MUSKEGO, Wis.–The profitability of indirect auto loan programs is not what it used to be and demands that credit unions carefully examine the performance of their indirect programs, insists
QuantyPhi.
“Maintaining your credit union’s share of the auto loan market is a continuous challenge. Increasing that share is an even greater challenge—because as we all know, consumer lending, particularly auto lending, is a highly competitive business,” said Kevin Chiappetta, president of Corporate Central's QuantyPhi CUSO. “Well-funded auto loan competition comes not only from banks, but also from automaker captive finance units and aggressive online lenders. To remain viable players in the auto lending arena, many credit unions have added indirect loan programs to augment their portfolios, a practice that delivered satisfactory ROAs in the past, but has ceased to deliver in today’s rate environments.”
Chiappetta said that increasing reliance on indirect lending has created numerous underperforming portfolios, and now warrants a “serious look-back” at price points and risk, and a look-forward to future performance expectations—especially after the recent run-up in short-term interest rates.
A Closer Analysis
To look closely at what has transpired, QuantyPhi compared indirect auto loan pricing models from 2015 and 2018 (see chart below).
“We chose to review auto loan pricing models in 2015 because the yield curve allowed credit unions to grab very low-cost funding from regular share deposits and money market accounts,” said Chiappetta. “There are several factors to make note of in the model above: the low cost-of-funds assumption, projected losses (assuming the 2015 national loss rate for prime auto loans), and more interesting, the loan pricing itself. The price point in 2015 was quite aggressive, not dissimilar from the kind of pricing offered by many credit unions today, even with the recent increase in the cost of deposits.”
Chiappetta said that as Example 1 in the chart shows, the forecasted cash flow stems from a relatively conservative assumption on prepayments: a 12-month increase—or ramp—in the prepayment rate.
“This assumption projects slow prepayment of principal in the early life of the loan pool, only to ramp up to the full, assumed prepayment rate after 12 months,” he explained. “The portfolio rate of 2.5% is about 1.5% lower than auto loan rates advertised today, and we see a 1% loan acquisition rate and 25 basis points of servicing expense. After applying loan loss averages, which never exceeded 1.14% throughout the time period noted, the portfolio returned 1.19% before the cost of funds was applied. Compared to the U.S. Treasury yield curve, the loan asset exceeded comparable Treasury yields by 60 basis points.”
What to Look at Now
But Chiappetta said it’s time to look at what has changed in auto loan pricing, loan performance, yields and the yield on comparable U.S. Treasury securities in recent months.
Kevin Chiapetta
“Loan acquisition costs are now between 1.5% and 2%. The Treasury yield curve is higher, prepayments are coming in faster, and loan losses are up,” he said. “Using the same ROA calculation method as we used in Example 1 (with one exception—rather than updating the net loss curve, we will leave the curve as it was in 2015), we can see how the same loan pool performs relative to current Treasuries.”
As shown in Example 2, QuantyPhi adjusted the loan rate to 4% and the prepayment rate to 20%, still accounting for the 12-month prepayment ramp, and using acquisition costs reflective of loan experience in the current marketplace, noted Chiappetta.
“We still assume that loans are purchased indirectly, and the credit union does not receive any ancillary revenues from back-end revenue sources like insurance sales. The one large flaw in this new calculation is not adjusting loss experience upward, which is unrealistic given recent auto loan risk knowledge,” he said. “But even when underestimating the losses in the loan pool, the credit union would have outperformed the pool ROA by simply purchasing a comparable U.S. Treasury security.”
What’s Also Clear
Chiappetta said that it’s clear from the examples that the profitability of indirect loan programs changes as rates rise.
“In Example 2, the actual return on the pool increased with the rate increase. But, in light of the overall interest-rate environment and opportunity elsewhere, the return on loan assets did not measure up against alternatives,” he said. “Relative to a U.S. Treasury, the return was less than satisfactory.”
It’s also important to note, added Chiappetta, that the analysis does not incorporate the ability of a credit union to turn loans into members.
“Each credit union has their own success rate of member conversions, and that should also be reviewed before embarking on, or expanding, any indirect loan program,” Chiappetta said. “How much it costs to convert a member will affect ROA too. Therefore, a credit union’s indirect loan program analysis should include the actual estimated cost of each pool, current rate environment and anticipated rate environment considerations, as well as the probability of turning a borrower into a full member.”