In 2010, the subprime auto loan market began to grow once more, returning from a near complete decimation to where it was pre-crisis. As far as the media is concerned, all growth was the product of a universal collusion to throw underwriting standards out the window. The following represents just a fraction of the stories that have been published since that time, sounding the alarm on risky auto loans and predicting another subprime crisis:
• 2010 – The Subprime Lending Business (auto) Survives, Even Thrives – Time Magazine
• 2011 – Ally Financial Bets on Risky Subprime Car Loans – Reuters
• 2012 – Subprime Auto Loans Grow as Lenders Charge a Premium – Forbes
• 2013 – How the Fed Fueled an Explosion of Subprime Auto Loans – Reuters
• 2014 – The Next Subprime Bubble to Burst: Auto Loans – New York Post
• 2015 – The Next Crisis, Subprime Auto Loans, Won’t End Well – Forbes
• 2016 – Significant Concern in Subprime Auto Loans – Investor’s Business Daily
• 2017–‘Deep’ Subprime Car Loans Hit Crisis-Era Milestone – Bloomberg
Nearly all of these stories reference subprime bond data, which is about $23 billion out of $250 billion in annual subprime originations. Of the roughly 10 percent that is put into bonds, about 60 percent comes from three companies – none of which are blowing up.
What has yet to become headline news is that subprime auto finance has been in a mild contraction for the last year now, with major lenders pulling out of the deepest paper and others limiting originations due to capital costs (otherwise known as rational lending). The real risk in auto finance comes not from conventionally structured auto loans, but from auto leasing.
Reviving the past
The oil crisis of the 1970s, along with a slew of regulations from the Environmental Protection Agency, pushed Americans to drive smaller, more fuel-efficient cars. Gone were the 428 Cobra V-8 engines and Mopar 400 blocks. Powerful muscle cars were soon replaced by aerodynamic wedges with better mileage. It was kind of like going from Sean Connery to Pierce Brosnan, for you 007 fans.
Fast forward 30 years, and we see that fuel prices have come down, technology has improved – and what is old has become new again. Camaros, Mustangs and Challengers roar down our streets once more. Retro on the outside, but substantially improved on the inside. However, not all historical revivals turn out this way. In some pockets of auto leasing, something is being passed off as new that is nothing more than a resurrection of the bad practices that caused a meltdown in auto leasing nearly 20 years ago.
In 1999, the market was saturated with leases, which accounted for nearly 26 percent of car sales. In order to make their product offering more attractive to dealers, lessors got into the habit of “enhancing” (i.e., inflating) residual values. This, among other bad practices, resulted in a near collapse of the leasing market and left many investors wondering how they were so exposed.
The mechanics of leasing
The terminology related to lease financing is different from an installment loan, but the components of how the lender makes money are essentially the same. The lender/lessor acquires a vehicle, and structures a note with the customer designed to produce a certain return on the capital that is put to work. The risks come in the form of customer non-payment and the costs associated with re-acquiring and disposing of the collateral.
In leasing, the amount financed is referred to as the net capitalized cost. The net capitalized cost minus the estimated residual value is the gross depreciation fee, which is divided by the term to form the basis of the customer’s monthly payment. A finance charge (referred to as a money factor) and sales tax are added to comprise the total monthly payment.
For the lessor to make money, they must fit all of their expenses into the finance charge plus whatever return they need to make. Some of the key costs they must account for are:
Residual loss – This is the difference between what the lessor estimated the value of the car to be at contract, and what they actually receive for it.
Turn-in rate – In prime leasing, approximately 10 to 15 percent of consumers buy the car. This equates to an 85 to 90 percent turn-in rate. The higher the turn-in rate, the higher the residual risk.
Non-payment – A certain portion of consumers will break the terms of the lease. The early payoff penalty is equivalent to the net loss on a standard installment loan.
If the lessor does not accurately account for these costs, they risk the stability of their entire platform – and anyone who has their money tied up in it.
I often get incensed at the lazy comparisons made between the subprime mortgages that led to the last downturn, and traditional subprime auto lending. With the exception of longer terms, the auto loans today look the same as they did 20 years ago. Likewise, performance has fluctuated within a very consistent range across multiple credit cycles.
The toxic mortgages, on the other hand, were the result of twisting conventional structures into forms that had never been seen before. No docs, adjustable rates and inappropriate credit risk were justified based on a false estimate of what the collateral would be worth. Proforma yield estimates appeared tremendous, and Wall Street could not get enough of them.
Today, leasing accounts for over 30 percent of vehicle sales, summing to over $200 billion in annual originations – much greater than the saturation point in 1999. While the overwhelming majority of leases are to prime consumers on new vehicles, Experian reports that 35 percent of non-prime and nearly 27 percent of subprime consumers are choosing to lease. That figure equates to over $50 billion, a number significantly larger than what is held in subprime bonds.
Several headwinds in the market make these statistics a cause for concern. First, vehicle demand has leveled off and dealer inventories have increased. Second, used vehicle values are declining and they are likely to continue to do so as a record level of off-lease vehicles flood the market. Finally, lessors have to work harder to maintain or grow volume, which opens the door for the stretching assumptions on lease economics.
Who is at risk?
Prior to the great recession, there were trillions of dollars in mortgage originations. Nearly $700 billion of that was subprime, and more than 75 percent was securitized. When these loans imploded, they took the banks and the rest of the economy with them. In contrast, the auto lease market is significantly smaller.
While a spike in lease defaults will send negative signals to the capital markets and regulators, it is unlikely to disrupt the broader market. The exposure is largely limited to companies that predominantly originate auto leases, their equity investors and debt providers. Executives, investors and credit committees will want to look for three red flags that signal potential performance issues. These are:
• Credit creep – Every credit default carries with it certain costs for the lessor. These costs go up exponentially as credit creeps down the spectrum. Unrecovered early termination fees, collection expense and lost collateral value (repossessed vehicles are worth far less than market for a similar unit) all must be paid for by the finance charge. When lenders and lessors in higher credit tiers feel pressure related to volume, it is not difficult to dig deeper in a way that cannot be detected by looking at credit score alone. Missed credit assumptions can easily take a budget of 100 basis points in annualized default expense to 300 or even 500 basis points. Many will point to the fact that a lease allows the customer to get in a lower payment than a loan, which suggests they default less frequently than loan customers do. That might be true, except for the fact that consumers are sold on a payment size, and typically pack as much into that payment as possible. The payment-to-income ratios for loan and lease customers are very similar, so that argument does not hold water. Investors and debt providers should look to early payment default rates, and 30 plus days past due delinquency in the first six months on books. These figures should be compared to delinquency rates of loan portfolios with similar credit score distributions to ensure that the credit assumptions line up with reality. Make sure that if the business model calls for near prime consumers, the portfolio is not filled with consumers who are near prime in score only.
• Collateral mismatch – The biggest miss lessors have historically experienced comes from playing games with estimates of residual values. There is a moral hazard present in that a higher residual estimate means a lower customer payment, which makes it easier to get volume. The increase in the number of nonprime and subprime leases may indicate another issue, that there is a complete mismatch between the vehicle and the financing instrument. For a lease to make sense the vehicle has to be worth something at the end of the term; otherwise, the customer would be financing the entire vehicle without ever owning it. A collateral mismatch occurs when the quality of the vehicle must be inflated to fit a lease scenario in the first place. To make matters worse, those contracts are usually laced with out-of-market incentives to dealers in order to get them to close mismatched deals. Not only are the losses on such leases unsustainable, but they also create serious compliance issues related to predatory lending. To protect against collateral mismatch, capital partners must have a direct line into the vehicle values. This goes beyond merely acquiring periodic data files from the company, but running independent outside checks by submitting vehicle identification numbers to third party data providers like ALG, Black Book, NADA and others. Those vehicle values should be compared to the statistics of other lease portfolios in similar credit tiers (available from credit bureaus and other marketing data sources). If the company’s collateral and lease structures do not line up with what should be considered the peer group, there may be a problem with collateral mismatch.
• Pseudo controls – Credit creep, collateral mismatch and other serious problems are borne by companies lacking real controls. Great leaders maintain proper controls and foster a culture committed to supporting those controls. Bad leaders simulate a tight control culture, and can go on at length citing many checks and balances that do not actually exist. Bad operators see controls as a nuisance that prevent them from having the latitude to properly run the business. When portfolio performance becomes a problem, a poorly controlled entity turns to cooking the books. In those types of organizations, it is not uncommon for the internal auditor, compliance manager, risk manager or other control person to be overpaid, and several levels above what their resume would warrant – in other words, a patsy. Investors can protect against this by having activist board members with direct connections to the control functions. Regular control audits must be conducted from independent parties. For debt providers, do not rely on covenants to protect you, or you may be surprised at how weak your security interest is. Make certain that the numbers in the system were not fabricated in order to fit something into the warehouse facility. Insist on periodic I.T. audits, conducted by independent forensic data specialists.
Unlike the steady stream of articles on subprime auto, I am not predicting a time bomb waiting to go off in the auto leasing space – nor am I grouping all operators together. There are many excellent auto lease originators, particularly among the captive finance companies. The latter are usually run by strong leaders with excellent control cultures. Furthermore, they have vast amounts of data that show how their vehicles hold up in a variety of economic environments. There are also many independent companies with long histories of proven performance. That being said, the practices that led to problems in the past still exist today.
In the subprime mortgage crisis, assumptions meant for conventional loans were applied to highly atypical structures. Investors fell for it, and consumers flocked to it – sold on the idea that they could access financing that was formerly only available to the top tier. In some pockets of auto leasing, the same thing is happening today. What the market will find is that what is pitched as new is actually the same old song and dance. By keeping an eye on credit, collateral and controls, capital partners can make sure they avoid seeing history repeat itself.
Daniel Parry is co-founder and CEO of TruDecision Inc., a fintech company focused on bringing competitive advantage 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 firstname.lastname@example.org or through www.trudecision.com.