Why LTV Has Supplanted Credit in Auto Lending Profitability

By Chas Roscow

If you think about it, credit problems seem to wander around aimlessly visiting various business lines at random, but specifically targeting those with unsound underwriting practices. Specifically, such credit problems tend to germinate in cultures that place loan volume in front of loan quality. The current mortgage crisis is nothing more than the result of reckless underwriting practices, or a lack of execution of the fundamentals. Manual “reality check” underwriting reviews might have scrutinized the fact that an option adjustable-rate mortgage encourages speculators, or in 1990s auto finance, there was simply no way any vehicle could be worth 65% of MRSP in four years. For today’s auto lenders, the reality check questions the feasibility of financing 130% of a depreciating vehicle’s value for more than five years. Yet it happens daily. Ask any auto lending risk manager to comment on the rise in severity per default within his portfolio — $7,000 not uncommon.

After decades of focus on credit scores, pricing strategy, capacity analysis, and extended terms, loan-to-value (LTV) has emerged as the primary factor in managing credit-loss expense. Historically the least respected “C” of the traditional “Five C’s of Credit,” LTV now commands the most respect. Unfortunately for dealers, it comes at a time when nearly half of those with an outstanding loan on their vehicle owe more than the vehicle is worth. Lenders (the smart ones) are curbing advances, not only for lower tier scores, but for the higher scoring applicants, as well. There is simply too much supply chasing too few buyers during economic recession. Lenders are witnessing unprecedented incidence of customers who “voluntarily surrender” their vehicles.

Imagine financing 100% of a vehicle’s purchase price plus taxes on a vehicle with an $8,000 rebate. Certainly, this structure is essential for a dealer helping a customer out from under an upside-down trade-in. Clearly, lenders need to reduce the value of such vehicles and not follow a policy that lends against some large percent of the vehicle’s “stated” value.

Even without heavy rebates, advance policy misses other industry realities. For example, isn’t it funny how most know that vehicles all have different rates of depreciation, yet we see advance guidelines applied consistently across all vehicle models? For example, the 36-month residual value of three similarly priced vehicles — a Lexus LS460, a BMW 750Li, and a Jaguar XJ8L — differ by $9,000. Regardless, lenders apply the same advance policy on each vehicle. Most automated underwriting systems would not catch this. In fact, we’ve all read about those lenders who were proud to claim that “90% of the applications are underwritten without review of an underwriter.” Those same lenders now have truckloads of credit losses to offset the savings from use of their efficient loss machines.

Perhaps now more than ever is the time to take a hard look at your advance policy to ensure sound underwriting practices. Some will say, “But 130% advance is fine if the customer has strong credit and pays.” This is mathematically incorrect, since the lender is not getting adequate risk premium on those higher-scoring applicants. Check the “odds charts” behind credit scores. Easy math shows that a lender who strives (and I mean strives) for a 1% return on asset might need 30 good loans to cover just one credit loss at the level of loss severity we are seeing in today’s marketplace. Lenders also need to be cognizant of the cost of early payoffs (as many as 20% of new loans pay in full within the first year) in relation to dealer participation split plans.

And beware of the lender with just one valuation guide. We use three — two traditional guides, as well as fresh online weekly auction reports — to determine true value. Last week, a senior underwriter pointed out a $6,000 variance between two current guidebooks for the same exact vehicle. This reminded me of an old Japanese proverb: “A seller needs only one eye; a buyer two.”

The days of winning business by “putting deals together” for dealerships are over — and is a losing strategy. Banks and credit unions are growing weary of building “relationships” by “buying deep” into lower credit score bands while providing loan advances well over the vehicle’s value, and leaving the lender with the tab. Even the manufacturers are beginning to realize that U.S. supply has exceeded demand to the point where subsidizing residual values is simply too costly. Look, dealers LOVE lenders who make bad loan decisions because it increases sales, but the fastest way to render a portfolio worthless is to build relationships by doing dealers “favors.” The slightest miscalculation in your subjectivity could not only destroy profits, but also bring down an entire business line. The best way to manage the indirect business is to nurture relationships with dealers over time and support those dealers that support you, by offering a full line of products to meet their needs. But one must also respect the report that shows portfolio performance by dealer. In short, your business is to finance rides, but don’t be taken on one.

Chas Roscow is 26-year industry veteran with captive and bank auto lending experience. Chas is currently senior vice president of the consumer lending division at Chevy Chase Bank, a $15 billion privately held federal savings bank in the Washington, D.C., market.