Posted 5 years ago
“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.