Hitting the brakes on subprime auto lending

Below is a lightly edited transcript of the podcast:

PRIOR: The COVID-19 pandemic didn’t slow down the auto salvage business. Oscar Nieto, the manager at Lane Recyclers in Southern Dallas is catching his breath as a forklift loads what used to look like a sedan into the crusher. So many parts have been harvested from it, it’s hard to tell what the make or model had been.

OSCAR NIETO: I mean, honestly, everything went up, like, you know, all these car, new car dealers, they started doing for the pandemic, the zero interest for the first six months, or you don’t pay for the first year stuff, crazy stuff like that. So a lot of people try to jump on that opportunity. So if they kept their jobs, it was a pretty good opportunity for them. And a lot of people have decided to get rid of their newer cars that they bought a year ago. So they don’t have that extra payment, and they decided to fix their old vehicle in the garage. So both ways. Business just skyrocketed.

PRIOR: Nieto’s junkyard can pull in as many as 160 cars a month, and junkyards like this one represent the end of the line for a business that begins at some of the largest banks in the world. And that business is huge: Americans held a record $1.37 trillion dollars in auto loans at the end of 2020, according to Experian. And all that debt services an asset that is always declining in value, and that will eventually end up here, in Nieto’s crusher. Nieto actually thinks about this all the time.

NIETO: Dealers all around the Dallas area, they call us hey, can you come and pick up these 10 cars that people just bought? And they wrecked them and they actually just turned them in in order to buy another one? So this is useless for me. Can you come and get all 10 of them? That’s fine. Yeah.

PRIOR: The churning cycle of trading in old cars for new ones — and using new loans to finance the new cars — was something that experts thought might get disrupted by the pandemic, especially for subprime borrowers, who Experian estimates make up one in five auto loans. That didn’t happen, thanks in part to stimulus checks and other interventions designed to keep markets afloat. But many banks are looking for the exit ramp.

From American Banker, I’m Jon Prior, and this is Bankshot, a podcast about banks, finance, and the world we live in.

PRIOR: Since the 2008 collapse of the housing market, the word ‘subprime’ has conjured images of catastrophe on Wall Street, of leverage run amok, and foreclosure signs in yards across America. But while subprime mortgages have scaled down considerably since the Great Recession, the subprime auto market has carried on, almost unchanged. A study from Transunion in 2011 actually found that cash-strapped consumers would make their car payment before paying their mortgage. The reasoning behind that assessment is that If someone still had a job, they had to get there to keep it, and lenders would still be needed to finance car purchases even for those with less than pristine credit. Then, the pandemic hit.

MELINDA ZABRITISKI: Melinda Zabritiski, Experian Automotive, Senior Director of automotive solutions. So overall, as far as subprime is concerned, we had seen the share of subprime financing steadily decline over the last several years. However, it certainly has been accentuated by the pandemic. For example, in 2019, subprime was just over 22% of total financing. And in 20, att dropped to under 19%. As far as the impact of the stimulus, when looking back at 2020, volume dropped considerably in April across all consumers. And there was certainly a rebound in the subsequent months, which may be tied to stimulus and tax season. However, we did see that as subprime consumers, while there were volume increases throughout the year, they didn’t recover at the same rate as near-prime and prime segments. Some of this decline could be attributed to tightening credit standards, as well as a lack of demand among subprime borrowers.

PRIOR: That tightening of credit has been happening across the industry, no matter the lender. But a closer look at where the existing subprime borrowers are going to get loans reveals that banks are ceding serious ground.

ZABRITISKI: When we look historically at bank origination, subprime has been a very small percentage, and it has been steadily declining. And this has been a decline that we’ve seen, really over the last several years. If we look back a couple years ago, 2018, 2019 for example, we would see subprime represent around 13% of bank origination and in 2020, it dropped to under 11%, again, it did drop all under types. But this is where we saw one of the bigger decreases.

PRIOR: As the pandemic raged on last year, many borrowers still kept up with their car payments, perhaps with the help of stimulus checks, perhaps because people really do make their car payments a priority. The percentage of car loans that fell 30 to 59 days past due actually declined in the third quarter of 2020 to 1.56%, down from 2.11% at the end of 2019, according to Experian’s data. That number edged up in the fourth quarter of 2020 to 1.75%, but forecasters are optimistic that drivers put a good chunk of the stimulus checks they received in March to their car payments.

ZABRITISKI: When you look at automotive lending, you do tend to see that automotive payments remain very high in the consumer hierarchy of making their payments. You’ll see a consumer make a payment on an auto loan, typically, before they would make a payment on a mortgage, if they have a mortgage. So you have that need in the demand for keeping your cars. Obviously, you know, you need your car to get to work and to maintain employment. So we do tend to see that delinquencies do tend to be lower than other industry types, when looking at making those car payments. And of course, from a lender side of things, we have a tangible asset — it’s certainly easier to repossess a car than it is you know, a mortgage. So you do tend to have the lenders able to cycle through … run their collections and repossession departments and remarketing departments. We have of course, in times when the inventory is short, then the auction values are improved. So the severity of loss is a little lower. And of course, the lenders have very robust underwriting standards, and a lot of analytics and practice around their pricing and their underwriting policy, ensuring that they’re able to really maximize the best decision when it comes to funding those auto loans.

PRIOR: Ally Financial is one of the bigger banks in the auto lending marketplace, having been formed out of General Motors’ lending arm in 2010, and its experience is illustrative of banks’ approach to auto lending as a whole. The percentage of Ally Financial’s auto loans that have gone to non prime borrowers has been on the decline even as it’s grown the number of overall new loans the company is making.

About 9% of its auto loans in the first quarter were non prime, down from 12% at the end of 2019, according to its latest earnings report. Meanwhile, Ally originated $10.2 billion in new auto loans in the first three months of the year, an increase of more than $1 billion from the prior year and its highest first-quarter volume in a decade. Jennifer LaClair, Ally’s chief financial officer, told analysts on an April 16 earnings call that they’re seeing some banks increase competition, but mostly for the lowest-risk borrowers.

JENNIFER MCCLAIR: We have seen kind of some of the larger banks and regionals growing originations in this sector. And we would expect that to happen because it’s a thriving market. What I would say is it’s mostly on the two ends of the barbell. It’s predominantly in super prime.

PRIOR: Out on the Dallas highway outside the Lane Recyclers junkyard, the skyline can be seen in the distance. One of the prominent skyrises, Thanksgiving Tower, has recently been renamed Santander Tower for Santander Consumer USA, one of the other largest auto lenders in the country, based here in Dallas.

Tim Wennes is the CEO of Santander U.S., the Boston-based parent company of Santander Consumer, which is itself a subsidiary of Spanish financial conglomerate Banco Santander. Wennes was in Dallas in April to announce the tower renaming, and I got a chance to ask him how the auto business was doing.

TIM WENNES: We’re very pleased with the performance of Santander Consumer here, through the crisis. We were early to focus on providing customer support extensions, etc. And we’ve gone through most of that now. We are seeing positive trends in terms of payment rates and credit performance. We do expect some normalization. But we’re uncertain on the timing there.

WENNES: And I think that we’ll have a combined effect of stimulus activities, but also how quickly the unemployment rate normalizes or gets back to pre-pandemic levels. It seems like we’ve got some positive signals there in terms of the unemployment rate and jobless claims, etc. And that will be a key determinant for us in terms of credit performance over the intermediate term.

PRIOR: Santander reported a boost to auto originations for 2020 as deals sprung up during the pandemic. About 32% of its total loans as of last year went to borrowers with FICO scores below 600, down from about 36% in 2019. Wennes indicated the company is aiming to grow its auto lending business but while keeping an eye on riskier credit.

WENNES: We were focused on full-spectrum auto lending and strengthening our full-spectrum capabilities. So we’re looking to expand everything from prime through to non prime in a prudent way. We are seeing healthy originations. The used car prices have held up very strong with the pandemic. For consumers, a safe use car is kind of the ultimate mask. And, and so we’ve seen very strong use car prices. And we have a positive outlook here over his near and intermediate term.

PRIOR: One cloud in that sunny outlook is the potential for greater regulatory oversight of auto lending. Santander settled a $550 million complaint last May with the attorneys general in 33 states and the District of Columbia for allegedly putting car loan borrowers into riskier deals with higher rates of default. Other banks are tightening their auto lending standards just as the Consumer Financial Protection Bureau is poised for the arrival of Federal Trade Commissioner Rohit Chopra, who made a name for himself as an outspoken consumer advocate.

PRIOR: We’ll get into that after this short break.

PRIOR: This is Rohit Chopra giving testimony before the Senate Banking Committee in March.

ROHIT CHOPRA: America in March of 2021 is far different than of a year ago. Every week we’ve seen hundreds of thousands lose their jobs, local businesses have shuttered and more than 500,000 have died. And while there are some hopeful signs that the tide is turning, we must not forget that the financial lives of millions of Americans lay in ruin. Experts expect distress across a number of consumer credit markets, including an avalanche of loan defaults and auto repossessions.

PRIOR: While Chopra stressed to Congress that the agency’s past pursuits of indirect auto lenders would not return because of a resolution lawmakers passed in 2018, some are expecting that under Chopra, the CFPB will aggressively pursue any high-cost loans that prove to be flawed.

JACK GILLIS: My name is Jack Gillis. I’m executive director of the Consumer Federation. Many consumers find themselves with subprime auto loans as the only way they can get into a vehicle. And the problem here is not only are these consumers paying enormous rates of interest, which dramatically increases the cost of owning and operating the vehicle, but they are what we call upside down in the vehicle for a long period of time, which means they likely owe more on the vehicle than it’s worth. So if they get into an accident and the car is totaled, they’ll have to pay off the balance of the loan. And if they want to sell the car, or they have, they realize that they’re in too deep, and they want to transfer the car to somebody else, they will have to pay off more than the car is worth. So subprime loans are a really, really horrible situation for consumers to be in. But unfortunately, for many folks with credit scores of less than 600, that’s their only choice. Rohit Chopra has a huge job ahead of him. We think he is well suited to tackle that job. But the first thing that he needs to do is kind of reverse all of the bad directions that the CFPB had gone in during the past administration. We know that Rohit is an expert on student lending. So that will be a prime area of interest. We also know that he is extraordinarily concerned about the financial instruments used by very low income consumers, or the lack of availability of financial institution’s instruments for that population group. But we think that he is going to attack overpriced loans across the board with a vengeance.

PRIOR: While banks may be losing market share, some companies like fintechs that operate beyond the reach of banking regulators are among those seizing ground. This is another big concern for consumer advocates like Gillis.

GILLIS: We are very concerned about many of the fintechs and other non bank organizations providing financial services, these companies can fly under regulatory oversight, number one, and number two, their very existence keeps legitimate financial institutions from entering into those markets. So we would like to see these organizations come under regulatory oversight, follow the same rules and regulations that traditional and approved financial institutions have to follow. And that would go a long way to adding some sunshine to this subprime auto market where many times these overpriced loans just simply go under the radar and do not get noticed.

PRIOR: Some have theorized that consumers may be more willing to pay their car payment before their mortgage because the borrower protections on them are far less stringent than on a home loan. This is why any new regulatory attention from the space may come from the CFPB instead of banking agencies. Banking regulators tend to focus more on threats to the financial system than protecting consumers, Gillis says, and as a result auto loans don’t always raise red flags with those regulators.

GILLIS: One of the things about subprime loans is their interest rates are so high that especially if they are paid off, banks and other offerers make a tremendous amount of money on them. If you are making 29, 30, 32% on an auto loan, there’s not a lot that a bank can do that can return that type of investment. So we’re not … we don’t feel too sorry about banks that, you know, there are organizations that charge these high interest rates when their customers go into default, because there is a tangible asset. That’s number one. And number two, they’ve made so much money until the default that you know, it’s hard to feel sorry for them.

PRIOR: As I mentioned earlier, banks as a whole have been doing fewer auto loans over the last several years. One of the main groups that has been picking up market share, especially in subprime auto loans, are credit unions. Mike Schenk, chief economist at the Credit Union National Association, said credit unions have about 30% of the overall auto lending market, which includes prime and subprime, and that could grow.

MIKE SCHENK: That has grown pretty significantly in the wake of the Great Recession. At the beginning of the Great Recession, I mean, credit unions had about 22 and a half percent market share, and it kind of bounced around in that vicinity, through 2014. And then we saw an increase in market share at credit unions, and I’m not sure if it was due to more aggressive pricing or more favorable underwriting on the part of credit unions, or the idea that you that you just posited, which would be that banks are, you know, a little bit more leery of that market. But we’ve gone up from about, say 22.5% to about 26% in 2015, 27%, in 2016, 29%, in 2017. And then we’ve been just a little bit over 30-32% since 2018.

PRIOR: While credit unions could still dabble in riskier auto loans, the structure of credit unions allows them to be more flexible in the terms they offer their members than banks can be with their customers. But for anyone underwriting a secured loan where the underlying asset depreciates so quickly and absolutely as a car, it takes a little finesse.

SCHENK: So for example, if you had a four-year, five-year automobile loan, it would be priced up over a five-year Treasury — the Treasury is being sort of the riskless rate. And then you would have sort of a premium above that Treasury yield to account for the historical risk profile of a similar loan with a similar loan with a similar credit score. So basically, you would have a little bit of a premium for every borrower at five years, over and above the five-year Treasury, and then you would have a variable premium above that, based on, you know, the credit score of the borrower. The basic idea is, you have a whole bunch of historical data that tells you the rate at which that stuff typically doesn’t pay back, and you have that data over the economic cycle. So, if you’re going into a recession, you know, from historical data, that a certain percentage of loans are going to default. And generally speaking, those with lower credit scores are going to default at higher rates. And so that’s kind of your starting point, you know, and would be the starting point for many lenders in the middle of an economic downturn or a disruption, kind of like the one we’re in today.

PRIOR: But this is where credit unions have an edge.

SCHENK: Now, having said that, it’s also important to note that credit unions are owned by their members. And because of that, and because of the fact that they tend to be smaller, and more sort of community-based institutions, credit unions, generally speaking, would be much more likely to listen to a potential borrower’s story, and to make exceptions to, you know, general underwriting criteria. So unlike in the banking industry, and especially at large banks, their underwriting is determined, you know, in a corporate office, five states away, credit union pricing is really determined locally. And generally speaking, because credit unions are member loans that are owned by their borrowers and the depositors, they would be a lot more likely to, you know, hear you out, and to make exceptions based on your unique circumstances to get you into a loan that some other lenders might not get you into, and especially in a crisis situation.

PRIOR: The other twist in the current state of the auto lending marketplace is that cars are actually in short supply. There has been a global shortage of microchips that go into new cars, pushing prices of used cars — which are already experiencing a supply crunch — even higher. That means the fundamental challenge of auto lending — underwriting a depreciating asset — isn’t so much of a challenge right now, because lenders can recoup more of their losses if a car gets repossessed, even for subprime borrowers. But higher prices for used cars also means higher monthly payments, and higher payments mean greater risk of missed payments for any lenders that remain in the subprime game. Here’s Zabritiski at Experian again.

ZABRITISKI: When you do look at availability of vehicles, and just overall inventory any year where we have a shortage, it certainly will impact the availability of inventory in the future. We saw that with 2009 model year vehicles. We had only nine months with 9 million vehicles sold for the 2009 model year. And that did cause shortages in subsequent years as a lack of late model used vehicles. We can expect to see something similar with 2020. It won’t be as accentuated because we certainly were still around I think 13, 14 million vehicles, so the impact wouldn’t be as great. But we could expect to see higher demand as they all go to used vehicles in the coming year. And of course, as we have that higher demand, it can generate higher values. And so ultimately higher payments and higher loan amounts for consumers.

PRIOR: Regulators are undoubtedly watching the auto loan market for any kind of distress that could have domino effects into the future. What has gone up for the auto loan market, essentially, could come down. Again, here’s Gillis at Consumer Federation.

GILLIS: The pandemic has hit lower income consumers very, very hard. In fact, people with subprime auto loans, for example, are defaulting at greater rates, while the government offered freedom from loan payments, in some cases, for mortgage holders or for people with student loans. There was no break for those folks that had auto loan payments, even if they needed that vehicle to exist. So the default rates are going up. And that is not only bad for the economy, obviously, but it’s also bad for those individuals who are already starting off with a low credit score. Defaulting on the car loan is only going to make that situation worse the next time they try to buy a car.

PRIOR: Oscar Nieto is packing up for a trip out of town to pick up a load of vehicles that he will bring back to the junkyard so he can gut them for parts and crush the hulls left over. He was shocked at how many cars they were processing when he first got into the business. But he learned over time that for all the changes going on up the line from him, the assets are always in need of replacing. Like economists and lenders in high rises down the highway, Nieto understands that people will still need to drive, and the business will adjust to get them behind the wheel.

NIETO: When I started here, I was, man, like, sooner or later, we’re gonna end up with all the vehicles since we bought 10 cars, maybe a day sometimes. So what’s going to happen when we finish them off? But we ended up knowing that there’s especially here in Dallas, people, they wreck vehicles, they fix them again, they put them in this street again. They do that several times. So I’ve noticed, I mean, this is never going to stop. Not anytime soon at least.

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