Is Nonprime About to Cave?

Largely due to a Standard & Poor (S&P)’s Research report, entitled, “U.S. Auto Loan Static Index and Collateral Trends Report: The Subprime Mortgage Crisis Could Affect Auto Loan Deals,” I have fielded quite a few inquiries similar to the article’s title. Actually, once you read a little past the title of the article, you realize that S&P was not intending it to be an alarmist article, as it points out that “the majority of subprime auto borrowers are renters, and thus are not subject to the vagaries of the mortgage market.” That being said, it is understandable why investors would worry about the subprime auto market, as well as the mortgage market.

I have always believed that the “other-than-prime” auto market is much more sensitive to the amount of capital available (i.e., the marketing pressure on this borrowing group) than the general economy. With the exception of a few cities in the United States — New York, Chicago, Washington, D.C., perhaps San Francisco and a few others — most working people really do need a vehicle in order to be able to function in their daily lives. History doesn’t support investors’ fear that borrowers will suddenly and voluntarily default on their loan just because the car payments become inconvenient.

Fortunately, we haven’t had anything approaching an economic depression in this country for many decades, but there have been a few recessions since the 1980s. Even though the stock market was having its troubles earlier this year, or some businesses were failing, there hasn’t been any meltdown in the nonprime/subprime auto finance industry. The closest thing to it was in the mid-’90s, when there was a clear oversupply of capital in the industry. Like many endeavors that require substantial capital to flourish, an oversupply can encourage less-than-prudent business policies. Besides banking and auto finance, the insurance industry also is susceptible to the pressure induced by having too much money to put to work, and routinely experiences cycles of feast and famine.

Oversupply Problems

The phenomenon that occurs is that in order to gain or preserve market share, volume of business starts becoming more important than the quality of the business. Underwriting discipline is sacrificed in order to produce greater volume. In all of the financial businesses, defaults typically follow the granting of credit by at least several months. Therefore, early performance data seems to support the wisdom of putting all that money to work and generating greater income. However, if this increased volume was being put on the books as a result of marketing pressure and at the expense of prudent underwriting, then higher than anticipated defaults will inevitably follow. For a period of time, the companies can outrun losses due to the lagging effect of defaults. But if volume levels off or decreases, the defaults will catch up and losses will become unacceptably high.

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Looking at publicly available data, such as the Standard & Poor’s report previously cited, we see that the industry is currently performing quite nicely. For example, annualized losses for nonprime pools have actually decreased substantially since 2002 to just slightly over 1 percent. On a vintage or static pool basis (which gives a better measure in my opinion), this trend forecasts a total loss on the pool of an approximate 3-percent net loss, which is quite acceptable. Subprime pools are currently performing in an acceptable range as well. Across the industry, the vintage or static pool losses from 2005-2006 are trending out to 10-percent net losses or less. Or, on an annualized basis (the method that banks usually report their performance), these losses approximate less than 5 percent, which, with weighted average interest rates of about 18 percent, leaves approximately 13 percent for overhead and profit. That works. Although 60-day delinquencies are ranging a little less than 3 percent for subprime auto loans, one should also take notice of the 97-plus percent of the notes that are being paid within reasonable expectations. On an over 30-day delinquency basis, the industry is running around 7-percent delinquency, which suggests that 93 percent of the borrowers are paying promptly. The simple truth is that the borrowers need their vehicles — their lives would be adversely affected without them.

Past Failures in Subprime

So, if all that is true, why have some subprime finance companies failed in the past? Well, that had to do more with poor management, inadequate systems, and unsophisticated risk-management tools. Successful companies are not driven by the quest for volume over all other considerations. These are companies that have experienced management that is oriented toward quality underwriting policies, and use modern, statistically based risk-management tools, such as credit scorecards, decision tree matrices, and payment- and debt-ratio analysis. Using these tools, higher volume of subprime auto financing can be put on the books without sacrificing quality. In addition, collection tools are also more sophisticated than a few years ago. The advent of predictive dialers, behavioral scoring, and paperless collections has greatly improved the efficiency and effectiveness of collections — the other part of successful nonprime/subprime auto-loan performance. It’s not that the borrowers have the intent to be late with their payments. The reality is that a percentage of these borrowers need a nudge in order to put their car payment at a higher priority than their unsecured debt.

Learning From the Past

Over the last 15 years, the nonprime/subprime finance industry has done a remarkable job of making the dealership community aware of potential sales and profits in the financing of nonprime/subprime customers. It has done this by providing a dependable market for a dealership’s other-than-prime finance contracts. Hence, many customers who would have been limited to the buy-here-pay-here market several years ago have moved up the quality scale to purchasing newer, lower mileage vehicles from franchise dealerships. Additionally, there have been numerous lower-cost, entry-level new vehicles that enjoy a good market with nonprime/subprime customers. In fact, the mainstream nonprime/subprime auto finance companies report that approximately 18 percent of their finance contracts are collateralized by new vehicles.

When looking at the nonprime/subprime tier of auto finance, do not look for this segment to dry up any time soon. It’s here to stay, so long as profits are available.