Article

Auto Loans: Rough Road Ahead?

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Contributing Writer

14 minutes

Strong used car demand has driven auto lending gains, but there could be economic trouble around the bend.

Credit unions grew their share of the car loan market by mid-year, but the rate of growth may be slowing. There are some signs that competitors are starting to pull back slowly. While the last 18 months have seen credit unions start to recapture some of the lost profitability starting with the first Fed rate increase in December 2015, margins remain thin. Lending executives and industry observers caution that economic, demographic and technological shifts are flashing warning signals to auto lenders.

Measuring the Car Loan Market

In the U.S., credit union auto loan growth has slowed in 2019, says Bob Child, COO of CUES Supplier member CU Direct, Ontario, California. Credit union total car loans grew 5.3% to $376.6 billion in the 12 months ending June 30, according to industry data. A year earlier they had grown 10.5%. Credit unions’ share of automotive loans was 32.1% in June, up from 31.7% in June 2018, notes Child, but their share of auto loans is down from a high of 32.3% in December. 

“Credit unions are well-positioned to maintain a strong presence in the used car market in 2020,” Child says. “Used car auto loans make up 70 percent of credit union auto loan portfolios, which we believe will continue over the next year and beyond.” 

Credit unions are holding steady on auto loan delinquencies—for now. The industry ended 2018 at a comfortable 66 basis points for average delinquency rate, the National Credit Union Administration reports. Curtis Sabbatino, CU Direct’s advisory services consultant, cites NCUA data showing indirect loan delinquencies have lowered to 54 points through Q1 of 2019. 

There are warning signs in the broader market, however. At year-end 2018, the Federal Reserve Bank of New York reports, a record 7 million Americans were 90 or more days delinquent on their auto loans. That’s 1 million more borrowers than in the previous peak at year-end 2010 and a trend that has been building slowly since 2014. The upward trend in 90-day-plus delinquencies continued into the first quarter of this year. 

CUES member Bill Vogeney applies a familiar phrase to credit unions’ auto lending experience in recent years—and to the near-term possibilities: “The bigger they are, the harder they fall.”

“We’re riding close to a six-year high of really strong auto loan performance. People are paying their car loans historically well, and used car values have been very strong, which contributes to that performance,” says Vogeney, chief revenue officer of $5.6 billion, 340,000-member Ent Credit Union, Colorado Springs. “But when you’ve had a period of strong credit performance, at some point in time that will change.”

Pressure is on to increase profitability. Credit unions failed to keep pace with the Fed rate increases since late 2015, and now may be the time, after a rate decrease, to widen margins and not be in a rush to lower rates, Vogeney advises. However, since February 2019, the rates for alternative investments have fallen almost a full 100 basis points. Vogeney says while this should theoretically increase indirect profitability in comparison to investing excess funds, the cost of funds (deposits) continues to rise as most institutions still have strong loan demand and are paying high rates to attract funds. 

“Theoretically the greatest margins are for B and C loans,” Vogeney notes. “Of course, there are also greater losses, so you have to price those loans accordingly, but that’s where some credit unions are moving in pursuit of a greater return.”

Curiously enough, Vogeney says, the chase for higher yields on B and C loans has led to the risk margin between an A+ loan and a B or C loan declining in the last 36 months. “That’s the impact of greater competition for these loans,” he suggests. “You may want more B and C loans, but if rates have not moved up, how badly do you want to chase that return? And how badly do you want to chase A-plus loans that offer a well-below-market rate?”

Pricing loans to enhance profitability is especially crucial for credit unions facing liquidity challenges. As Ent CU’s loan-to-share ratio hovers around 100 percent, “we have to be more conscious about what kind of loans we make and what returns those loans produce,” he says.

Credit unions are well-positioned to maintain a strong presence in the used car market in 2020.
Bob Child
COO
CU Direct

Demand for used autos is high, spurred in part by the average $2,000 price hike for new vehicles, primarily due to the increased cost of technology and additional taxes, Child reports. 

In combination with rising loan rates, higher sticker prices are steering consumers with top-tier credit, who have traditionally been new car buyers, toward used vehicles. But those borrowers still expect favorable loan rates. As a result, “the divergence between new auto loan rates and interest rates for late-model used vehicles—especially for those prime and super-prime borrowers—is getting narrower and narrower,” Child notes. 

Contributing to this demand, extreme weather experienced throughout the country over the last year—from major hurricanes on the East Coast to wildfires in the West—have also forced many consumers into the market to replace damaged or destroyed vehicles. In response to these factors, industry analysts are forecasting that 40.4 million used cars and trucks will be sold in the United States this year, up 3 percent over 2018. 

Loss ratios are a function of both the frequency and magnitude of loss, so low default rates combined with used cars holding their values have been good for lenders. Some aspects of the strong used car market can be traced back to the Great Recession, Vogeney suggests. The Cash for Clunkers program in 2009 took hundreds of thousands of older vehicles off the market in a short time, and leasing declined steeply during the downturn so that the pipeline of three-year-old vehicles returning to the market slowed to a trickle. The resulting shortage of good, used, affordable cars and corresponding upward shift in prices have stuck around.

In recognition that prime borrowers are as likely to buy used as new, and that they also will repay those newer used cars as well as a new car loan, Ent CU’s auto loan rates are the same for used cars three years old and newer as for new vehicles. Another factor driving used car demand and, thus, high used car prices is rapidly escalating new car prices, Vogeney says. “Mid-sized and full-sized sedans are not what consumers are buying and the manufacturers are producing. It’s all about sport utility and crossover vehicles rich in features. Even families with the income to buy a new vehicle are choosing used models, helping support used values.”

Overall auto sales have leveled off. Though total vehicle sales climbed to historic highs in 2015, they have declined slightly or held steady in the years since, and “our anticipation is that 2019 sales will be down as well as the slowdown continues,” says Bill Handel, VP/research at Raddon, a Fiserv company, Schaumburg, Illinois.

The intertwined challenge facing credit unions is competing in an increasingly crowded field for a lower volume of auto loans even as the profitability of that product line is declining, particularly in the indirect market. 

“In our analysis, many indirect lenders, depending on how they allocate costs, are either unprofitable or nearing unprofitability. At the very least, they are generating fewer profits for these loans in comparison to three to five years ago,” Handel says.

Interest rate compression is a major factor behind declining profitability, Handel says. For the most part, auto loan rates are not increasing in lockstep with rising interest rates, and credit union lenders facing competitive pressures may feel especially constrained in setting rates. 

At the same time, as delinquencies are starting to creep up, lenders need to be cognizant of the reality that borrowers are more likely to miss or delay payments to seemingly distant indirect lenders. Handel quotes a credit union CEO who once told him: “‘I really don’t care if members are late with their payments. I only care if they’re late paying me.’ He was looking out for that loyalty where members would repay their credit union first.” 

An additional drain on profitability in the indirect channel is that competition is so high that dealers can command higher compensation from lenders, which can cut into an already dwindling return on those loans, he adds. 

It’s hard to exit entirely from indirect lending since most consumers don’t arrange for financing before they walk into the dealership, no matter what credit unions have tried to do to convince them otherwise. However, Raddon’s analysis anticipates that some will leave or curtail their indirect lending by raising rates or decreasing dealer compensation in 2019.

Ent CU employs indirect lending through relationships with dealers in its primary markets and through CU Direct’s CUDL as the most efficient way to maintain an auto lending presence in other communities. Vogeney does not anticipate that the credit union will pull back on indirect lending in response to changing economic conditions because it has maintained credit standards rather than increasing and decreasing loan volume by varying its approach to credit risk management. 

At the same time, as credit unions become increasingly loaned out—the industry average loan-to-share ratio is around 85 percent—they may need to sharpen their strategies to become “more selective in the loans they are taking so that they can get a higher margin,” he advises. “Credit unions with more sophisticated lending strategies are not going to be chasing a bigger share. They’re going to be chasing a better margin. When you’re 100% loan-to-share, you can’t be just lending for small returns.”

Trends to Keep Tabs On

1. Continual evaluation is a must. For credit unions considering slowing down indirect volume, Sabbatino and Child suggest “doing deeper dives into vintages,” or analyzing loan performance on a year-by-year basis. How do delinquency and prepayment rates for auto loans made in 2016 (a.k.a. Vintage A) compare to loans made in 2017 (Vintage B) and 2018 (Vintage C)? The loans running off the books are typically being paid off early by prime borrowers, increasing the overall delinquency ratio of the remaining portfolio. 

The aim of this analysis is to assess whether reducing current indirect volume would increase the impact of delinquencies in earlier vintages on the overall portfolio and, if so, whether the best course might be to tip the scales of current indirect loans toward higher credit tiers.

This assessment “allows you to analyze your yield and performance and identify the quality and quantity of indirect loans you want to originate going forward,” Sabbatino says.

Credit union lenders are also monitoring the impact of long-term loan contracts of six or seven years’ increasing repayment risk and extending the time that owners owe more than their vehicles’ value. Even with those longer terms, Child notes, the average time borrowers hold on to loans before paying them off or trading in their vehicles has held steady at 2.6 years. 

And, on the positive side, “the cars that are being built today are so much better quality than they were 10 years ago,” he adds. “Cars are lasting longer, so their values hold up longer as well.”

Another way credit unions are continuing to improve the probability of repayment and reduce the severity of losses is by limiting the loan amount based on the vehicle’s value. 

$130 million Alive Credit Union, Jacksonville, Florida, has always taken a conservative approach to the amount of money it will lend on a car loan, with a top end of 115 percent for direct and 105% for indirect loans. When such products as gap and mechanical breakdown coverage are added, that may bring the total loan-to-value ratio up to 125 percent, less than the 150 percent loans that some competitors finance, notes CEO Rose Gunter, a CUES member.

“We can’t be taking huge losses, and we try to look after our members’ best interests as well,” she explains.

Credit unions with more sophisticated lending strategies are not going to be chasing a bigger share. They’re going to be chasing a better margin.
Bill Vogeney
Bill Vogeney
Chief Revenue Officer
Ent Credit Union

2. Gen Xers and millennials are now the dominant auto buyers, surpassing boomers for the first time in 2019. Contrary to speculation that these generations were not interested in car ownership, it now appears that they were just taking their time. And their preference to start shopping online—at dealer websites, sites like TrueCar and Cars.com, and CU Direct’s own AutoSmart—could reshape the industry. The customizable AutoSMART directs preapprovals and shoppers through the websites of partner credit unions.

“Credit unions need to be present where people are shopping or risk losing out on that opportunity to serve members,” Child suggests. “If they’re shopping at a dealer’s website, we want to make sure that they can get a preapproval right there so that the loan doesn’t go to a bank.” 

CU Direct plans to introduce “Penny Perfect pricing” during third quarter, to lay out online the full costs for members of their next car, the value of their trade-in, and the rate and terms of credit union financing, calculating their monthly payments as the bottom line. “As a buyer, when I feel good about all that, I’ll head for the car dealer where the loan application will be ready for me so I can get in and out quickly if everything looks good. That’s the direction we see the car-buying experience going,” he adds.

3. Over the long term, a rise in ride-sharing may decrease cars per household. Despite predictions that reliance on Uber and Lyft may someday usurp car ownership, Raddon’s research finds that most consumers who have embraced ride-sharing view this form of transportation as an alternative to mass transit and taxis, not a replacement for driving themselves. 

Still, “one impact of ride-sharing is that households will likely have fewer cars, so that families that had three cars might now get by with two and two-car households might be comfortable with just one,” Handel notes. 

Recession: When, Not If

As of June, the recovery in the wake of the Great Recession will officially become the longest in U.S. economic history, Handel says, so lenders are scanning the horizon for clues about when the next slowdown will begin.

Vehicle sales trends correspond closely to economic ebbs and flows, he notes. “You can see the incidence of recessions in changing demands for new and used cars. While the long-term curve in vehicle sales has mostly been upward, where you see small downturns in the trend line, that largely correlates to recessions,” including the precipitous drop in 2008 and 2009.

One of Newton’s laws of physics—for every action, there is an equal and opposite reaction—can also be applied to lending, Vogeney suggests. Auto lenders who opened the “risk spigot” during the high tide of the economic cycle will likely be stepping back now on making loans to higher-risk borrowers and preparing to increase collections in the coming months. 

In comparison at Ent CU, “we certainly have our eye on indirect, but we’re not concerned about the next downturn. We know we will have a recession. We’re not sure how deep that recession will be, but we’re not overly concerned with it because we know our credit quality is really strong,” he says. “We’ve focused on working a little harder for loans through business development and strategic planning rather than loosening credit quality.”

Handel notes that long-term trends in auto sales and lending are more influenced by technological advances and demographic and cultural shifts than economic cycles, though lenders need to monitor both short-term and more distant influences. 

“At any rate, we don’t think we’ll see a recession in 2019, though there’s a reasonable possibility for a downturn in the second half of 2020,” he adds. “But who knows if that will actually happen. We don’t see any specific economic pressures. It’s more the case that recessions happen, and we’re due.”   

Watching the Speedometer 

National Credit Union Administration statistics for federally insured credit unions identify healthy gains in auto lending as of the end of the first quarter 2019:

  • Auto loan volume increased 7.7% over the year ending March 31, to $366.5 billion. Though used vehicle loans produced higher volume, new auto loans increased more than used vehicle financing, at 8.5% and 7.2% respectively. 
  • The delinquency rate for auto loans was 53 basis points, down from 55 basis points in the first quarter of 2018. 
  • Auto loans commanded 24.3% of total assets, down from 31% a decade earlier. New auto loans accounted for 8.5% of total assets at the end of the first quarter this year, compared to used vehicle loans at 14.6%. cues icon

Karen Bankston is a long-time contributor to Credit Union Management magazine and writes about membership growth, operations, technology and governance. She is the proprietor of Precision Prose, Eugene, Oregon.

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Strategy | Operations