“Keeping Them Sold” in Subprime Auto Finance – Part 4

 

By Kenneth Shilson

President, Subprime Analytics

 

In my initial three articles 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%


 

            In my last article (Part 3), I explained how underwriting differences have impacted collections and recoveries.  In this article I will discuss the importance of risk management considerations needed to maximize subprime auto financing success.

            Due to the highly competitive subprime market over the last few years, some operators reduced financing rates in an attempt to increase market penetration.  Unfortunately, that approach ignores a fundamental rule in finance: “financing rates should be commensurate with risk”.

            In compiling the subprime benchmarks for 2017, I noted that the loss to liquidation rate (pace of losses) for the operators surveyed increased from 31% in 2013 to 35% in 2017.  This represents a 13% increase in default rates.  During that same period, the average financing rates charged by the operators surveyed was reduced from a 22.3% (average in 2013) to a 20.5% in 2017! This trend indicates that these operators wrongly reduced their rates while assuming more default risk by contracting with weaker credit quality customers.  A fundamental industry postulate is that “your losses should be covered by your financing charges”.  In the aforementioned comparison the pace of losses exceeded interest rate coverage by a whopping 71%!  Lowering rates to avoid regulatory scrutiny makes perfect sense.  However, lowering finance charges for weaker customers caused by the increased market competition does not!

            For many years I have searched for a mathematical equation that properly measures credit risk in the deep subprime industry.  After analyzing more than two million loans and over $20 billion in contracts, I concluded that “cash in deal” best defines portfolio risk.  Utilizing my historic portfolio metric data, I noted that the average “cash in deal” for BHPH operators surveyed has increased from an average of $5,294 in 2013 to a $6,400 average in 2017.  This represents a 12% increase!

            The increase in “cash in deal” results from operators paying more for the vehicles they sell while reducing their down payments, increasing sales prices and the amounts they financed.  In my last article (Part 3), I mentioned this formula is not a recipe for success because it resulted in higher charge-offs and default rates.  This trend should not be continued in the future because it is economically unsustainable.

            Prudent risk management starts by using a business model which maximizes cash returns while minimizing cash in deal (higher return on investment “ROI”).  My analyses indicates that “selling vehicles that will run the term of the contract at affordable sales prices increases the probability of “keeping them sold”.”  The economic matching between customer and the right vehicle should occur during underwriting, by setting a reasonable markup at origination and determining the customers ability to pay.  A reasonable markup which will be “collectible” during the contract term beats paper profits which become “fool’s gold”.

            In conclusion, I recommend that operators analyze their own portfolios and business models to ascertain their cash return on investment (ROI).  At Subprime Analytics, ROI is our primary gradient in measuring portfolio performance.  The ROI calculation requires using your static pool and loss / liquidation rates to loss adjust estimated future cash flows.  Do you know these loss rates for your own portfolio?  If not, visit www.subanalytics.com for a metrics video on the home page, which illustrates these computations.  Copies of my previous articles (Parts 1-3) are also posted on that site, in the “Views” tab.  All are available free of charge.  If you want to increase cash flow and capital you need to look under the hood of your portfolio by giving it an MRI!

 

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 capital formation consulting services to operators 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.