By Robert Brannum
As the home foreclosure crisis persists, millions of consumers are now experiencing a form of residual economic damage – defaulting automobile loans. The implications for banks include increased incentives to do loan workouts, due to reduced resale prices at auction. But on the bright side, a shakeout in the auto loan industry that weeds out the less stable non-bank lenders could result in a flight to quality, back to banks with sounder underwriting policies.
The problem in auto loans predates the current high cost of fuel. Its roots are similar to those of the subprime housing crisis: relaxed standards for granting credit during what had been a booming economy, coupled with longer loan periods and reduced down payments. The traditional 36-month and 60-month loan terms are now 78 and 84 months; 20 percent down-payments were whittled to 5 percent. Borrowers who wanted to upsize to a larger or more expensive car, while already carrying an existing car loan, were encouraged by lenders to simply roll that existing loan into their new loan.
Auto borrowers were able to secure loans with little credit, little income, and often without employment verification. Although auto loans are typically fixed rate loans, consumers were over-extended, and as housing and other costs have risen, they are getting squeezed. When choosing between the mortgage payment or the auto payment, most chose the house, and let the auto loan payments slide.
A Worsening Situation
The most recent data available from the American Bankers Association confirms a worsening situation. Its April bulletin reported fourth quarter 2007 data, and it was not a pretty picture. Consumer lending delinquencies during that period reached their highest levels in 25 years. The ABA tracks eight different loan categories, from auto loans to home equity to personal loans to marine loans, and all eight categories indicated growing delinquencies, which the ABA calls “a rare occurrence.” James Chessen, the ABA’s chief economist, pointed to auto loan delinquencies as the chief culprit. “The rise in consumer credit delinquencies is consistent with a rapidly slowing economy. Stress in the housing market still dominates the story but it’s a broader tale of an overall weak economy,” Chessen said in a statement (see Exhibit 1, page 19).
Not only is this a terrible predicament for consumers – who lose their vehicles at minimum but can also destroy their credit ratings for a decade – it is also a very bad situation for the lenders, who have only their repossessed cars to show for the failed loans. As oil prices rise, consumers seek to downsize their large trucks, vans, and SUVs to smaller, more gas-efficient choices, which would reduce both fuel prices and car loan payments. But with inventories and gas prices rising , lenders need to take significant discounts to resell those repossessed vans, SUVs, and pick-up trucks. Here’s another home/auto crisis link: As mortgages payments rise, discretionary incomes falls, and home improvement projects drop. As projects dwindle, contractors have less income, and those contractors with large truck loans get pulled down.
The “easy credit” for auto loans has had a major impact in the debt levels of US consumers: this year, Americans owe $772 billion in auto financing, up from $282 billion ten years ago. Consider these statistics: loan delinquencies (which are defined as loans more than 30 days past due) exceeded 3% in late 2007, which is the highest it has been in 17 years. In 2008, an estimated 1.6 million cars are likely to be repossessed, which is a 10 percent increase over last year. Automobile auction companies are reporting inventories triple of last year’s levels.
Indirect auto loans are loans which are made to car buyers by dealers, and which are then sold to lenders. Direct auto loans are made directly made by the bank to a borrower. Today, a majority of car loans are indirect loans, by some estimates around 70 percent, as car purchasing and financing have become a one-stop shopping event.
Anything for a Sale
Keith Leggett, a senior economist with the ABA comments, “The incentive structure of auto dealers and banks are different when originating loans. A bank is interested in whether the borrower will be able to repay the loan. However, auto dealer is primarily interested in selling a vehicle.” Dealers are more likely to loosen the underwriting standards, if it results in a sale. They may lengthen the maturity structure to make monthly payments lower, or require a smaller down payment. “Higher loan-to-value ratios and longer maturities are associated with greater risk, and this accounts for higher delinquency rates,” Leggett says.
Exhibits 2 and 3 (page 19) illustrate the growing rate of car repossessions nationally over the past few years, and through 2007. With the loosened credit practices seen in the indirect channels, it is clearly understood why repossession rates for indirect loans are so much higher than for direct, bank-originated loans.
The nature of interest rate risk, in which high risk borrowers are only offered high interest rates, also contributes to the combustible situation. During the third and fourth quarters last year, the top credit borrowers received auto loan interest rates that averaged 5.7 percent, while the riskiest subprime borrowers received an average 15 percent rate – almost triple that of the best borrowers.
Then, there’s the growing number of auto loans that reach a pivot point where the outstanding loan balance on a vehicle exceeds the value of the car, commonly called an “upside down loan.” Unlike homes – which are assets that are expected to appreciate over the long term – automobiles begin depreciating as soon as they are sold.
According to Leggett, “The longer maturity structures mean smaller monthly payments resulting in slower repayment of principal. As a result more car loans are upside down. Upside down auto loans won’t necessarily worsen the auto delinquency rate, but it will result in larger losses for lenders in the case of repossessions.”
Let’s Work It Out
There is a very interesting dynamic occurring now between car lenders and borrowers. Consumers are not quite as stressed with auto loan defaults as they are with mortgage defaults. While housing remains a fundamental need, for many car owners, having their own vehicle is partly of convenience, with other options available if necessary.
This attitude has impacted lender behavior as well. Lenders are getting hurt at auctions, where auto prices are dropping. In those situations where the auction price fails to cover the outstanding loan balance, the lender will continue to expend considerable effort to seek the difference from the borrowers. As a result, lenders are becoming less quick to want to foreclose and more willing to help consumers work it out and to find a way to keep the loan current. By enacting favorable conditions – such as forgiving some interest due, extending the term, or deferring some payments – lenders provide a better chance for borrowers to keep their loans – and their credit ratings – in the black.
The Road Ahead for Banks
The stronger performance of the direct loans portfolio (as measured by considerably lower delinquency and repossession rates) leads to speculation on how this shaky loan market will play out for banks, as opposed to nonbank lenders. Again, the sub-prime mortgage market provides a model for the auto loan industry.
As with the mortgage industry, the auto loan industry should expect to see a flight to quality. Fly-by-night mortgage lenders were shaken out of the industry, and those institutions which upheld proper underwriting standards – such as banks – remained. Certainly those banks are fighting significant issues with delinquencies, but for most banks, their solvency is not in question.
Analogous to the mortgage segment, those providers of cheap auto loans may price themselves out of business as well. Those that remain are hurt, even mega-lenders like Ford Motor Credit. Consider the case of Chase Auto Finance, a subsidiary of JP Morgan Chase. In its Second Quarter 2008 earnings presentation, it presented two key data points. The first was that revenues in auto finance dropped compared to the previous quarter, primarily due to growing expenses related to charge-off allowances and delinquency issues. However, that same statement indicated strong growth in its auto loan originations – an increase of nearly 30 percent ($1.6B) in originations over the previous quarter, and a perfect illustration of the flight to quality.
Unfortunately, at present, the roiling economy will affect both banks and nonbanks alike, since they share the same customer base – auto buyers. Auto sales in May, as reported by Ford, GM, and Toyota, have plunged. Fuel prices and credit tightening are likely to keep sales down for the summer. However, as auto shoppers become buyers, and buyers become borrowers, banks should be in a good place to rebound their auto lending businesses, as their nonbank competitors continue to reel from past lending difficulties.
Robert Brannum is a freelance writer based in Boston with special expertise in the financial industry.