Auto lending continues to receive considerable attention, having experienced a significant increase in origination

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1 ANALYSIS Is Auto Lending Doomed? BY Cristian deritis and Pedro Castro Auto lending continues to receive considerable attention, having experienced a significant increase in origination volume relative to other consumer credit products since the recession ended (see Chart 1). Regulators and investors in auto loan securities are increasingly concerned that the frenzied activity is leading to loose underwriting practices similar to those that were associated with subprime mortgages during the housing boom. Anecdotal reports suggest that some lenders have been willing to forgo the verification of borrowers income and/or employment in an effort to underwrite loans for those who have questionable credit histories, hoping that higher finance charges and improvements in the labor market will offset the risk of default. Other critics suggest that lenders have been increasing the length of loan terms in an effort to reduce monthly payments and lower payment-to-income ratios. To date there have been few, if any, studies that have attempted to measure the prevalence of these risky lending practices overall and the use of extended terms in particular. Based on a review of a comprehensive dataset provided by Equifax, we find that overall lending standards have loosened but are consistent with a return to normal or equilibrium lending practices rather than an overcorrection. The current auto lending outlook is stable but could deteriorate quickly should underwriting standards loosen further. In this report, we leverage a unique dataset constructed by the consumer credit bureau Equifax that summarizes outstanding balances, loan terms and performance on a % random sample of the auto loans and leases reported to the credit bureau for Chart 1: Auto Lending Leads the Expansion Outstanding account balances, % change yr ago Auto First mortgage Student Bankcard every quarter since 6. These data allow us to examine how underwriting trends have evolved before and after the Great Recession along with loan performance. The data also permit us to quantify the extent to which the anecdotal evidence on credit easing is supported by market data. Based on this detailed consumer credit report data, we find evidence of loosening of underwriting standards that is consistent with a return to normal lending after a period of extraordinarily tight lending in 9 and 1. As we can see from Charts and, average credit scores are falling, and average loan terms are rising. We also confirm that the fraction of auto loans with a term of more than five years has steadily increased during the recovery (see Chart ). However, the evidence is much more nuanced than what has been reported in the popular media, suggesting more of a gradual loosening and normalization of standards than an abrupt opening of the credit spigot. The average credit score on auto loans and leases is around 69, down from the 71 level reached during the recession but well above the 67 average that existed during the housing boom (see Chart ). Similarly, the average loan term has crept up to 61 months from a recession low of 7 but is still below the average of 6 months that was in place in 6 (see Chart ). MOODY S ANALYTICS / Regional Financial Review / February 1 11

2 Chart : Borrower Credit Scores Retreat Mean credit score, 6-mo MA 7 Chart : Average Loan Term Lengthens Term length in mo, 6-mo MA Jan-6 Apr-7 Jul-8 Oct-9 Jan-11 Apr-1 Jul-1 Oct-1 Jan-6 Apr-7 Jul-8 Oct-9 Jan-11 Apr-1 Jul-1 Oct-1 Chart : With More Extended-Term Loans Distribution of origination loan terms, % of total, 6-mo MA Terms >8 mo Terms 8 mo Terms 7-8 mo Terms 6-71 mo Terms <6 mo Jan-6 Apr-7 Jul-8 Oct-9 Jan-11 Apr-1 Jul-1 Oct-1 Chart : Credit Score Distribution Is Stable Loans with terms of 8 mo at origination, %, 6-mo MA 6 Scores -619 Scores Scores Scores Jan-6 Jan-7 Jan-8 Jan-9 Jan-1 Jan-11 Jan-1 Jan-1 Jan-1 Some commentators have pointed to increases in the origination of loans with terms of seven or more years as a precursor to a collapse in the auto lending industry. Here again, the data suggest that the concerns may be well-grounded but misdirected toward 8-month loans. Although the number of loans originated with a term of 8 or more months rose by % from 1 to 1, this segment still commands less than a % share of the total auto lending market (see Chart ). The data are not suggestive of a crisis, but they do highlight growing risks in auto portfolios that merit attention. If anything was learned from the mortgage crisis, it is that expanded lending can rise rapidly and performance can turn on a dime. If riskier lending practices such as longer loan terms are being combined with other risky practices such as waiving employment verification or lowering down payments, it is best to identify these trends in advance while there is still time to take corrective actions. Supporters of extended loan terms suggest that the trend may be a rational choice based on record low interest rates and improvements in the quality of vehicles over time. If consumers believe that interest rates will rise in the future, then locking in a low rate for a longer period of time may make financial sense. Data from the Department of Transportation indicate that the average age of vehicles on the road rose to 11. years in 1 from 8. years in 199 and.1 years in If the quality of vehicles has risen such that consumers can drive them longer, then a longer financing term may also be justified. Although extended-term loans represent a relatively small share of the total auto lending market, a careful evaluation of those 1 See U.S. Department of Transportation website loans is needed to determine whether they are concentrated in certain borrower population and/or specific lenders. In addition, we analyze the performance of these loans relative to other loan segments to identify any early-warning signs. Longer terms, layered risks? Contrary to popular opinion, we find little evidence that the expansion of extended-term (8 months) loans has been concentrated in the population of borrowers with lower credit scores. Although the share of recent borrowers with high credit scores (above 68) has been constantly declining since peaking in late 9, the share of borrowers in the lowest credit score category (less than 6) has remained relatively constant during the last years (see Chart ). Rather, the market share of borrowers with intermediate scores of 6 to 68 has risen as lenders have eased standards. 1 MOODY S ANALYTICS / Regional Financial Review / February 1

3 Chart 6: Large Lenders Market Share Fluctuates % of originations, 6-mo MA 1 9 Captive Credit unions Large lenders Other lenders Jan-6 Apr-7 Jul-8 Oct-9 Jan-11 Apr-1 Jul-1 Chart 7: Credit Unions Offer 8-Month Loans 8-mo loans, % of originations, 6-mo MA 7 Captive Credit union Indirect lenders Other lenders 6 1 Jan-6 Apr-7 Jul-8 Oct-9 Jan-11 Apr-1 Jul-1 Oct-1 Although the data on credit scores are informative, they do reflect other lending practices and tools that lenders may be employing to choose among borrowers with similar scores and mitigate risks. For example, Equifax has reported a significant increase in the number of auto finance lenders using third-party verification of employment and income services over the last two years. Risk-based pricing has also become more sophisticated, allowing lenders to potentially take on additional risk while mitigating against adverse selection. Although it is still too early to assess the impact of these measures on lifetime defaults, the performance data to date do not indicate a rapid weakening in performance. While the trend in expansion is toward borrowers with less than perfect credit, a vast majority or 7% of 8-month loans are going to borrowers with scores greater than 68. Again, extended loan terms do raise a red flag, but in contrast with the subprime mortgage crisis, the expansion does not appear to be driven by borrowers with poor credit histories. Who s responsible? Given the evidence of loosening, who is providing this additional credit? Again, popular media and anecdotes paint a picture of unscrupulous dealers and auto finance companies extending loan terms irresponsibly under an originate-to-sell strategy that leaves them little, if any, skin in the game. See Equifax press release. Others have hypothesized that the captive auto finance companies may be easing aggressively in an effort to support auto and truck sales at their parent companies. Again, the Equifax data tell a more nuanced story. Equifax identifies four types of auto lenders in its consumer credit reports: 1. Captive auto lenders associated with manufacturers. Credit unions. Large bank lenders. Other lenders Looking at the market as a whole, we find that the participation of captive lenders has been stable over time, fluctuating from 1% to % of all auto credit originated (see Chart 6). The other three types of lenders share the market in approximately equal parts, although their market shares have fluctuated historically with the business cycle. For example, large bank lenders retreated from 8 to 1 as they sought to repair their balance sheets and raise capital. Having digested their losses, they came roaring back in 11 and 1 and have since returned to their long-run equilibrium market share. Again, contrary to popular opinion, the data show that the portfolio share of 8-month loans has expanded the most among credit unions, rising from % to 6% of their originations in the last five years (see Chart 7). The share of 8-month loans has also expanded for large banks and other lenders but has actually decreased for captive auto lenders. Although the increased presence of credit unions in this market may seem counterintuitive, we note that the web sites of captive auto finance companies typically do not provide financing options for loan terms beyond 7 months, while credit unions may provide 8- and even 96-month options. Credit unions may be in a better position to offer longer-term auto loans, given the unique relationship they have with their members. Indeed, credit unions avoided many of the large losses that banks experienced during the Great Recession. The relatively strong credit profiles of borrowers with 8-month terms observed in the Equifax data suggest that credit unions may be quite selective in offering this product, requiring applicants to have other compensating characteristics such as a sizable down payment or a long-term financial relationship. The relative income stability of government and military credit union members along with automated payment drafting may also contribute to the superior on-time payment performance of this group. For all of the concern that 8-month loans have received, the Equifax data suggest that this attention may be misplaced, given their small market share and relatively strong credit score profile. In contrast, loans with 7-month terms command a much larger market share overall and have experienced the greatest growth across all lenders in addition to credit unions. Indeed, the market share of 7-month loans has gone from around % in 1 to % in 1, warranting a closer look (see Chart ). See for example Toyota Financial and Navy Federal Credit Union. MOODY S ANALYTICS / Regional Financial Review / February 1 1

4 Chart 8: -Day Delinquency Rates Stable % of dollars outstanding, 6-mo MA 1 Terms <6 mo Terms 6-71 mo Terms 7-8 mo Terms 8 mo Jan-6 Jan-7 Jan-8 Jan-9 Jan-1 Jan-11 Jan-1 Jan-1 Jan-1 Chart 9: No Deterioration in 8-Month Loans -day delinq. rates, 8-mo loans by origination vintage, % of $ Q1 11Q1 1Q1 1Q1 1Q1 1 6 Clean performance, for now Shifting our focus to loan performance, we find that 8-month loans have not performed worse than loans with shorter terms. Thirty-day delinquency rates for this group have actually been lower in recent quarters (see Chart 8). This may not be too surprising, since one reason lenders make these loans is to lower the monthly payments for borrowers. Indeed, a valid criticism of looking at overall market delinquency rates is that they may not capture the lifetime losses incurred by these loans. Sure, performance is superior early on in the life of the loans, but lifetime losses may be higher, given that it takes longer for borrowers to break even on longerterm loans. To address these concerns, we leveraged the Equifax data to examine delinquency rates by months on book (or loan age) by vintage. Here, too, we find little evidence of a sharp deterioration in loan performance for more recent vintages (see Chart 9). In light of the limited historical experience with longer-term loans, time will tell if the superior performance continues in the long run. For the time being, at least, the data do not support the notion that 8-month loans are designed to fail. Unlike some of the subprime mortgage products that had interest-only payments or negative amortization, most auto buyers are likely aware that they are purchasing a depreciating asset and may adjust their behavior accordingly. It is also worth noting that, even at 8 months, auto loans are short relative to the typical 1- or -year mortgage term. Although a borrower with an 8-month loan may not break even for a couple of years after a borrower with a 8-month term does so, he or she is likely to be in a positive equity position by the fourth year of ownership (see Chart 1). For borrowers who intend to hang on to their vehicles for a long time, extending their loan terms may be quite rational especially at a time when interest rates are near all-time lows. Despite the increased share of 8-month loans among credit union auto loan originations, the performance of those loans has not worsened in recent years and is still better than that of other lenders (see Charts 11 and 1). In particular, credit unions have markedly lower delinquency and loss rates (see Chart 1.) The available data on 8-month loans downplay the concerns of market analysts and the popular media. Though it is important to monitor future originations and performance, the evidence suggests that seven-year loans are a small fraction of the total auto lending market. Their expansion has not been concentrated in low credit score borrowers or led to a swift decline in performance, as some have predicted. Chart 1: Break-Even Time Extends With Term Toyota Camry value versus loan balance, $ ths Depreciation schedule - KBB Outstanding balance - 6-mo loans Outstanding balance - 7-mo loans Outstanding balance - 8-mo loans Sources: Equifax, Kelley Blue Book, Moody s Analytics Chart 11: Longer Loans Performing Overall 8-mo loans, % of outstanding balances, 6-mo MA. Del. -9 days rate Del days rate. Del days rate Del. 1+ days rate Gross charge-off rate Jan-6 Apr-7 Jul-8 Oct-9 Jan-11 Apr-1 Jul-1 Oct-1 1 MOODY S ANALYTICS / Regional Financial Review / February 1

5 Chart 1: And at Credit Unions -day delinq. rate, 8-mo loans, % of $ outstanding, 6-mo MA 7 Scores -619 Scores Scores Scores Jan-6 Mar-7 May-8 Jul-9 Sep-1 Nov-11 Jan-1 Mar-1 Chart 1: Credit Union Loans Perform Better -day delinq. rate, all loan terms, % of $ outstanding, 6-mo MA Captive Credit union. Indirect large lender Others. Jan-6 Apr-7 Jul-8 Oct-9 Jan-11 Apr-1 Jul-1 Chart 1: Lower Credit Scores in 7-Month Loans Credit score distribution, % of origination, 6-mo MA Scores -619 Scores Scores Scores Jan-6 Jan-7 Jan-8 Jan-9 Jan-1 Jan-11 Jan-1 Jan-1 Jan-1 Chart 1: Most 7-Month Loans Are Indirect Distribution of 7-mo loan originations, %, 6-mo MA Captive Credit union Indirect large lender Others 1 Jan-6 Jan-7 Jan-8 Jan-9 Jan-1 Jan-11 Jan-1 Jan-1 Jan-1 7 is the new 8 If 8-month loans are of limited concern, where should we focus our attention regarding auto loans? The answer is simple: 7-month terms. As shown in Chart 8, the highest delinquency rates are observed for loans of that length. Borrowers with 7-month loans have a much weaker profile than those with 8-month terms. The share of prime and near-prime credit score borrowers has been constantly decreasing since 1 in favor of those in the subprime and near-subprime categories (see Chart 1). The share of borrowers with a score of 68 or more is much higher in this population, at about %. Here, too, recent trends need to be placed in historical context. The rising share of subprime loan originations to % is alarming but is still well below the % share that was present just prior to the recession in 7. Recent trends also suggest that the share is stabilizing and will not expand soon, given the increased attention the loans are receiving. Unlike the rapid expansion of 8-month loans by credit unions, all types of lenders have expanded their shares of 7-month 1 loans (see Chart 1). Since delinquency and default performance of 7-month auto loans has been far worse than that of other products, continued expansion of this group will necessarily lead to a deterioration in overall performance because of the shifting mix. And yet delinquency rates within the 7-month product category have been high but stable (see Chart 16). Chart 16: 7-Month Delinquencies Stable Delinquency rates, % of $ outstanding, 6-mo MA Del. -9 day Del day Del day Del. 1+ day Gross charge-off Jan-6 Apr-7 Jul-8 Oct-9 Jan-11 Apr-1 Jul-1 Oct-1 Performance on 7-month loans has been consistent across lender types, although the levels do vary (see Chart 17). Delinquency and loss rates are extremely low at credit unions and highest among captive auto lenders. Provided lenders do not loosen their standards further, the auto loan market MOODY S ANALYTICS / Regional Financial Review / February 1 1

6 Chart 17: Captive-Lender Loans Perform Worse -day delinq. rate, 7-mo loans, score, % of $, 6-mo MA Captive Credit union Indirect large lender Others. Jan-6 Jan-7 Jan-8 Jan-9 Jan-1 Jan-11 Jan-1 Jan-1 Jan-1 Chart 18: 7-Month Loans Show Deterioration -day delinquency rate by vintage for 7-mo loans by age, % of $ 6 9Q1 1Q1 11Q1 1Q1 1Q should stabilize, with levels of delinquency on par with prerecession trends. This is a large and critical assumption. Now that the spotlight is on lenders, they are likely to slow the pace of loosening. However, once regulatory and media attention fades and competitive pressures build, the temptation to loosen will re-emerge. Comparing 7-month loan performance by age or months since origination, we can see that performance is clearly weakening (see Chart 18). Loans originated in 1 and 1 are experiencing delinquency rates that are % to 1% higher than those of loans originated in 9 and 1 at the same points in their life cycle. Clearly, this category of loans merits further attention from lenders, regulators and investors in asset-backed securities to ensure that the risks are understood and are fully accounted for when setting borrowers interest rates. Prognosis positive if lenders heed the warnings Auto lending has been the star of the consumer-credit recovery, a trend that is expected to continue in 1. Outstanding loan and lease balances were the first consumer-credit segments to decline during the Great Recession, as borrowers cut back on vehicle purchases in an attempt to control finances in the face of rising unemployment and falling house prices (see Chart 19). Newvehicle sales fell in 9 to a 8-year low of 9 million annualized units before recovering to their prerecession level of 16 million units in 1 (see Chart 19). The pent-up demand that developed during the Great Recession will be worked off over the next couple of years, resulting in a short-term burst of sales activity. This temporary growth will be followed by a gradual decline as baby boomers retire and as changing preferences among urban-dwelling millennials lead to lower sales growth. But the trends for growth in 1 are firmly in pace. If anything, the recent declines in gasoline prices may provide a tailwind, as consumers return to dealer lots in search of sport-utility vehicles and light trucks. Average balances and monthly payments on auto loans and leases have risen as buyers opt for more expensive vehicles (see Chart ). A continued increase in average balances will lead more borrowers to consider longer-term loans to reduce their monthly payments. For borrowers who plan to own their vehicles for a long time and view historically low interest rates as an opportunity to lock in cheap financing, extended-term loans may pose little additional risk. However, for borrowers who rely on extended terms to meet affordability constraints, such terms can signal significant risk. Chart 19: Vehicle Sales Climb Out of the Abyss New-vehicle sales volume, SAAR, mil Trucks (L) Autos (L) New-vehicle sales, % y/y (R) Sources: BEA, Moody s Analytics Chart : Average Loan Amounts Inch Upward Avg loan amount at origination by qtr, $ ths Avg loan amount, score <6 Avg loan amount, score MOODY S ANALYTICS / Regional Financial Review / February 1

7 Chart 1: Auto Lenders Loosen to Support Sales Origination volume by credit score and origination qtr, $ bil 7+ (L) (L) (L) 1 <6 (L) 1 New-vehicle sales, mil (R) As a result of the increased sales activity, auto lending is expected to continue at a brisk pace, growing % to 1% over the next year. Market share between finance companies and banks will remain evenly split as banks continue to pick up share for prime borrowers and as finance companies make loans to credit-impaired borrowers. Although the market share of credit unions is small, it is growing in light of the highly competitive rates those institutions can offer their members. Auto lending has received greater media and regulatory attention in recent quarters because of the rapid expansion of lending overall and to subprime borrowers with credit scores below 6 in particular (see Chart 1). While this segment has grown at double-digit rates over the past year, the overall share of loan originations going to subprime borrowers remains below prerecession levels. Reports of risky lending practices clearly need to be investigated and monitored to prevent excesses from spreading, but the data thus Forecast far suggest that 1 the loosening of 19 standards is more of a return to 17 equilibrium than a 1 general overheating of the market Despite rapid recent growth, there 9 remains a large amount of pentup demand to be satisfied. Lenders will be under tremendous pressure to provide credit in an efficient but safe manner. Investors and regulators are wise to investigate the potential for fraud and/or excessive risk-taking at this point in the cycle to stave off bubble formation. The increased use of longer loan terms of 7 months or more, low down payment requirements, and limited income and employment verification are reminiscent of the housing bubble. But the market for auto loans is much smaller than that for houses, limiting the systemic risk that it may pose on the broader financial system. Potential abuses are being spotlighted early on, making it unlikely that they will grow into significant threats. Delinquency and default rates on auto portfolios are expected to rise modestly in 1 as the recent loosening of credit standards shifts the population mix back toward its long-run average. Increased origination volume will keep delinquency rates based on outstanding balances from rising dramatically in the short term, and improvements in the labor market will make it easier for borrowers with weaker credit to make their payments. Notwithstanding the tailwinds, risks to the forecast remain. A pause in the recovery could lead to an uptick in delinquency rates, as consumers have leveraged up and increased the average size of their auto loans. A sharp decline in used-car prices could lead to higher defaults, as borrowers who could previously sell their vehicles or borrow against them in times of financial distress may no longer have that option. Aggressive risk-taking on the part of lenders and investors could weaken underwriting standards and processes, resulting in a rapid rise in loan losses. Overall auto lending is expected to remain strong in 1, with performance problems surfacing later in the decade if lending practices should loosen further. Concerns around the rapid rise of 8-month loans appear to be overstated, based on the Equifax data, but the increased origination of 7-month loans is clearly something to watch, given an accompanying decline in credit scores and performance. More focus on these lending practices through various channels including this report should help to limit further expansion and keep auto lending on a sustainable growth path. A failure to hold the line on current lending standards could quickly lead to a sharp rise in auto credit losses and have repercussions on auto sales and the economy more broadly. MOODY S ANALYTICS / Regional Financial Review / February 1 17

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