Cautious Optimism

The auto industry is at or near the North Pole of success, meaning that in the relatively near term, the only way for business to go is south.

A growing supply of late-model used cars, looser credit standards, and longer loan terms head the list of concerns, said dealers, auto finance execs and analysts at the recent American Financial Services Association (AFSA)’s Vehicle Finance Conference and the National Automobile Dealers Association (NADA)’s convention.

The net effect on dealers is continuing pressure on per-vehicle margins for new and used cars and trucks, and the need to make up for it in unit volume and in other profit centers, such as F&I and parts and service. Still, no one at the annual industry get-togethers in Las Vegas predicted disaster any time soon.

Living in Interesting Times

Consumer demand is high, interest rates are low, gas is cheap, the U.S. economy is chugging along, and the OEMs are profitable. Many analysts expect new-vehicle sales this year to top last year’s record 17.5 million-unit total.

“We’re in an interesting place,” said Andrew Stuart, president and CEO of TD Auto Finance, at the Vehicle Finance Conference in late March.

“We know there’s pent-up demand. The average vehicle on the road is 11.5, 11.7 years old, something like that,” he said. “We’re all expecting used-car values to drop. You’re looking at losses on defaults.”

The coming decrease in used-car values would be a “slight” softening, Stuart added. “I don’t think anybody’s going off a cliff any time soon.” Other speakers at the AFSA’s annual event noted that higher prices for used trucks are offsetting lower prices for used small cars.

At the NADA convention, Manheim Chief Economist Tom Webb also carefully expressed some concerns, saying he didn’t want to overdo it.

He flat-out dismissed media reports and reports from some financial analysts who don’t follow the auto industry full time, and who predict a so-called “bubble” in subprime auto finance that could lead to a meltdown similar to subprime mortgages in the run-up to the Great Recession. “I do not see this,” Webb said at the firm's April 1 press conference.

Used-Car Pileup

But those alarms are persistent, with Webb admitting they’re getting under his skin. “I am becoming a little more concerned about where we are in the cycle,” he said. “What am I missing that they are seeing?”

Webb said late-model used cars are piling up, echoing the increase in new-vehicle sales and especially leasing since new-car volume bottomed out in 2009. According to an April 7 Manheim report, off-lease volume is expected to approach four million units in 2018, up from slightly more than 3.5 million next year and just over three million in 2016.

“Four million in 2018, that’s a challenge,” Webb said. “Yes, the growing supply will affect prices. The question is, at what profit? All that volume … will be sold. It has to be sold. It has to be retailed.”

However, Webb said he doesn’t expect used-car prices to drop far or fast in the short term.

Separately, ADESA Analytical Services said in an April 14 report the average wholesale used-vehicle price for March 2016 was $10,815, up 1.7% from a year ago.

Tom Kontos, ADESA executive vice president and chief economist, said the increase in the average price disguised the fact that truck prices were up, while car prices were down. “Price softening driven by supply growth remains a visible undercurrent,” he noted.

Help With Remarketing

At the AFSA’s Vehicle Finance Conference, one auto finance executive said he was concerned because a couple of OEMs he wouldn’t name had approached him for help remarketing an overabundance of off-lease cars.

“We don’t do leasing,” said Ian Anderson, president of Westlake Financial Services. “But one manufacturer called us and asked us what to do with an increase of 90,000 off-lease returns, and how that would affect their valuations. Two of them have called us.”

Anderson predicted used-car prices would decline more steeply in the third and fourth quarter of this year, due to rental car companies reducing their fleets, higher repossessions following tax season, and off-lease returns. “I think it’s going to slide,” he said.

Easy Money

Meanwhile, Chicago-area dealer Joe Castle said at the AFSA conference that he is seeing auto lenders relax their approval standards to get more business, beyond what he considers reasonable.

“When everything hit in ’08 and ’09, everything was over-tightened, and you couldn’t get a contract for a 700 [credit score] who had been with that lender for their entire life. On the other hand, what does worry me is a lender waiving stips (stipulations) on 550 credit scores,” he said.

“Don’t get me wrong, it’s revenue; I like the money. But when am I going to have to pay it back to the market? I tell my guys, ‘Don’t be a greedy pig,’ because we’re going to get slaughtered,” he said. Castle is the dealer principal of Castle Auto Group.

Long, Long Loans

Stretching loan terms are another common concern, since longer terms mean customers are more likely to be upside down on their vehicles at trade-in time. Nevertheless, longer terms are popular because they keep monthly payments down.

In the fourth quarter of 2015, the average new-car loan term was 67 months, up one month from a year ago, according to Experian Automotive. The 73- to 84-month loan category was the fastest-growing category, Experian said.

David Paul, senior vice president of financial services for American Honda Finance Corp., said his company strictly limits 84-month approvals. “We take a more conservative view on 84 months. Eighty-four months is less than 1% of our book. Our view is, long term that may not be good for the customer. Long term, we are seeing an uptick in negative equity and that’s a concern,” he said at the Vehicle Finance Conference.

John Hyatt, head of the indirect lending group at U.S. Bank, said the bank is reluctantly “looking at ways” to offer 84-month loans. “It’s very dangerous for the dealer because the (trade-in) cycle is so long, and they come up so far upside down,” he said. By approving such long loans, “We are doing a disservice to the dealer,” Hyatt added.

Under the Microscope

Auto finance sources still expect the Consumer Financial Protection Bureau to crack down on the marketing and financing of F&I products like extended service contracts, even though it’s been about three years since the CFPB reached a consent order in that segment of the automotive market.

“I wouldn’t be surprised if that’s the next focus for the CFPB,” said John Hyatt, executive vice president of dealer services for U.S. Bank, at the American Financial Services Association (AFSA)’s 2016 Vehicle Finance Conference. “I do think we need to be focused on regulatory issues, which I think are coming.”

And with the CFPB now pushing finance sources to lower caps on interest rate markups, Hyatt added, the pressure will be on F&I offices to maintain deal profitability through the sale of F&I products.

Shoe No. 1 Drops

Back in June 2013, the CFPB reached a consent order with U.S. Bank and a vendor, Dealers’ Financial Services, over an auto finance program for military service members called Military Installment Loans and Educational Services. U.S. Bank dropped its participation in the MILES program, and DFS rewrote its consumer disclosures.

The businesses were also ordered to refund $6.5 million to service members for marketing that allegedly exaggerated the benefits and minimized the cost of add-ons like service contracts. Some aspects of the case were unique to service members, like the use of automatic monthly allotments to make payments.

Since then, the CFPB has reached consent orders with credit card companies regarding the marketing of add-on products, but the bureau hasn’t revisited F&I products.

No Second Shoe, Yet                

Nevertheless, auto finance sources continue to worry. “I would absolutely agree it’s an area regulators will be scrutinizing,” said Dawn Martin Harp, head of dealer services for Wells Fargo Dealer Services.

She said the bank is monitoring auto loans originated through the indirect financing channel, as well as F&I product sales included in those deals. What the bank is looking for is “suitability,” which seemed to imply keeping an eye on pricing. “We are meeting great support from our dealer customers in this,” she said.

Last June, the CFPB added new examination procedures for auto finance to its Supervision and Examination Manual. They include a section on ancillary products, establishing that GAP insurance, vehicle service contracts and other add-ons are subject to review by CFPB examiners. They also ask examiners to determine whether the servicer they are examining “offers or finances” those products, suggesting that finance sources could be on the hook for financing add-ons.

Industry insiders, however, believe the CFPB’s examination will be limited to how the products are disclosed and marketed because it has no authority over dealers. But that hasn’t stopped the bureau from using its oversight of finance sources to turn the screws on dealers.

David Paul, senior vice president of financial services for American Honda Finance Corp., said that, like the rest of the industry, Honda Finance has “regulatory concerns” about F&I products. But he said the captive, which agreed last July to lower its dealer markup caps as part of its $24 million settlement with the bureau and the U.S. Department of Justice, would continue to support them because service contracts encourage customer loyalty. “For us, it’s more for having customers for life,” he said.

Jim Henry is a freelance writer based in the greater New York city area. Contact him at [email protected].