Conventional automobile loans are the mainstay of credit union lending. Despite the recent mortgage-lending boom, auto loans represent the largest category of consumer debt and hold the largest slice of the total credit union loan portfolio with over $140 billion outstanding, according to Callahan & Associates. Credit unions cannot afford to lose this core business to other lenders. A credit union's future success in the lending arena depends on its ability to recognize potential trends and issues that could affect its local market area as well as macroeconomic conditions. This opinion piece focuses on the three most critical auto lending challenges we believe credit unions will face in 2004-continued automaker incentives, deteriorating residual and used car values and enhanced service capabilities. Since the fall of 2001, the proliferation of zero percent or low-rate financing from automakers has intensified the competitive pressure felt by most credit unions. Historically, characteristics of zero percent financing included the following: * Qualification determined by credit rating. Many consumers do not qualify. * Special rate applies to loan terms of 36 months or less. The shorter the term, the higher the monthly payment, which precludes most borrowers. * Special rate only applies to "non-popular" models. Recent captive financing strategies include extended loan terms from 60 to 72 months on a greater percentage of the dealer's inventory rather than just "select" vehicles, and relaxed credit-qualifying criteria. Subvention programs will provide credit unions with the most severe test when competing for financing opportunities during the next 12-24 months. Mark Wild, Vice President of Colorado Lending for Security Service FCU, noted, "During the past two years, loan financing success was based upon understanding captive incentive limitations, educating finance directors as to their alternative options and maximizing all financing opportunities. This entailed developing strategies which targeted members that did not qualify for incentive rates and terms, focusing on non-incentive vehicles and on used auto loans." Security Service recognizes that the market is experiencing continual changes and sustained success relies on appropriate responses to these changes, and it is the credit union's response to dealing with market changes that helped SSFCU boost its outstanding indirect lending portfolio to more than $1.9 billion and for SSFCU to be named "Best in Class" by Callahan & Associates for its indirect auto lending. The credit union ranked number one in the nation for indirect auto loans granted. As Charles Goss, vp of lending at Security Service put it: "Dealership Finance and Insurance (F & I) statistics indicate that 80% of all credit union members are converted to dealership-arranged financing. Exceptional service to members and positive, long-term dealer relationships built over time have led to our successful indirect program and the steady loan growth we have experienced year after year." The U.S. auto industry is poised for a record-setting rebound fueled by job growth, a manufacturing recovery, and increased consumer buying power. Recent industry analysis indicates that manufacturer inventory levels remain high and that the industry is expecting sales levels in excess of 17 million units in 2004. This would be the first time in four years that auto sales have increased over the previous year. Although automakers indicate they want to curtail incentives, several conditions suggest the contrary. The combination of high inventory levels, increased sales expectations, desire for greater market share, buyer conditioning for incentives and lower pent-up demand means that incentives will most likely continue stronger than ever in 2004. Manufacturers' cash rebates in lieu of incentive rate financing opened the door for other lenders to compete for a wider variety of new car financing. Successful lenders will continually monitor incentives and develop pricing strategies that allow them to compete for financing opportunities. A basic misconception is that the dealership's F & I Department has an underlying loyalty to captive financing. On the contrary, a dealer's primary goal is to maximize profitability. Captive incentive financing does not necessarily accommodate this goal. A solid relationship between the credit union and the dealer often results in the dealership converting the member to attractive credit union financing and having the member accept the cash rebate in lieu of the automaker's zero percent incentive. Familiarization with current incentives, strong dealer relationships and appropriate pricing on the part of the credit union in terms of competition will go a long way in ensuring a mutually beneficial outcome between the member, the dealer and the credit union. Deteriorating residual and used car values are a direct derivative of the high level of new car sales caused by captive subvention programs. Compounding this deterioration is the high number of trade-ins, resulting in a surplus in the used car market. According to Automotive News, it is estimated that six out of 10 new car buyers are "upside-down" on their current car loan. Some members owe $8,000 to $10,000 more than their vehicles are worth. In a new vehicle purchase, this negative equity must be added to the new loan. Lenders will be faced with a difficult decision – deny the member's request because of unacceptable collateral values, or adjust underwriting guidelines to address evolving credit conditions. Serious consideration must be given to each member's individual credit situation to ensure the safety and soundness of each loan. Emerging technology is playing an increasingly important role in the auto-lending arena. There is a paradigm shift taking place in today's world of electronic communication. Dealers have the ability to send an application instantly to many lenders at one time. The benchmark has been raised in defining member service as speed and consistency become even more important elements of a business-to-business relationship. The industry is shifting to Web-enabled submission of applications. Credit unions that are using an Internet-based system to efficiently manage the underwriting, decision notification, online status tracking and back-end loan processing functions have the advantage in capturing financing opportunities. Dealers are in a cash flow intensive business, and in most instances, the first lender approval received obtains the loan. Competition from varying lending sources will continue to challenge credit unions in the years to come. By consistently following the basic credit union premise of placing the needs of our members first, we are confident that we will continue to meet these challenges. Security Service has excelled in lending primarily because of our indirect lending program and our flexibility to meet our members' needs. Successful auto lending depends on proactive and pragmatic responses to potential trends and issues that impact the market environment. Credit unions should continually evaluate "what-if" scenarios and exercise risk management practices to effectively manage cyclical and structural economic forces, positioning themselves to respond rapidly to the changes shaping the consumer lending industry.