to deploy their capital,” Dayal told AFN. “But the smaller you are, the harder it is to set up your own captive, and most of them don’t believe it’s an effective use of capital. You’re competing to put your capital against product development, capital investment, and I don’t think the small OEMs have capital like Ford Motor Co. does to set up their own captive.”

With its sales on the rise, FCA clearly feels it has the capital to invest now, however, those funds will have to come from the capital markets, which can be volatile through a recession. FCA has a turbulent history of dealing with recessions. It sought a Congressional bailout in 1979 and had to restructure following its purchase of the Jeep brand and another financial crisis in 1987. Inconsistent financial results prompted the purchase and sale of the company by Daimler and Cerberus Capital.

“When OEMs have a captive, the cost of funding typically comes from their paper and the asset-backed securitization market,” Dayal said. “A big bank like ours has material cost-of-funding advantages over their economics. It becomes more stark when you enter a recession, because ABS prices skyrocket, and [Chase] is not dependent on ABS for funding.”

Dayal also stressed the importance of separating the bank’s auto finance team from the private-label captive team. The Santander-Chrysler arrangement lacks that separation.

“We do have some small parts of our company — like our sales team — which is separated, but you can imagine having to separate the technology team, the operations team, the risk teams, etc., to create a separate entity from what we have today,” Santander’s Powell told analysts and investors.

“That’s why we expect there will be — assuming this transaction moves forward —transition services agreements that are required to get them fully up to speed and running [FCA’s] own captive finance company.”

Santander is an unusual banking institution. Its parent company is Banco Santander S.A. in Spain, however, it operates separately and doesn’t have access to depository funding mechanisms the same way Chase does.

As part of Santander’s efforts to court FCA and better fund prime loans, the lender acquired a $700 million flow agreement from its parent bank in March 2017.

But dealers know the difference, and many send more paper to the true captives, Dan Fields, president of Chicago-based Fields Automotive Group, told AFN.

“The OEMs that we work with have had an inherent advantage, and I think the ones that do not would admit that’s true,” Fields said. “Even the [OEMs] that have very good partnerships with quasi-captives that are really banks with a name in front of them are just not the same as a true captive, which will make a sacrifice for the greater good of the company. With the bank, there’s more of a rational decisioning, and sometimes in the automotive business the emotional decisions are the right ones.”

Santander’s Future

Back when Ally Financial lost its GM partnership, there was a doom-and-gloom attitude surrounding the company’s prospects. But those forecasts didn’t play out.

“OEM agreements are great and we welcome the business, but we’ve proven time and again that we can succeed without them,” Ally’s Timmerman said. “Ally is well-positioned to earn dealers’ business, and we are committed to continuing to do so, regardless of the competition.”

© Can Stock Photo / alphaspirit

This time around, there’s far more optimism that Santander will succeed.

Santander is likely to keep the most profitable loans from the portfolio, while FCA is more interested in the lower yielding leases, Susquehanna Financial’s Micenko noted.

“The spread is narrower for the Chrysler assets than it is for the subprime assets that [Santander] is retaining,” Micenko said. “If you look at Santander overall, the net interest spread is about 10 percentage points. In our [projections], we assume the higher quality assets are net interest spread 3% on that business.”

Santander noted during its third-quarter 2017 earnings call that it planned to “increase nonprime volume while ensuring the appropriate risk-return profile,” following a period of pullback through much of 2017, Powell said shortly after assuming leadership of the company.

“We’re seeing [Santander] step up a little more with franchise dealers, same with Wells Fargo Auto,” Westlake’s Anderson said. “You see them coming back down [the credit spectrum],” though not yet to the competitive level the lenders were at before they pulled back.

“Our biggest growth area this year besides [the prime program] is our franchise business,” he added. “You tend to think that would change if you see Santander getting [really] aggressive, but we haven’t seen it yet.”

Santander’s Powell noted that the company plans to stick to its current credit box through this transition, especially since there’s a possibility the deal doesn’t pan out.

One of the potential outcomes highlighted on the June 1 call by UBS Analyst Eric Wasserstrom was the possibility that Santander could maintain a third-party servicing relationship for the Chrysler Capital portfolio.

To exit the existing contract, FCA has to make a fair-value purchase of the portfolio, which would include the servicing staff.

Although the sales function is currently separated at Santander and Chrysler Capital, much of the back-end collection team is not.

“Carving out a company from within a company is not an easy thing to do, and having said that, we have a really deep and knowledgeable management team, very experienced, and we are very focused on that risk,” Powell said on the call. “It is a real risk. I’m not going to sit here on this phone and try to tell you guys it’s not, but we’ve recognized that, and as we go through that process we will try to keep everybody focused on the right outcome for our company and our shareholders, as well as on delivering for Chrysler, which again, we expect to have a relationship with Chrysler, well into the future.”

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