The Outlook for Used Vehicle Values

A number of years ago, I helped my oldest daughter with a project for her science class. The assignment involved monitoring short-term weather forecasts and comparing them to the actual outcomes a few weeks later. As a large part of my career has revolved around predicting the future performance of things, I decided to have some fun with her in order to make a point.
I instructed her to track all of the major national forecasts for the Dallas area (i.e., AccuWeather, WeatherBug, The Weather Channel), as well as the daily forecasts from our four local network news stations. To her surprise, the local weather forecasts were consistently more accurate than those produced by the major national forecasting groups.

The reason for this is simple – local meteorologists are much closer to the problem. They place substantially more focus on local factors that influence how weather systems move through the area, and tend to be better at recognizing when a quantitative model spits out nonsense. This is a lesson that I am certain would be useful for those who follow the auto finance industry.In March 2017, Ally Financial issued guidance suggesting that earnings could be lower due to a decrease in vehicle recovery

values. The next month, MarketWatch quoted Jamie Dimon, CEO, JP Morgan Chase, warning that lenders would likely be impacted by negative trends in vehicle values. Never ones to miss a potential crisis, the national media outlets set to work sounding the alarm on the next meltdown, issuing a slew of stories over the last year, which included the following:

  • “How much Morgan Stanley thinks used-car prices will crater — in one chart”, MarketWatch, April 10, 2017.
    Most people abuse the acronym “LOL”, but in this case, I actually did laugh out loud. The analyst produced a chart that projected a potential 50 percent drop in the Manheim index by 2021. The Manheim index is pegged to 1995 dollars, and is not adjusted for inflation, or the value of new vehicles. This prediction essentially says vehicle values will drop to 68% of 1995 dollars. A two-year-old Toyota Camry presently sells for around $16,000, which equates to $9,000 in 1995 terms. Therefore, a two-year-old Camry will sell for about $6,100 in 2021 – LOL.
  • “Off-lease vehicles are flooding the market, pushing prices down”, FoxNews Auto, May 26, 2017.
    The U.S. has seen approximately 500,000 off-lease vehicles enter the market each year since 2013. Predictions of a vehicle value cliff resulting from off-lease volume have been made for the last four years, but that has not happened. Supply does matter, but it has been offset by compensating factors.
  • “Your car is now worth less than you think – a glut has used cars depreciating at a breakneck pace”, Bloomberg, August 21, 2017.

A massive shortage inventory between 2010 and 2013, combined with the return of capital and consumers following the downturn, led to record high used vehicle values. Demand levelled off in late 2016 followed by a temporary increase in supply. The Bloomberg article measures the drop in values from the peak in 2014 through the end of the buying season in 2017, when values were at their seasonal low point. This is kind of like measuring the change in population rate from Adam to Cain, and using it as a baseline for future growth.

I suppose I should be grateful every time one of these stories is published, because I receive loads of consulting work from bond and equity investors. On the other hand, the fear induced by these articles creates disruption among investors and lenders alike. The time has come to switch to the local weather forecast.

A multi-dimensional problem

The focus on this issue is not so much about the current state of used vehicle values, but where they will be at specific points in the future and what that means to the bottom line. For lenders, the concern is what the car will be worth at the time it is repossessed and put through the auction, which on average occurs 15 to 18 months out for sub-prime lenders. For lessors, the problem relates to what the vehicle will be worth at the end of the lease, which is on average 36 months out.
Many conceive of future vehicle values as a simple function of supply and demand. While those factors are important, they do not alone adequately account for the variation in recovery or residual rates. A robust forecast must include:

  • Vehicle mix – “Supply of what?” and “demand for what?” are the critical questions to ask. Many of the off-lease vehicles have been in the truck and SUV class. For the past several years, recovery rates have been high in that category due to strong demand. In contrast, small to mid-size vehicles have been in oversupply, leading manufacturers to make production cuts at plants where those units are produced. Small to mid-size car values have trended 3-5 percent down for year over year comparisons since 2015, but production cuts made in 2016-2017 have started to reverse that trend.
  • Availability of credit – In 2009 to 2010 there was high demand for autos, but with little credit available, it did not matter. From 2011 through 2015, a tremendous amount of capital poured into auto lending, and as a result, used values were very strong. Consumers’ normal buying patterns are often influenced by things like incentives, interest rates or other promotions. When this happens, demand is pulled forward in time (i.e., the transaction would have otherwise happened later). An abundance of credit allows people to respond to these influences more frequently, whereas a capital crisis prevents this, subsequently putting downward pressure on values.
  • Economic factors – Consumer expectations around employment, inflation, global stability and income play a large part in the supply and demand equation. Uncertainty around the election and economy was high in 2016, resulting in a levelling off of overall demand. Since that time, GDP has picked up, tax cuts are on the way and unemployment is at record lows. We are now seeing a seasonally adjusted annual rate of new auto sales rise in 2018. On a micro level, low fuel prices have directly contributed to a strong demand for trucks and SUVs, which have propped up their values while other classes have declined.
  • Lender behavior – In the July 2016 edition of Non-Prime Times, I wrote an article on recovery values, and provided an illustration of what happens to net credit losses with a 10 percent drop in auction recovery values. All things being equal, it amounted to half a percent on an annualized basis (visit www.nafassociation.com/subscribe.php to view the article). Of course, anyone who follows auto lending knows that lenders can see 500 basis point swings in recoveries across the credit cycle – so what is driving such volatility? In my estimation, 70 percent of credit performance is determined by what happens at origination. Approximately 20 percent is related to servicing strategy, and perhaps 10 percent is the result of exogenous factors such as the economy. If the company is allowing higher loan-to-value ratios, for example, recovery rates will subsequently drop. How a lender validates vehicle-adds or books out the vehicle will also have an impact. Over the last four years, I have observed some lenders increase the use of deferments, and push out repossession assignment dates. Much of that amounts to delaying the inevitable charge-off, which can rapidly drive a 45 percent recovery rate into the high 30s.

Used vehicle outlook

There have been two periods in the last 20 years where there was a shock to vehicle values. The first was in the quarter one of 2003, when manufacturers were offering employee-pricing incentives at the same time rental car companies were dumping their fleets. Sub-prime auto recovery rates for large mid-tier players dropped from 45 percent to 38 percent within two months. A similar downward recovery spike happened in the fourth quarter of 2008, when the capital markets suddenly contracted and credit availability evaporated. The drop was short-lived, and within a few months, values were back up again.

When sudden shocks to vehicle values occur, opportunistic consumers rush to take advantage of the situation. This causes the excess inventory to rapidly disappear, which pushes prices back up. The vast majority of the time shifts in used vehicle values happen at a modest pace over several years. This is true of most market factors, including economic catastrophes. The Great Recession began in 2007, when unemployment was at a low of 4.5 percent. It took a year for it to climb to 5 percent, and another year to reach 7 percent. As such, any change coming in the near future is much more likely to be modest and gradual as opposed to a sudden bottoming out.

Production cuts by major manufacturers, starting in late 2016, are already starting to have a positive effect on dealer inventories. In addition, the inventory glut from 2017 has completely turned around (refer to the Production and Inventory graphs on page 15 – Charts 1 & 2). While this data relates exclusively to new cars, it is relevant to lenders because this determines the supply issues two to three years down the road, when these vehicles are traded in. All of this suggests we are not likely to see a major mismatch in supply versus demand, barring a major economic setback.

prod-v-sales1

 

 

 

With regard to the availability of credit, there has been a modest contraction in sub-prime auto. In some cases, this is due to capital constraints for privately held companies. In other cases, large lenders, such as Santander, have tightened credit. This notwithstanding, credit availability remains strong, and is not likely to change in the near term without a major capital crisis (refer to the Consumer Credit graph – Chart 3).

value-vs-inv-graph-2There is little question that the economy is the strongest it has been in many years. Gross Domestic Product and Consumer Sentiment are on a sustained upward swing, while inflation, unemployment and interest rates remain at record lows. While the Federal Reserve is likely to raise interest rates over the next 24 months, it is not expected to be more than a percent. Such small increases are easily absorbed, particularly by sub-prime lenders where the customer tends to be payment sensitive instead of rate sensitive.

Final considerations

The largest increase in vehicle values in recent history occurred between 2009 and 2011, which was a side effect of the last economic crisis. The abiding fear has been that “what goes up must come down”, and so market watchers have been anxiously awaiting a collapse; but the overall state of used vehicle values is not related to what happened nearly a decade ago – it is a direct outcome of the market dynamics today.

consumer-credit-graph-3Production has been adjusted, the economy is strong and consumer credit is widely available. All of these signs point to only modest changes in the coming year. A spike in fuel prices will affect gas-guzzlers, an interest rate increase may influence prime demand and an increase in off-lease could put pressure on sub-prime recovery rates. None of these possibilities will impact lenders to the degree that their own underwriting and servicing practices will.

It is easy to predict doom and gloom. If things turn out well, no one will remember. If they turn out poorly, one could claim market clairvoyance. With that in mind, I will close on some very real, and positive, possibilities. Businesses and consumers have not yet experienced the full effect of the tax cuts. This is also the first recovery that did not involve housing starts, which are only half of where they were at their peak in 2006. A robust housing market combined with employment levels that push wages higher could lead to a significant increase in consumer spending. If that happens, we may find that the production cuts to small and mid-size cars may have been too much to meet increased demand, leading to a sizeable increase in recovery values for those vehicle classes.

Overall, the data suggests that used vehicle values will remain stable for the near term, and are not in danger of cratering. Lenders and analysts should keep in mind that change is gradual, and inventory issues are often compensated for by a host of other factors. Many lenders model depreciation rates on their own portfolio data, which is better than not modeling anything; however, I strongly recommend that lenders take advantage of the excellent auto valuation data products provided by major national vendors, as most of the answer for future values is not contained in the company’s own historical data. Strong analytics combined with disciplined underwriting and servicing will prove very powerful in mitigating any unforeseen shifts in used vehicle values.

If you would like to receive TruDecision’s free quarterly Auto Finance Market Report, or our monthly update on forward looking vehicle values, please e-mail Solutions@TruDecision.com.

Daniel Parry is co-founder and CEO of TruDecision Inc., a fintech company focused on bringing competitive advantages to auto dealers and lenders. He is also co-founder and CEO of Praxis Finance, a portfolio acquisition company, and co-founder and former chief credit officer for Exeter Finance Corp.

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Disruption! How Blockchain Technology will Impact Consumer Lending

Blockbuster Video opened its first store in Dallas, Texas, in 1985. Over the next 20 years, they added more than 9,000 stores and 58,000 employees worldwide. In 2011, the bankrupt company was acquired by Dish Network for $320 million. The irony of this is that in 2000 former Blockbuster CEO John Antioco passed on an offer to acquire Netflix for $50 million, thinking it was just a niche business. Today, Netflix has a market cap of over $82 billion, while Blockbuster stores are but a memory.

The annals of business are replete with similar stories. For example, Yahoo passed on a chance to buy both Google and Facebook, and spent 2008 thwarting acquisition offers from Microsoft. In 2003, Friendster rejected a $30 million offer from Google, and they were soon after displaced by Myspace and Facebook. Each example illustrates a case where the company had achieved so much success that they did not take emerging threats seriously. Perhaps the old adage should be revised to say, “Nothing impedes like success”.

It is said that everyone has perfect vision when looking into the past. It is a different thing, altogether, to see things in real time. Blockchain technology is one of those things. It is the latest buzzword sensation, and companies are rushing to force fit the suggestion of it into their technology offerings in hopes of obtaining a higher valuation. All of the hype makes it very easy to dismiss, but blockchain technology is already having a profound impact on how lenders will operate in the future.

Blockchain overview
The initial concept of blockchain was published under the pseudonym Satoshi Nakamoto in 2009, and was first deployed as a core component of the cryptocurrency Bitcoin. The model is essentially a distributed ledger, meaning that each transaction is recorded in many locations (nodes). The transactions (blocks) are unalterable once accepted by the chain. Each new transaction must reconcile with a majority of the other nodes, making it virtually impossible to forge. There are numerous other benefits to blockchain technology, which will become apparent when considering how to apply this technology to consumer lending.

There are three basic configurations, which are public, private and consortium (often referred to as federated). In a public blockchain, anyone can send transactions, and see them if they are valid. In addition, anyone can participate in the consensus process. All transactions are encrypted and anonymous, but they are also completely transparent. Public blockchains are the slowest because the records exponentially increase with each new transaction, but they are still faster and cheaper than the traditional process of audit and reconciliation occurring between companies today. The middleman is cut out in the public blockchain, because each transaction must reconcile with other nodes in the network before it is written into the record and assets are transferred.

In a private blockchain, read permissions are kept centralized within one organization. Read permissions may be public or private, and a limited group within the organization is responsible for the consensus process. A consortium operates in the same way, except that multiple organizations share the responsibilities of maintaining the core functions. Private blockchains are significantly faster and less expensive than public blockchains, but are less secure due to their centralized structure (i.e., a single point of failure). The consortium offers a hybrid approach, where there is the speed and efficiency of a private blockchain, but power over the network is not consolidated in one company.

Applications in auto finance
The auto finance industry is large, fragmented and inefficient. A recent Experian Automotive report stated that for used vehicle finance (which represents two-thirds of the U.S. auto finance market), the top 20 lenders only accounted for only 38 percent of the total market share. The twentieth lender had less than a one percent market share, meaning that 62 percent of the auto finance market is made up of thousands of bit players. In addition to the multitude of lenders, there are approximately 60,000 franchise and independent dealers interacting with these companies. The speed, efficiency and security of blockchain holds the promise of numerous improvements throughout the industry. Some of the major initiatives that are presently in development are:

•    Dealer loyalty programs – There are a few constants in the universe. Among them are that dealers want to get paid, and paid quickly. Some of the most successful lenders have developed loyalty programs that incent dealers to create efficiencies by paying for a certain number of contracts, clean funding packages or other factors that drive down cost per acquisition. These programs can be cumbersome to track and time-consuming to administer, minimizing their value to the dealer. Blockchain allows for real time tracking and execution of loyalty rewards, which could have a substantial impact on program effectiveness.

•    Smart contracts – The terms of contracts may be embedded into programs that allow for automatic verification and enforcement, eliminating the need for a legal and/or accounting intermediary to certify. This construct can be fully or partially self-executing, saving a tremendous amount of time and money for all parties connected to the deal.

•    Credit reporting and identity management – A major point of frustration for consumers, and lenders alike, is that the three credit reporting agencies may produce different information on a report for a single individual. That can influence not only the consumer’s credit score, but also whether or not that person can qualify for credit. A blockchain system can resolve this age-old problem, by reconciling all transactions and payments. Furthermore, the ability of this technology to put control of credit information in the hands of the user could literally wipe out identify theft and make data breaches a thing of the past. When enough consumers demand this, it will not be up to the industry to change – it will be legislated.

Preparing for disruption
According to a recent report by Accenture, 9 out of 10 banks in North America and Europe are actively exploring blockchain technology for payments. The report estimates that this technology could reduce bank infrastructure costs by 30 percent. A 2016 survey, conducted by IBM with 400 banks and finance companies, suggests that 65 percent of banks globally will be actively using blockchain by 2019. Change is coming, regardless of whether we in the auto lending space prepare for it.

Consider that electronic documents and e-contracts have been around for nearly 20 years, but very few lenders have embraced them. Amazon, Google and Microsoft have amazing cloud technology on the world’s biggest and fastest servers. Superior technology and service is available from them for pennies on the dollar of what it would take a single company to develop, yet most lenders still build and maintain their own technology infrastructure.

Almost 15 years ago, I remember some senior operations managers I worked with commenting on how Capital One Auto Finance had transformed to analytic, model-driven underwriting (auto-decisioning) from a manual, judgmental process. One of these managers smugly quipped, “They just went out of business!” Of course, that did not happen – the company has done quite well. You might forgive such a myopic comment at that point in time, because the idea was fairly new.

Fast forward to 2012, and some of these same leaders were still laughing off the idea of auto-decisioning, saying it would never work. This was in spite of the fact that many of the players who were out-competing us in the market had been successfully deploying this technology for over a decade. Eight years before the Wright Brothers made their first flight at Kitty Hawk, famed British scientist Lord Kelvin said that heavier than air flying machines were impossible. It seems unimaginable that Kelvin would make that statement today, sitting in an office outside of one of the busiest international airports in the country.

The punchline in all of this is that the auto finance industry has been slow to adapt to new technological innovation. The size of the market, and the number of dealer intermediaries has allowed lenders at all different levels of sophistication to thrive; but, it is the nature of markets to become efficient – and blockchain is the technology to facilitate that.

The combined wealth of the top five tech-giants is greater than the GDP of all but four countries. Amazon has disrupted dozens of industries, and it is now focused on grocery and pharmaceutical delivery. Google has massive amounts of data on every consumer’s online activity, and has the analytic horsepower to make use of it. It is just a matter of time before these companies leverage their unprecedented amount of capital, and use technological innovation to change the competitive landscape of auto finance forever.
Banks, captives and independent finance companies who are not actively investigating this technology would be well advised to learn the lessons of Blockbuster, Yahoo and Friendster. At TruDecision, we are actively researching ways to leverage blockchain technology, so that we will be part of the new market and not a victim of it.

Daniel Parry is co-founder and CEO of TruDecision Inc., a fintech company focused on bringing competitive advantages to auto dealers and lenders. He is also co-founder and CEO of Praxis Finance, a portfolio acquisition company, and co-founder and former chief credit officer for Exeter Finance Corp. For questions or inquiries, please email danielparrynaf@live.com visit www.trudecision.com.

Choosing a Lender

by Scott Brackin

creditmailIn the presence of fierce competition and razor thin margins, it’s more important than ever for dealers to look for lenders who are engaged in innovative ways to protect risk, while providing the best in class service levels for the dealership and the consumer.

Dealers understand non-prime consumers are on extremely tight budgets. Would-be customers walking into the showroom already know exactly what monthly payment they can afford.  To accommodate these potential buyers, dealers rely on lenders to help provide the right interest rate and term. Historically, lenders have relied primarily on the Big 3 bureaus, however those bureaus have limited information on non-prime consumers. Most dealers know that millions cannot be scored. Per the CFPB, 45 million U.S. adults are living without credit scores due to no credit history, limited data or out of date credit data with the Big 3 bureaus. There are also nearly 90 million adults with scores below 650 and that number is just going up.

Top lenders are innovating and learning alternative data is shedding more light on these thin-file, ghost consumers to help them better assess the risk and offer more flexibility in pricing. To be competitive, dealers must work with those lenders that employ all available information —specifically alternative data—to provide a more complete picture. By utilizing lenders that have access to alternative data on those consumers, dealers will sell more cars, minimize buybacks and help to build better customer relationships.

passtimeWhat is alternative data?
Just as the label implies, alternative data falls outside the scope of the Big 3 credit bureaus and includes public and private records procured from governmental and institutional sources and is accessible via third-party aggregators. Alternative data sources could include records from public files, utility and telecommunications companies and others.

From public records, one may access an immense amount of data regarding a consumer’s property ownership, bankruptcies, liens or judgments and relationships. Public records provide asset and adverse action information that may be modeled. Another source of alternative data is tradeline information that offer access to application inquiries, loan performance and consumer stability details. Alternative tradelines provide past loan payment behavior and an understanding of outstanding debt. At the end of the day, what you are looking for is a lender that has a complete the picture of someone’s ability to afford the automobile.

Move more metal
Lenders that leverage alternative data have deeper information on consumers’ buying behavior. These lenders will provide a pricing advantage over those who are not accessing alternative data.

For example, a lender who uses short-term tradeline data will have information on whether or not the consumer has taken out or paid off any short-term loans. Paying off short-term loans correlates with reduced risk. Specifically, borrowers with three or more paid off short-term loans in the prior year have a 33% lower than average auto loan bad rate – an improvement three times as large!

This information of a lower default rate translates directly into pricing power and the ability for dealers to close more sales.

automotive-personel-200x300Better buying experience
Lenders using alternative data have information enabling them to quickly verify information online, reducing some of the manual verification process. Such services include identity verification and information on the consumers’ stability that correlates directly with risk. Often lenders will access alternative data to verify income, employment and ACH events. When successfully implemented, these services make the funding process more cost-effective for the dealer.  As a result, the experience is also faster and more efficient for the buyer.

Win-win
Alternative data providers have built a business around collecting unique quality data from a variety of less traditional sources.  The buzz is this data is quickly becoming more mainstream with auto lenders. When choosing a lender, find out if they are using alternative data, what types of data and how they are using the data to help them more accurately assess risk and price the loan.

Lenders leverage alternative data to take a “closer look” at prospects and build a win-win for the dealer and the consumer. Not only will it allow dealers to be more competitive, resulting in more sales, but it will also allow the consumer to be able to afford the vehicle their credit really deserves. By meeting their needs quickly the first time, this will undoubtedly bring about repeat business.  A true win-win-win for the dealer, the consumer and the lender.

Scott-BrackinScott Brackin is the automotive practice segment leader for FactorTrust. Scott has more than 24 factortrust-200x300years of experience in financial services, credit risk data, and technology. Since joining FactorTrust in 2013, he’s overseen the company’s rapid growth in the automotive segment as part of his vision to become the premier alternative credit reporting agency (CRA) and analytics business for the automotive finance industry.