“Keeping Them Sold” in Subprime Auto Finance – Part 2

By Kenneth Shilson

President, Subprime Analytics

 

In my first article in this five-part series, I mentioned that auto bond securitizations have fueled the high level of subprime auto finance competition during the last 3 years. I indicated that the business models used in these securitizations differed from those used by the independents that we surveyed during the same period, as follows:

Business Model Comparison

2017 Deep Subprime per Experian

2017 Independent BHPH Benchmarks

 

 

Difference

 

Percent

Difference

Amount Financed

$14,022

$11,951

$2,071

17%

Used Loan Term

55 Months

44 Months

11 Months

25%

Used Monthly Payment

$394

$390

$4

1%

Average Finance Rate

20.3%

20.5%

0.2%

1%


 

            Understanding the differences in underwriting, their impact on collections and recoveries, risk management, and cash flow is the focus of this series of articles.  In Part 2, I am addressing the underwriting differences between the models above.

            Cheap money and the investor’s quest for higher yields fueled the subprime auto bond securitization market during the last three years.  These securitizations were comprised of pools of loans with differing credit quality – prime, near prime, subprime, and deep subprime. In some cases, the deep subprime component was 33% of the overall pool, according to Morgan Stanley in March 2017.  The inclusion of deep subprime bonds in these pools increased the overall yield. Unfortunately, it also greatly increased the risk of default (as unhappy investors have subsequently learned).

            In fairness, several of the poor performing securitizations were done by issuers who had very limited experience with subprime auto finance originations and collections.  They accessed the market when demand was greater than supply, and filled the need!  Investors were attracted by potential yields which were greater than other investment opportunities.

            As indicated by the table above, the bond terms were 55 months or greater, and began with higher amounts financed.  This was necessary because the collateral for many of these deep subprime bonds was either new or CPO vehicles!  Therefore, the original terms were lengthened to make the monthly payments “more affordable” to the borrowers.  Investors derived comfort from the higher collateral values at origination.  Independent buy here, pay here dealers who previously dominated the “unbankable customer” market preferred shorter terms, approximately one year less.

            As the defaults on these deep subprime securitized portfolios have increased, some lessons can be learned as follows:

1)      Good underwriting requires the proper matching of the borrower with a vehicle they can afford.  Historically this has been a vehicle model 4 years or older.  Starting with better more expensive collateral does not assure repayment.  On the contrary, it results in higher bad debt charge-offs when subprime customers inevitably default.

2)      Lengthening the term does not guarantee repayment of deep subprime loans; time is the enemy!  Standard & Poors said it best: “longer terms remain outstanding longer, and are exposed to adverse changes in borrowers’ credit conditions.”  Vehicle performance and condition also deteriorates dramatically over time.  Therefore, the longer loan terms increase both repayment risk and defaults.

3)      Increasing sales prices and the amounts financed only benefits when and if you collect it! Otherwise, “paper profits” become “fool’s gold” instead of cash!

4)      The high rate of competition in subprime auto finance caused down payments to be lowered and repayments to remain relatively unchanged.  This was done primarily to retain market share in the more competitive environment.  Unfortunately, these decisions result in substantially more “cash in deal” and greater risk of default to the lender.  It also reduces return on investment (ROI) when the borrower defaults during the term of the contract.  The earlier they default, the higher the bad-debt charge-off, and the lower the ROI.  My $20 billion database historically shows that deep subprime customers only want to drive the same vehicle for approximately 2 years and then get another one!

            Now for the good news: many capital providers have now shifted their emphasis to higher credit quality prime and near-prime customers instead of addressing the underwriting mistakes above.  This creates a “golden opportunity” for the independents to regain market share lost during the last three years.  It is hoped that we have learned from these past losses, so they are not repeated.

 

Kenneth Shilson is President of Subprime Analytics (www.subanalytics.com) which provides computerized subprime auto portfolio analysis using proprietary data mining technology.  To date, the company has analyzed over 2 million subprime auto deals aggregating $20 billion.  The company provides portfolio analysis, profit and cash flow enhancement and other consulting services to operators and capital providers nationwide.  Mr. Shilson is the President and Founder of NABD, which merged with NIADA on Jan. 1, 2018.  A copy of the latest subprime benchmarks report can be obtained by emailing him at ken@kenshilson.com or by calling 832-767-4759.