Posted 5 years ago
“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.