Auto lending has been on regulators' radar for a number of years as an enhanced-risk lending sector. In particular, the Office of the Comptroller of the Currency has been discussing auto lending in its Semiannual Risk Perspective since 2012. Considering that credit unions have a sizeable share of the auto lending market (roughly 20% of the outstanding balance), it is important that this message of enhanced risk be effectively communicated to the credit union industry. ALM First proposes not abandoning the asset class, but ensuring prudent underwriting and lending practices, especially with respect to indirect auto lending.

It's no secret that auto sales have been exceptionally strong. Annual auto sales in the U.S. have increased for several years in a row – an unprecedented growth streak – setting an all-time high number of units sold last year. This growth has trickled down to auto lenders. Specific to credit unions, the industry's total outstanding auto loan balance is roughly $320 billion as of the second quarter of 2017, according to aggregated Call Report data. This balance has grown at double-digit annualized rates for 17 quarters in a row, another unprecedented streak since data tracking began in 1994.

As early as spring 2012, the OCC made note of banks seeking asset growth through launching new products, services and processes; indirect auto lending was specifically mentioned. Of course, growth by itself isn't necessarily bad. But since then, auto lending has been mentioned eight times (every risk report since fall 2013). It is important for credit unions to understand these risks regulators are discussing.

Lending Standards

The auto industry, like many, has seen progressively more intense competition. Many participants have been pursuing growth by loosening credit standards. Advance rates are up, leading to rising LTV ratios, and borrowers with lower credit scores are increasingly qualifying for credit. Additionally, to motivate borrowers, lenders are offering longer terms than ever before. According to Edmunds.com data, the average car loan term has increased from five years in the early 2000s to well over six years in today's environment.

National offer-rate data from SNL Financial (now S&P Global Market Intelligence) also paints an interesting picture: Average 72-month auto rates are actually lower than shorter-term rates. This effect began in approximately the 2013 timeframe, near when the OCC added auto lending to its monitoring radar, and it makes about as much sense as an inverted yield curve.

Delinquencies and Loss Severities

Asset quality indicators, such as delinquency ratios and net charge-offs, are trailing indicators, meaning they take time to materialize as the credit lifecycle matures for a particular vintage of loans. Asset quality metrics related to auto loans have deteriorated, and some expect them to worsen as more aggressively underwritten loans continue to mature. Subprime lending has also increased, right in line with the overall auto lending market.

For the credit union industry, delinquencies and charge-offs have been rising quickly. But the fast-growing origination volume has offset what otherwise would have been larger increases in industry asset quality ratios. Currently, auto loans delinquent 60 days or greater represent 0.59% of outstanding balance, growing from $1.02 billion four years ago to $1.89 billion today. Moreover, delinquent indirect-loan balances have more than doubled from four years ago. Industry charge-off volume has almost doubled from only three years ago, and the charge-off ratio for the year 2016 was 0.61% for the industry.

Fair Lending and Indirect Auto

For indirect auto lending, one of the risks more widely discussed by the OCC is fair lending risk, which is a result of ceding underwriting decisions to a third party, such as an auto dealer. This doesn't just pose a risk to credit standards (i.e., mispricing credit), it also poses significant compliance risk. A notable case involved Ally Financial in 2013, in which the CFPB alleged discriminatory lending practices resulting from its indirect auto lending program. As a result, Ally Financial was required to pay a total of $98 million in damages and penalties. This type of fair lending risk results from dealer incentives, sometimes called dealer markups, which compensates dealers based on the rate to the borrower over the lender's stated buy rate.

It is imperative for credit unions to ensure adequate controls and compensation that are appropriate with respect to dealers. Perhaps a flat fee per transaction would eliminate hazardous incentives. The last thing any lender should want is a dealer making pricing decisions for it, not to mention getting slapped with a multi-million-dollar settlement.

So, What to Do?

Some large banks have been pulling back from the auto loan market. As early as 2015, Wells Fargo appeared to be wary of subprime auto lending, announcing a cap on subprime auto loan originations. Wells Fargo has been a big player in this market, particularly subprime auto lending post-financial crisis. Moves from big players like this can affect the markets. Since then, other lenders, notably big banks, have also pulled back from the auto loan market, citing rising stress and the desire for protection from credit risk. Should credit unions follow suit?

The answer probably depends on your current practices. At ALM First, we continue to warn credit unions of the dangers of indirect auto lending, and it's not just about fair-lending risk; it's also about profits. The fees obviously eat into the returns if the loan matures on contract; if it prepays earlier than expected, you could be looking at substantially negative returns on capital. Even worse would be deteriorating credit conditions, especially for indirect subprime lending. We advocate the use of return on capital models to objectively assess the profitability of product lines; and much like what Wells Fargo did, if risks are mounting, take a step back from the market. In this regard, ALM First publishes monthly commentary on relative value in lending, with a focus on risk-adjusted return on capital analysis.

Overall, auto lending is a very important part of credit unions' business, and credit unions are in a position to provide great value nationwide to ordinary borrowers. Indirect lending and dealer relationships can be a great tool to expand the credit union's reach. However, make sure to do so in a safe and sound manner. History has shown that loosening credit standards to increase loan volume generally is not successful in the long run.

Alec Hollis, CFA is the Director, ALM Strategy Group for ALM First Financial Advisors, LLC. He can be reached at tahollis@almfirst.com.

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Putting the Brakes on Auto Lending

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