Lending Practices of Captive Auto Lenders Are Driving Risks in Bank Auto Paper
The auto finance market is very competitive, dominated by car manufacturers and their captive finance companies that have a direct stake in the success of the auto industry.¹ To promote sales, auto manufacturers offer a wide variety of financial incentives to entice customers into car dealership showrooms. These incentives include cash rebates, favorable financing rates (as low as 0 percent), lower down payments, and longer repayment schedules.

In the current environment, banks are competing against aggressive terms offered by captive finance companies, credit unions, and other insured institutions. As a result, banks may have loosened auto loan underwriting standards that could leave them vulnerable if interest rates continue to rise or if economic fundamentals weaken.² Fortunately, market conditions to date have helped banks maintain asset quality levels that are relatively low and stable.

This article will look at the keenly contested auto lending arena and how banks operate in it. The article also examines the factors that may affect auto credit loan quality going forward.

In the Competitive U.S. Auto Industry, Incentives Offered to Buyers Have Increased
Outstanding retail auto loan balances totaled almost $740 billion as of 2003; $186 billion of that amount represents new credit extended in 2003.³ Therefore, each tick, or increase in market share, by auto lenders is extremely valuable. A small handful of captive auto finance companies, including General Motors Acceptance Corporation (GMAC) and Ford Motor Credit Company, account for approximately 56 percent of total auto financings; the remaining 44 percent is held by banks, credit unions, and other independent financial institutions.⁴ Because of the dominance of the captive finance companies, banks often have to compete with aggressive incentive programs offered by non-bank lenders.

To sustain demand for new models over the past three years, automakers have offered low prices and thousands of dollars in incentives for each car (see Chart 1). Average annual incentive amounts have increased each year since 2001, and 2004 incentives are on pace to continue that trend. The discount from the manufacturer's suggested retail price (MSRP) averaged 18.4 percent over the first nine months of 2004. These incentives, which include cash rebates, price discounts, added car extras, and interest rate and lease subsidies, contribute to pulling consumers back into the market before typical auto needs would dictate.⁵ Analysts expect that after a slowing rate of growth in the first half of 2004, incentives will increase in the second half, along with prices.⁶

Chart 1
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Financing terms have become increasingly aggressive as lenders find ways to lower borrower payments. Both subsidized interest rates and longer loan maturities have enabled consumers to afford higher levels of debt owed on cars with decreasing average monthly car payments.⁷ Federal Reserve data show that the average maturity of a new car loan lengthened from 53 months in 1999 to 62.5 months in fourth quarter 2003, then settled back to 61 months in June 2004. According to one industry analyst, 20 percent of car buyers now choose 72-month loans.⁸ Similar trends were noted on used car loans. Due in part to declining loan amounts and increasing loan maturities, the average monthly payment on car loans declined to $453 in June 2004 from $466 in June 2003 and from a cyclical peak of $493 in January 2004.⁹

Incentives also have been extended to borrowers who are already at the margin of affordability, which is clear from the increasing rate of publicly issued subprime and near-prime auto asset backed securities (ABS) over the past few years. Moody's Investors Services indicates subprime and near-prime auto ABS issuance hit an all-time high of $23.8 billion in 2002, up consistently from approximately $2 billion in 1994.¹⁰ Although issuance fell to $18.5 billion in 2003, analysts expect it to rebound to $20.5 billion in 2004, based on economic and loan origination forecasts. Although issuance trends are similar for prime auto ABS, their rate of growth since 1994 does not match the rate of growth in subprime auto ABS. Favorable financing terms and dealer incentives have been offered across the pricing spectrum from luxury to economy cars, enabling consumers to purchase more car for their dollar. Borrowers whose primary concern is the dollar level of payments are often less creditworthy and may be more vulnerable to default risk should they face any adversity, including rising interest rates on other debt.

As a result of already high and increasing incentives, the volume of new car sales has been expanding. Although the rate of new car sales moderated slightly during the summer, the volume of sales is still at a historically high level. Between August 2003 and August 2004, sales of new cars grew at a 2.3 percent rate; that rate increased to a 4.8 percent rate in September 2004. In contrast to new car sales, which have been propelled by various incentives, used car sales increased at a modest 0.6 percent annualized rate through August 2004.¹¹

Chart 2
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The main factors that influence used car values are sales incentives for new cars and inventory levels for used cars. Higher incentives for new cars negatively affect used car values by putting an upper limit on a model's resale value. For example, the Power Information Network says a typical two-year-old sport utility vehicle declines in value by $500 for every $1,000 in incentives offered on the new model.

Supply and demand factors also influence used car values. A greater volume of new car sales increases the inventory of used cars on the market, which places downward pressure on used car prices. Used car inventories in August 2004 increased by 11.6 percent over the same month one year ago. Declining used car prices in late 2003 were consistent with year-end new car sales promotions that encouraged car owners to sell their used cars in favor of brand-new models.

In addition, used car inventory is affected by fleet sales of used cars, such as sales from car rental agencies. Because fleet sales tend to be larger volume sales, used car prices tend to decline as these cars return to the used car market. Recent industry reports suggest that some major auto manufacturers have increased fleet sales, thereby boosting their sales volume, but these higher fleet sales could place pressure on used car values going forward.¹² For example, midsize cars have displayed noticeably weaker used car values, which can be attributed in large part to popularity in, and eventual disposition from, rental car fleets.¹³

Cars coming off leases also affect used car prices by adding to the used car inventory. Although leasing was popular in the late 1990s, it has become less so in recent years, because automakers have lowered their estimates of residual auto values offered on car leases. Reduced residual values, a consequence of the declining market value of used cars, have made leasing a relatively more expensive option than an outright purchase. Lower interest rates and other incentives also make purchasing the more attractive option. Some analysts expect leasing to increase in coming months as higher interest rates and a lower volume of mortgage refinancing activity make purchases more difficult for the average consumer.¹⁴

Negative Equity among Car Owners Has Increased
An alarming number of recent car buyers have owed more on their cars at trade-in than they are worth. Earlier this year, J.D. Power and Associates estimated that approximately 38 percent of new car buyers are "upside down" (that is, have negative equity) at trade-in, which contrasts with 25 percent just two years ago.¹⁵ Using data from June 2004, one analyst estimates that the average buyer becomes "right-side up"—that is, when the buyer owes less on the loan than the car is worth—at 34 months, up from 33 months in May 2004.¹⁶ (See the inset box for more information on the origination of auto loans with negative equity.)

The amount of time it takes for a borrower to achieve positive equity depends on a variety of factors, including the loan amount, loan-to-value ratio, loan maturity, and the vehicle's rate of depreciation. Higher loan-to-value ratios and longer repayment terms are key factors that have contributed to the increased frequency of negative equity. Some car owners with high loan-to-value ratios and extended repayment plans may never reach positive equity, as they are enticed back into the showroom while owing more on their current vehicles than the cars are worth.

The amount of negative equity on outstanding car loans may continue to increase in 2004. While information on the maturity of car loans held by FDIC-insured institutions is not readily available, car loan maturities have increased among captive auto finance companies. Reports indicate that approximately 21 percent of Ford Motor Credit's new car loans in 2003 span 72 months—compared with 7 percent in 2002—even though Ford projects that consumers will sell their cars after 40 months. The percentage of 72-month loans also substantially increased last year at GMAC (29 percent) and Chrysler (35 percent).¹⁷ Incentive programs, such as loans recently offered by General Motors and Ford with 72-month terms and 0 percent financing, are likely to continue this trend.

Negative Equity Explained
A loan typically has negative equity (also known as being upside down) earlier in the loan cycle as the depreciation on the car exceeds the principal paydown—the total principal repaid to the lender—on the car loan (see Chart 3). Negative equity declines more slowly with lower monthly car payments and more quickly with higher payments. As the owner makes payments and the depreciation rate slows, the level of negative equity declines until the owner is right-side up, or when the owner owes less on the loan than the car is worth, which is approximately 30 months into the loan in the Chart 3 scenario.

Chart 3
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Competition within the industry has led many dealers to roll negative equity into a purchaser's new loan. A scenario in which negative equity is consolidated into a new car loan is described in the table below:

Scenario Resulting in Negative Equity

• Dealership offers new car for $25,000.
• Buyer negotiates price to $22,000.
• Buyer and seller agree on $10,000 value of trade-in car and recognize $12,500 debt outstanding on existing car loan.
• Dealer adds $2,500 to $22,000 negotiated price of new car, resulting in new purchase price of $24,500.
• Dealer presents lender with loan application for a $24,500 car.
• Lender agrees to finance 95 percent of the $24,500 transaction price ($23,275) on a car with a $25,000 MSRP.
• Customer borrows $23,275 for a car that had a negotiated purchase price of $22,000.
• Loan-to-market market value ratio approximates 106 percent (loan amount of $23,275 as compared with original negotiated sales price of $22,000).

Chart 4
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While overall credit scores on auto loans among lenders may have modestly improved, reports suggest that other aspects of auto loan underwriting may have eased in the past several years. According to the May 2004 CBA study, the percentage of auto lenders that allowed dealers to approve loans without the lenders' initial approval doubled in 2003, rising from 25 percent in 2002 to 51 percent last year. The percentage of lenders that accepted indirect auto loan applications via the Internet also substantially increased in 2003. In addition, processing times for car loan applications have declined. For example, the percentage of lenders that spent less than ten minutes per loan increased from 18 percent to 28 percent during the past year. While these results may indicate increased automation and efficiency among auto lenders, it may also indicate less scrutiny by some lenders.

Credit quality on securitized prime auto loans remains relatively well-behaved at present. However, auto loan maturities are extending, auto loan collateral is increasingly upside down, and lenders continue to finance aggressively in the subprime sector. Rising interest rates, consumer fundamentals, and economic conditions, as well as institution-specific loan underwriting, will be the drivers of auto loan credit quality going forward. On the positive side, stabilization in credit quality ratios of securitized auto loans during the first three quarters of 2004 suggest that improving economic conditions could partially mitigate the effects of higher loan-to-value ratios, longer maturities, and increasing incidences of negative equity on auto loans' credit quality. However, auto loans to marginal or subprime borrowers in particular may remain more vulnerable to credit quality deterioration, particularly in a rising rate environment.

Alexander Gilchrist, Regional Economist

The author wishes to acknowledge the contribution of Edward Butler, Senior Examination Specialist, FDIC Division of Supervision and Consumer Protection, New York Regional Office, in the preparation of this article.

¹ A captive finance company is usually a wholly owned finance subsidiary of a major auto producer, such as General Motors Acceptance Corporation.

² Delinquency and charge-off rates on auto loans are not provided in the Call Reports.

³ Christine Pratt, "Automobile Finance Industry Overview: Do Portfolio Metrics Constrain IT Investments?" Needham, MA: TowerGroup, September 2004, http://www.towergroup.com.

⁴ Deutsche Bank, "U.S. Autos: A Triple Threat," February 20, 2004.

⁵ Merrill Lynch, "Auto Incentives Monthly Snapshot," September 2, 2004.

⁶ Credit Suisse First Boston, "Big Three Incentives Bounced Higher in July," August 5, 2004.

⁷ Subsidized interest rates refer to rates on auto loans that are below market interest rates, such as 0 percent financing. Captive finance companies may extend credit on car loans at below market rates to facilitate sales of cars manufactured by their parent company.

⁸ Jason Stein, "Upside Down and Sinking Fast," Automotive News, February 16, 2004.

⁹ Morgan Stanley, "Rates Rise and Consumers Buy Down," August 9, 2004.

¹⁰ Moody's Investors Service, "2003 Review and 2004 Outlook: Vehicle-Backed Securities Incentives Rule the Road," January 2004.

¹¹ Economy.com, "Vehicle Sales," October 1, 2004; and Credit Suisse First Boston, "Specialty Finance September Monthly," September 2, 2004.

¹² Deutsche Bank Securities, Inc., "Beware of False Dawns: March Sales Boosted by Fleet," March 2004.

¹³ Fitch Ratings Ltd., "2004 Term ABS Outlook and Fourth Quarter Recap," February 2004.

¹⁴ John Porretto, "Auto Leasing Expected to Rise in 2004, a Plus for Dealers," Detroit News Autos Insider, January 31, 2004.

¹⁵ Danny Hakim, "Owing More on an Auto Than It's Worth as a Trade-In," New York Times, March 27, 2004.

¹⁶ Morgan Stanley, "Consumer Credit: Rates Rise and Consumers Buy Down," August 9, 2004.

¹⁷ Deutsche Bank Securities, Inc., "Ford Motor Company," March 2004.

¹⁸ Although auto loans are not segregated on Call Reports filed by insured institutions, credit quality information on securitized auto loans is available from various rating agencies.

¹⁹ Fitch Ratings Ltd., "Third Quarter 2004 Term ABS Recap and Outlook: Through the Looking Glass," October 8, 2004.

²⁰ Consumer Bankers Association, 2004 Automobile Finance Study, May 2004. This is a national study of indirect auto financing, leasing, and direct floor-plan financing. Surveys were completed in January and February 2004 and based on activity during 2003.

²¹ CreditSights, Inc., "Consumer Credit Scoring: Is FICO Fixed?" August 24, 2004, http://www.creditsights.com.

²² An indirect loan is a loan that is sold by a dealer or a retailer of goods to a third-party financial institution that owns the loan contract as a holder in due course and collects principal and interest payments from the borrower.

²³ Moshe Orenbuch, "Specialty Finance September Monthly," Credit Suisse First Boston, September 2, 2004. Mid-prime loans are defined as loans with expected cumulative losses of less than 6.0 percent.