Add the Office of the Comptroller of the Currency (OCC) to the list of regulators, media outlets and lawmakers that remain concerned with the pace of growth in the auto finance arena. In its Semiannual Risk Perspective, released yesterday, the agency said it continues to monitor the market, specifically the trend toward longer terms.
The 41-page report, which detailed the OCC’s top concerns in all credit markets — from the prolonged interest rate environment to cybersecurity — reported that outstanding balances have grown for 17 straight quarters. But it also noted that delinquency and loss rates have remained within manageable levels thanks to declining unemployment, low gas prices and resilient used-car prices. But the report also made clear the OCC is concerned that the trends could be a problem when the market turns.
“While performance remains reasonable at present, the OCC continues to closely monitor underwriting practices and loan structures,” the report read, in part. “Extended rapid growth is difficult to maintain and can sometimes mask early signs of weakening credit quality. Too much emphasis on monthly payment management and volatile collateral values can increase risk, and this often occurs gradually until the loan structures become imprudent.
“Signs of movement in this direction are evident, as lenders offer loans with larger balances, higher advance rates and longer repayment terms.”
This isn’t the first time the OCC, an independent bureau of the U.S. Department of the Treasury, has raised concerns about the auto finance market. Last August, the agency issued guidance detailing its expectation for banks that engage in debt-sale arrangements. Speaking at an auto finance conference last November, Darrin Benhart, deputy comptroller for Supervision Risk Management, warned that if banks failed to comply with regulations, the OCC will take supervisory or enforcement action when warranted.
Benhart also noted the agency’s close coordination with federal regulatory agencies like the Consumer Financial Protection Bureau. “Some in the media and industry have downplayed the significance of the risk we are identifying in the auto lending industry, but at the OCC, we will continue to monitor terms and risk layering practices to ensure that banks manage growth and exposure prudently,” Benhart said at the Financial Services Collections and Credit Risk Conference last fall.
According to Experian Automotive, total outstanding loan balances in the first quarter 2015 increased 11.3% from a year ago to a record high of $905 billion. But that wasn’t the only record set during the period. The average amount financed for new vehicles increased $1,099 from a year ago to a record $28,711, while monthly new-vehicle payments also reached a record $488.
Record-high transaction prices pushed payment-conscience car buyers to seek out ways to keep their payments affordable. It’s one of the reasons leasing accounted for 31.4% of all new vehicles financed during the first quarter and loan terms for new-vehicle loans reached a record 67 months.
The firm also reported that loans with terms between 73 and 84 months accounted for a record-setting 29.5% of all new vehicles financed — an 18.6% increase from a year ago.
“It is true that the total volume of subprime is growing, that we’re seeing high total dollar volumes and that loans are getting more expensive and have higher monthly payments,” Experian Automotive’s Melinda Zabritski wrote in her quarterly report for F&I and Showroom’s July issue. “Looking at those trends alone might raise some concern, but fear not, as the underlying fundamentals of the auto finance market remain strong.”
Credit rating agency DBRS also weighed in on stretching loan terms. “The trend is largely attributable to demand and increased auto prices,” the agency wrote in its weekly newsletter, which was issued today. “The primarily arguments in favor of extending longer term contracts are that they lower the monthly payments borrowers must make, thus making vehicles more affordable and, one can infer, less likely to default.
“However, these ‘benefits’ also have some potential risks,” the agency added. “Legal/regulatory hazards may arise from having borrowers paying far more for a vehicle than they would have paid had they used a shorter term contract or from the use of low monthly payment to coerce borrowers into buying vehicles that, given maintenance and operating costs, they can’t afford.”
The ratings agency added that another risk is the potential loan-to-value mismatch that may arise from using long-term financing for a quickly depreciating asset. “By amortizing a loan over a longer period of time, the gap between what is owed on the vehicle and the vehicle’s actual market value, as determined by a relatively fast depreciation curve, become wider, thus making trade-in or sale of the vehicle more problematic, which in turn makes the loan more likely to default.
The OCC raised the same concerns in its 41-page semiannual report, saying, “Extended terms are becoming the norm rather than the exception and need to be carefully managed.” And citing Experian Automotive data from the fourth quarter 2014, which showed that loan-to-value ratios for used-vehicle loans was 137% — 150% for subprime borrowers — the OCC said collateral advancements is another major area of concern.
“Sales of add-on products such as maintenance agreements, extended warranties and GAP insurance are often financed at origination,” the OCC noted in its report. “These add-on products in combination with debt rolled over from existing auto loans contributed to the aggressive advance rates.
“As in the mortgage markets, the OCC expects banks to fully consider cycles and trends in the auto markets and respond in a prudent and sound manner,” the OCC wrote. “Underwriting standards and product structures established in times of low interest rates and unusually high used-car values may not prove prudent when conditions normalize or during times of stress.”