February 12, 2018
Auto Lending at a Crossroads
By Alec Hollis, Director – ALM Strategy Group, ALM First Financial Advisors, LLC

“Transitions to delinquency show persistent increases for auto and credit card debt; auto loan delinquency rates especially problematic for subprime auto finance loans.”

So reads the press release from The Federal Reserve Bank of New York for a recent Quarterly Report on Household Debt and Credit. Headlines like these are becoming more common in relation to auto lending as regulators cite concerns over several years of strong growth alongside eased underwriting standards and unabated flows into delinquency.

The unprecedented growth in auto debt can be derived in part by the underlying demand for the collateral. Annual auto sales have seen several consecutive years of growth, setting an all-time high of 17.5 million units in 2016. This growth has trickled down to auto lenders, as total auto loan debt notched a new all-time record at $1.21 trillion in outstanding balances at the end of the third quarter of 2017. This represents a 48% increase from ten years ago – second only to a 157% increase in student loan debt – while total household debt increased 7% over the same time period.

This growth has the OCC’s attention – the agency took notice as early as the spring of 2012, citing banks launching new products, services and processes to catalyze asset growth, and specifically mentioning the growth in indirect auto lending. While growth in and of itself is not necessarily bad, the OCC has consistently discussed auto lending, which is why it is important for financial institutions to understand the reasons behind the elevated risk status.

Originations
Total originated auto loans surpassed $430 billion through the first three quarters of 2017, with roughly $88 billion of those loans considered to be subprime (credit scores below 620). Subprime auto loan originations have not been growing as fast as in preceding years, as some major market participations have capped subprime production, but overall originations continue unabated, with an ongoing streak of year-over-year increases.

At the close of 2017, roughly 20% of auto loan originations were subprime, compared to 21% in 2016, 23% in 2015 and 29% pre-crisis in 2007. Despite this decrease, Figure 1 shows that subprime origination volume has nevertheless has accelerated to roughly pre-crisis levels today, while originations with excellent credit have far surpassed pre-crisis levels.

Figure 1



Delinquencies
Delinquencies in the auto lending space have likewise ticked up. Auto loans 90+ days delinquent measured 3.97% of the outstanding balance in the third quarter of 2017, continuing a streak of quarterly increases. Delinquency flow (newly delinquent loans) has also been increasing steadily for several years. Figure 2 shows the outstanding seriously delinquent balance, which has increased steadily since 2014.

Figure 2


Although widespread delinquencies have yet to materialize, there are certainly problematic sectors. Auto finance companies represent $602 billion – or roughly half of the $1.21 trillion outstanding – in auto loan debt. When it comes to subprime lending, auto finance companies dominate, representing 74% of outstanding balances with credit scores at origination of less than 620.

Auto financing companies might not look quite so dominant, though, when digging into delinquency flows. Figure 3 shows the flow into serious delinquency for auto loans originated with a credit score of less than 620. These flows have diverged from banks and credit unions in a major way, and are currently at levels not seen since the financial crisis for this major subset of subprime auto lenders.

Figure 3


The OCC has been consistently discussing and monitoring the trends in delinquencies since they first mentioned the drift higher in 2013. Asset quality indicators such as delinquency ratios and net charge-offs are trailing indicators, meaning that they take time to materialize as the credit lifecycle matures for a particular vintage of loans. Many are expecting delinquencies to continue to rise, as aggressively underwritten vintages continue to mature. To prepare for this, it is important for financial institutions to ensure collections operations can meet the potential delinquencies and that reserves are appropriate given this expectation.

Indirect Auto Lending
As it relates to auto lending, the OCC has widely discussed fair-lending risk, a result of yielding underwriting decisions to auto dealers or other third parties. Not only does this practice create a risk to credit standards, but it also carries significant compliance risk.

A notable case in 2013 involved Ally Financial, a large lender in the indirect auto space. The Consumer Financial Protection Bureau (CFPB) and the Department of Justice (DOJ) took action against discriminatory lending practices present in Ally’s program. Incentivized by dealer markups, minority borrowers were being charged higher interest rates at the discretion of the auto dealer. As a result, Ally was required to pay a total of $98 million in damages and penalties.

This example demonstrates how crucial it is for financial institutions to have adequate controls and appropriate compensation for dealer relationships. The last thing an institution needs is a dealer making underwriting decisions – not to mention the potential multimillion dollar penalties that may accompany them.

Action Plan
Recent news is riddled with coverage on auto loan delinquencies, subprime auto lending and large institutions scaling back from auto lending. Most recently, TCF Financial Corporation, a Minnesota-based bank holding company with $23 billion in total assets, announced discontinuation of all indirect auto lending. Other big banks have announced the limitation of auto loan originations in general, citing rising stress and protection from credit risk. As far back as 2015, Wells Fargo announced a cap on subprime production, after years of being aggressive lenders in the space. Moves like these could indicate some concern.

Particularly in regards to indirect lending, institutions need to understand the importance of assessing the additional risks posed by dealer relationships, as well as the additional fees. Return-on-capital models can objectively assess the profitability of product lines – if risks are mounting, institutions can take a cue from TCF and perhaps take a step back from the market.

Overall, auto lending can be a very important part of the balance sheet for many consumer-focused financial institutions, and indirect lending and dealer relationships can be an excellent tool to expand the institution’s reach. However, if ensuring safe and steady growth is the goal, history has shown that loosening credit standards to increase loan volume is not often successful in the long run.

Disclaimer: The views and opinions expressed in this article are those of the author(s) and do not necessarily reflect the official policy or position of the Financial Managers Society.

About the Author

Alec Hollis is a Director in the ALM Strategy Group at ALM First Financial Advisors, LLC.