Auto lending has been on regulators' radar for a number of yearsas an enhanced-risk lending sector. In particular, the Office ofthe Comptroller of the Currency has been discussing auto lending inits Semiannual Risk Perspective since 2012. Considering that creditunions have a sizeable share of the auto lending market (roughly20% of the outstanding balance), it is important that this messageof enhanced risk be effectively communicated to the credit unionindustry. ALM First proposes not abandoning the asset class, butensuring prudent underwriting and lending practices, especiallywith respect to indirect auto lending.

It's no secret that auto sales have been exceptionally strong.Annual auto sales in the U.S. have increased for several years in arow – an unprecedented growth streak – setting an all-time highnumber of units sold last year. This growth has trickled down toauto lenders. Specific to credit unions, the industry's totaloutstanding auto loan balance is roughly $320 billion as of thesecond quarter of 2017, according to aggregated Call Report data.This balance has grown at double-digit annualized rates for 17quarters in a row, another unprecedented streak since data trackingbegan in 1994.

As early as spring 2012, the OCC made note of banks seekingasset growth through launching new products, services andprocesses; indirect auto lending was specifically mentioned. Ofcourse, growth by itself isn't necessarily bad. But since then,auto lending has been mentioned eight times (every risk reportsince fall 2013). It is important for credit unions to understandthese risks regulators are discussing.

Lending Standards

The auto industry, like many, has seen progressively moreintense competition. Many participants have been pursuing growth byloosening credit standards. Advance rates are up, leading to risingLTV ratios, and borrowers with lower credit scores are increasinglyqualifying for credit. Additionally, to motivate borrowers, lendersare offering longer terms than ever before. According toEdmunds.com data, the average car loan term has increased from fiveyears in the early 2000s to well over six years in today'senvironment.

National offer-rate data from SNL Financial (now S&P GlobalMarket Intelligence) also paints an interesting picture: Average72-month auto rates are actually lower than shorter-term rates.This effect began in approximately the 2013 timeframe, near whenthe OCC added auto lending to its monitoring radar, and it makesabout as much sense as an inverted yield curve.

Delinquencies and Loss Severities

Asset quality indicators, such as delinquency ratios and netcharge-offs, are trailing indicators, meaning they take time tomaterialize as the credit lifecycle matures for a particularvintage of loans. Asset quality metrics related to auto loans havedeteriorated, and some expect them to worsen as more aggressivelyunderwritten loans continue to mature. Subprime lending has alsoincreased, right in line with the overall auto lending market.

For the credit union industry, delinquencies and charge-offshave been rising quickly. But the fast-growing origination volumehas offset what otherwise would have been larger increases inindustry asset quality ratios. Currently, auto loans delinquent 60days or greater represent 0.59% of outstanding balance, growingfrom $1.02 billion four years ago to $1.89 billion today. Moreover,delinquent indirect-loan balances have more than doubled from fouryears ago. Industry charge-off volume has almost doubled from onlythree years ago, and the charge-off ratio for the year 2016 was0.61% for the industry.

Fair Lending and Indirect Auto

For indirect auto lending, one of the risks more widelydiscussed by the OCC is fair lending risk, which is a result ofceding underwriting decisions to a third party, such as an autodealer. This doesn't just pose a risk to credit standards (i.e.,mispricing credit), it also poses significant compliance risk. Anotable case involved Ally Financial in 2013, in which the CFPBalleged discriminatory lending practices resulting from itsindirect auto lending program. As a result, Ally Financial wasrequired to pay a total of $98 million in damages and penalties.This type of fair lending risk results from dealer incentives,sometimes called dealer markups, which compensates dealers based onthe rate to the borrower over the lender's stated buy rate.

It is imperative for credit unions to ensure adequate controlsand compensation that are appropriate with respect to dealers.Perhaps a flat fee per transaction would eliminate hazardousincentives. The last thing any lender should want is a dealermaking pricing decisions for it, not to mention getting slappedwith a multi-million-dollar settlement.

So, What to Do?

Some large banks have been pulling back from the auto loanmarket. As early as 2015, Wells Fargo appeared to be wary ofsubprime auto lending, announcing a cap on subprime auto loanoriginations. Wells Fargo has been a big player in this market,particularly subprime auto lending post-financial crisis. Movesfrom big players like this can affect the markets. Since then,other lenders, notably big banks, have also pulled back from theauto loan market, citing rising stress and the desire forprotection from credit risk. Should credit unions follow suit?

The answer probably depends on your current practices. At ALMFirst, we continue to warn credit unions of the dangers of indirectauto lending, and it's not just about fair-lending risk; it's alsoabout profits. The fees obviously eat into the returns if the loanmatures on contract; if it prepays earlier than expected, you couldbe looking at substantially negative returns on capital. Even worsewould be deteriorating credit conditions, especially for indirectsubprime lending. We advocate the use of return on capital modelsto objectively assess the profitability of product lines; and muchlike what Wells Fargo did, if risks are mounting, take a step backfrom the market. In this regard, ALM First publishes monthlycommentary on relative value in lending, with a focus onrisk-adjusted return on capital analysis.

Overall, auto lending is a very important part of credit unions'business, and credit unions are in a position to provide greatvalue nationwide to ordinary borrowers. Indirect lending and dealerrelationships can be a great tool to expand the credit union'sreach. However, make sure to do so in a safe and sound manner.History has shown that loosening credit standards to increase loanvolume generally is not successful in the long run.

Alec Hollis, CFA is the Director, ALMStrategy Group for ALM First Financial Advisors, LLC. Hecan be reached at [email protected].