Recent data points to it and the atmosphere at two recent auto finance-related conferences confirmed it: nonprime auto finance is back. But how long will it last? And how soon will the lessons learned during the credit crisis three years ago be forgotten?
From the speaker presentations to the positive vibes flowing throughout the exhibit hall at the National Automotive Finance (NAF) Association’s Below-Prime Conference in Fort Worth, Texas, in June, the mood of the nonprime auto finance industry is as upbeat as I’ve seen in the last 15 years.
The same was true at the National Alliance of Buy Here, Pay Here Dealers (NABD) Conference in Las Vegas in May. And that’s in spite of the supply shortage of used vehicles, which has resulted in higher prices at both wholesale and retail.
Expanding Once Again
Renewed interest among institutional investors is driving the auto finance industry’s improved mood. The deep-pockets of this community is once again making their millions of dollars available to finance companies; in fact, here are three recent examples:
• In March, Prestige Financial Services Inc. completed a $222 million asset-backed securitization (ABS) transaction at a favorable funding rate and interest rate, followed by a $150 million deal with Wells Fargo Securities on a warehouse line of credit in July.
• GM Financial/AmeriCredit Corp. completed a $1 billion securitization in June at favorable interest rates and credit enhancement requirements, the third transaction the company has completed this year.
• A number of experienced management teams have successfully secured funding from investment bankers to begin new companies. Notable mentions are Flagship Acceptance Corp., led by auto finance industry veteran Michael Ritter, and CarFinance
Capital, which has four former Triad Finance Corp. execs, including founder Jim Landy, at the helm. Word is that more companies will enter the market before the end of the year.
The fact that below-prime portfolios performed well through the credit crisis and ensuing recession is, in my opinion, the driving force behind these new investments — well, that and the fact that higher yielding investments are always attractive to investors. Whatever the reason, it’s all good news for the industry. Finance companies now have the funds to purchase the paper, while dealers have more options to place that paper than they’ve had in the last two years.
However, having been around this industry for a while and observing several cycles firsthand, I’m already a bit nervous about the competitive landscape. It seems inconsistent, doesn’t it?[PAGEBREAK]
Fear of a Replay
Things are moving in the right direction. My concern is that, as in most cycles, the industry and investors will soon throw caution to the wind.
Here’s how things are playing out based on my analysis of the current cycle: Investors see an opportunity to earn higher yields on their funding of the nonprime segment, and, led by respected institutions, begin to invest more and more funds. That’s when the “herd” syndrome sets in among investors, which eventually leads to an oversupply of capital in the market.
Then, particularly for publicly funded or private equity-funded companies, the pressure to put a lot of business on the books and gain market share intensifies. And, as you know, the more finance companies there are, the more competitive the purchasing programs become at the dealer level. That’s exactly what happened in 2006 and 2008, when dealer advances and term lengths spun out of control.
Basically, companies were offering higher prices for finance paper that was dropping in credit quality. Dealers were able to shop finance contracts around and receive multiple bids from the finance community, and loan-to-value (LTV) ratios of 140 percent or higher and terms of up to 84 months on higher priced vehicles became commonplace.
About the only thing that didn’t get out of control was dealer participation, which was, more or less, held in line by the regulatory climate. Otherwise, that too would have spun out of control.
Those were some highly profitable years for knowledgeable dealers, but they ended up hurting finance companies. Ultimately, those fast times would hurt dealers as well. Looking at the 2009-2010 period, LTVs were more likely to be less than 100 percent, while average loan terms were greatly reduced. Underwriting guidelines also were tightened on items such as debt-to-income and payment-to-income ratios.
Many franchised and independent dealers found that they could no longer access financing for the below-prime customer, while the finance sources they once relied on were forced to curtail production due to the loss of the secondary market for ABS securitizations.
The equity investment community also retreated from anything with the term “subprime.” Was the auto finance community to blame? No. It was the out-of-control subprime mortgage industry, which tarnished everything associated with that term.[PAGEBREAK]
Holding the Line
Underwriting standards are currently holding up well, which will result in acceptable loss statistics on the paper finance companies are currently originating. However, pressure is building to amass larger portfolios of loans, generate higher profits for investors and increase market share.
Manufacturers also are desperately trying to increase their production and are offering favorable terms to qualifying customers through their captive finance companies. Enticed by attractive rebates, cash-back offers and low-cost financing, customers set on purchasing a used vehicle are being driven to the new-vehicle lot.
So, you can expect finance companies — particularly those serving the nonprime and subprime segments — to slowly loosen underwriting standards in the quest for more business. This will be accompanied by higher LTVs and longer terms. What will inevitably follow, perhaps within a year or so, is a rise in defaults, repossessions and portfolio losses.
Once that begins to happen, the investment community will once again begin pulling back. This will manifest itself in ABS securitizations with higher interest rates and greater credit enhancement, increasing the cost of financing for auto finance companies. Providers of warehouse lines of credit also will become more cautious, raise their rates and underwrite more carefully. Equity investors also will flee the subprime auto finance arena again, signaling the move into the negative part of the cycle.
What can prevent this from happening? First, auto finance companies must maintain their discipline by holding quality standards on credit requirements, LTV percentages and terms of finance. If some competitor decides to “buy” the market, let them fire up the rockets and burn out by themselves. That’s the discipline that is required by the companies who are in business for the long haul.
There are some wise CEOs in this industry that understand the causes of cycles like the one we experienced and will choose not to participate. Their companies may not reach the heights of the high flyers, but they will stay in business during the low parts of the cycle.
Am I advocating a 1950s-like, financially conservative atmosphere with sleeve garters and green eyeshades? No, but this is a season to responsibly enjoy the good times and do the things that keep those good times rolling as long as possible.
Will holding the line on credit pricing harm dealers? Not in the long run. The emphasis at the dealership should be on obtaining a fair price for the vehicle and securing a sufficient down payment from the customer to enable subprime companies to reasonably and prudently purchase finance contracts.
If all of that happens, losses will remain in an acceptable range, the investment community will continue to show interest in the subprime arena, and the entire system — from car buyers to the securitization bondholders — will be better off. This will allow interest in the investment community to be sustained. So, the solution is fairly simple. And although it is almost impossible to defeat economic cycles, we should try our best to do just that.
Jim Bass is CEO of Auto Acceptance Corp., treasurer of the NAF Association and a licensed CPA. He is a frequent speaker at industry events and a leading voice for the subprime, nonprime and BHPH segments. E-mail him at [email protected].special-finance.com