Credit Crescendo

By Jack Milligan

The indirect auto lending business has revived amid record vehicle sales. Will credit discipline hold up?

Looking at the crowd of consumers in auto showrooms this year, it's hard to believe the indirect auto market has been something of a highway wreck for banks in recent times.

After all, it was only last year that many lenders were forced to flee for the exit ramps as loan delinquencies and chargeoffs skidded out of control, leaving big dents in income statements.

Ironically, the stalwart group that remains now enjoys the most favorable market seen in years. Loan growth is excellent thanks to manufacturer incentives, such as 0% financing, that have spurred a steady stream of buyers into dealer showrooms. Additionally, "there's less competition now, and profit margins have improved because funding costs are at historic lows," says Jerry Baugh, a vice president at the Consumer Bankers Association and a liaison to the CBA's automotive finance committee. "There's plenty of opportunity for everybody," adds David Stevens, an executive vice president with Charlotte-based Wachovia Corp.

But will the current crop of winners stay ahead of the game? It's not an idle question, given the volatility of the auto lending business and serious pain that can accompany a losing position. Delinquencies and chargeoffs of new vehicle loans had already risen sharply going into 2002, according to the CBA. And auto sales growth began slowing again this fall, albeit from a torrid pace.

Experts say it's critical that institutions retain their credit discipline during this latest buying frenzy. "Your shareholders will growl a little bit if you don't make it on the revenue side. But if they wake up one morning to a big credit problem, they'll fire you," says Michael Holloway, president of Rochester, N.Y.-based Charter One Auto Finance Corp., a unit of the Cleveland-based bank.

Strategic focus also is essential. Some lenders finance dealer inventories; others only make retail loans. Some make a living in the subprime, or lower credit quality market, while others handle only the best quality paper. Trying to cover all these bases usually does not work, and mistakes — as many players recently discovered — can be very expensive.

Clearing the Wreckage

The roots of the most recent auto loan pileup trace back to the late '90s, when banks began competing too aggressively in auto financing. Lenders were then caught over-exposed when the nation began sliding into a modest recession that was subsequently exacerbated by the September 2001 terrorist attacks. The profit deterioration in indirect auto loans coincided with problems in the related auto leasing business, where lenders had miscalculated the future resale value of cars being financed in the midst of a multi-year sales glut.

Suffering steep losses, some banks went into full-scale retreat. The list of major lenders that either left the market or scaled back significantly during the last three years include Bank of America Corp., Mellon Financial Corp., KeyCorp, PNC Financial Services Group Inc., Provident Bankshares Corp. and Washington Mutual Inc. Others, such as Wachovia and Charter One, abandoned leasing but stayed in indirect auto lending.

Despite these adjustments, the market still was left with a credit hangover going into 2002. Loan delinquencies of 30 days or more on new and used cars rose to 2.55% in 2001 from 1.55% in 2000, according to the CBA's annual automotive finance survey of 41 U.S. institutions involved in indirect auto financing and leasing and direct floor-plan financing. The rise in delinquencies also pushed chargeoffs higher, to 1.14% from just 0.58% the year before.

Meanwhile, the market went on steroids as automakers decided they had to do something dramatic to bring consumers back into dealer showrooms. Zero percent financing and other generous rebates had the desired effect: new car sales in 2001 hit 17.1 million units despite a September sales lull, according to the National Automotive Dealers Association, falling just short of the record 17.3 million cars sold in 2000.

New car sales through this past August were running at an annualized rate of approximately 16.8 million units, according to the NADA — a much stronger showing than most experts expected. "Manufacturers are subsidizing the product as never before," says Charter One's Holloway.

The cheap financing served a useful purpose by bringing people back into the market, where dealers still have plenty of incentives to steer buyers toward a higher-cost bank loan. Banks typically offer dealers a small percentage of the interest they charge on loans — paid as a fee — as an inducement to steer business their way.

For example, on a 6% car loan, a dealer might get as much as 1% of the projected interest income, paid up front, as an incentive to choose a bank partner. Not so with those 0% deals from a captive finance company. "There's typically no profit in that financing for the dealer at all," says Thomas W. Nadeau, managing director of the automotive finance group at Sovereign Bancorp, a large thrift headquartered in Wyomissing, Penn.

It helped that the eye-catching finance deals were often limited to the manufacturers' less popular models, or restricted to terms of three years or less, which placed the more expensive models out of reach for consumers who couldn't make the sizable down payments. Also, some customers chose to take cash rebates instead of the financing, while foreign manufacturers generally have not pushed interest-free loans as aggressively as the U.S. carmakers.

The surge of consumers into dealer showrooms, combined with the previous departure of some large competitors and historically low interest rates, has made 2002 an unexpectedly good year for the bank lenders. Consolidated numbers for car loans by banks are not yet available, but the anecdotal evidence in this direction is strong.

Wachovia's car loan volume, for example, rose 23% between the first and second quarters of this year, according to Stevens. And Nadeau says loan volume at Sovereign reached $1 billion through July, compared with $1.2 billion for all of 2001. "It has been better than we expected when we did our plan last year," says Preston E. Davenport Jr., an executive vice president who runs the auto finance unit at BB&T Corp., Winston-Salem, N.C. He declined to reveal BB&T's specific numbers.

Deeper and Cheaper

From a credit quality perspective, is this a window of opportunity or a trap? Margins on high-quality car loans and financed leases are thin to begin with, so even a modest deterioration in credit quality can ruin profitability. While margins are higher in the subprime market, which serves people with lower credit ratings, so too are loan losses and processing costs. And it isn't too hard to get in a position of over-competing on loans, considering how auto lending works.

Essentially, dealers have grabbed control of auto loan originations and have learned to play lenders against each other to get the best rates or highest referral fees. In contrast to direct loans, where customers apply at the bank, indirect loans are actually initiated by the dealer, usually while the customer is at the showroom. The indirect process has become so fast and efficient over the years that about 90% of car loans are now made in that manner. Except for credit unions, most financial institutions no longer make direct loans.

The emphasis on indirect lending means the dealer is, in effect, the customer. These dealers maintain a list of banks and finance companies to which they steer car buyers. For the lenders, that means "you have to be service-oriented," says Sovereign's Nadeau.

And service, in this context, usually entails providing a "yes" response quickly. A lender that doesn't may soon find itself at the bottom of the dealer's list. And since service typically includes a rate offer that will encourage the customer to make the purchase, the business is highly commoditized. "In this market, 'deeper, cheaper' is the byword of the dealers; that's what they like to see from all of us," says BB&T's Davenport.

By deeper and cheaper, Davenport means that lenders are under constant pressure to drop deeper into the credit spectrum, cut their rates and loosen terms like loan-to-value ratios in order to get the business. This causes problems when competition gets out of hand, as occurred in the late '90s. "Auto lenders don't step back from poorly priced business fast enough," says Thomas K. Brown, president of Second Curve Capital, a New York City-based hedge fund that specializes in financial stocks.

Car sales remained strong going into the fall, but lenders report continued deterioration in the underwriting environment, particularly in the prime sector, to which a number of banks retreated when the leasing business blew up on them. So many institutions competing in one sector of the market generates the kind of competitive pressures that can make the situation worse.

A Matter of Focus

In that sort of environment, it's inevitable that some lenders will consider moving down-market into the subprime category. Long-time players say this is a mistake if the institution isn't already well entrenched in this very tricky part of the business.

Subprime loans are more difficult to underwrite because the borrowers have lower credit ratings. Once on the books, subprime loans also can be more expensive to service because lenders often need to stay in closer contact with their borrowers, some of which may experience greater difficulty in meeting their monthly repayment obligations than higher-rated borrowers.

For these reasons, some experts advise sticking with either prime or subprime, but never trying to do both. "You can't be prime and subprime at the same time," says Wachovia's Stevens. "It's almost like they require you to use different sides of your brain."

Assuming an institution does stay put in its chosen market, the key issue then becomes dealer relationships. Long-term players need to cultivate relationships with a network of dealers and provide good service through every permutation of the business cycle. Different institutions handle this challenge in different ways.

Wachovia and Charter One, for example, employ a centralized model where all dealer requests for financing are fed into one operational center. This usually ensures a quick response from the lender — something dealers really value. It also helps the bank keep its costs down, which is an important element in maintaining long-term competitiveness.

BB&T, on the other hand, utilizes a decentralized structure that revolves around 10 dedicated offices, staffed by both loan underwriters and relationship managers, serving the bank's nine-state territory in the southeast. The relationship managers are assigned to look after their share of the bank's 2,000 active dealer relationships. "We charge our lenders with the responsibility of knowing what's going on in the marketplace," Davenport says. He believes this makes for better credit decisions since the local managers have a better feel for local economic conditions, including salaries and layoffs.

Davenport concedes this model is more expensive than a centralized approach, but he believes BB&T's "local touch" becomes a key advantage in a highly competitive market because it builds stronger dealer relationships. Dealers might take advantage of highly attractive financing deals being offered by an aggressive competitor, while they last, but most will be reluctant to altogether abandon a lender they have been doing business with for years. "We've got a lot of very loyal dealers," Davenport says. "They might steer a little more business somewhere else, but they'll keep us in the game."

This is especially likely in those cases where the bank provides dealers with other products. Both BB&T and Wachovia offer their dealers inventory financing and try to penetrate the overall relationship as deeply as possible. Davenport says the average car dealership may book up to $40 million in annual sales and employ as many as 150 people. In other words, they can be categorized as middle-market businesses that also need commercial and real estate loans, treasury services and 401(k) plans — products that Wachovia and BB&T are happy to provide.

Despite their emphasis on dealer relationships, lenders need the discipline to step back from the kind of deals that could haunt them in a few years. When the auto lending market overheats, there are essentially two ways in which lenders compete for business: they either offer dealers a little more incentive on loans, or they lower their credit standards to make more loans.

Of the two, the latter course is the most dangerous, particularly in the prime segments where lenders have not mastered the subprime technique of charging a rate commensurate with the borrower's credit risk. When lenders pay dealers a little higher fee for their business, they know today what that concession will cost. But when lenders lower their underwriting standards, they won't know the true cost of that decision for a couple of years. "We'll compete a little on price, but we'll never cut our credit standards," says Holloway at Charter One.

One of the advantages of running a multi-state auto finance franchise — Charter One writes car loans in 20 states — is that the lender can step back from areas where the markets are too competitive. Holloway did this recently in Florida. Of course, top executives don't like it when business managers miss their annual revenue budgets. So to compensate for the lost revenue, Holloway has pushed harder for loan production in other regions such as Chicago, where Charter One has added personnel. "We found a way to cover it," he says.

But the lesson is clear: to ensure long-term survival in indirect auto lending, institutions need to pull every lever except reducing credit standards. That's something to keep in mind during the current auto credit crescendo.

Mr. Milligan is a freelance writer based in Charlottesville, Va.

Copyright © 2003 by Banking Strategies, published by BAI.

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