Subprime Doesn’t Have to be Subpar

Daniel Chu, chief executive, Tricolor Auto Group

New data shows that more consumers are late on subprime auto loans than at any point since 1996. That means more people are skipping payments now than even during the financial crisis.

As a result, lenders are pulling back from the space and credit options for subprime borrowers are drying up or rising in cost. But a new model is poised to emerge that could lead to quality used car sales at more affordable rates, reversing today’s trend and launching subprime auto on a sustainable, upward trajectory.

By The Numbers

Financial markets follow a cyclical path, and the subprime auto finance industry is no different. By the end of 2017, outstanding balances on all auto loans in the US exceeded an all-time high of $1.1 trillion. Approximately 20% of these loans were made to subprime borrowers.

At the same time, sales of subprime auto asset-backed securities (ABS) reached $25 billion in 2017, topping last year’s total and almost tripling the amount in 2010. To support the funding of these loans, private equity firms and hedge funds invested around $3 billion into these specialty auto lenders during the last cycle, according to Bloomberg.

Now, the total impact of this aggressive lending to subprime borrowers is being seen in declining loan performance.  According to recent data from Fitch, 60+ day delinquencies on subprime auto ABS reached 5.8% in the first quarter of 2018. This is a 50% increase over 2014 and ranks as the highest level since October 1996, even higher than during the financial crisis.

The numbers are even worse for borrowers with credit scores below 620. The 90+ day delinquency rates on these loans have reached near recession levels. Keep in mind this trend has occurred during what is the most robust labor market in nearly 20 years. Consequently, lenders are being forced to pull back and tighten their underwriting standards.

To be clear, this bubble bears no risk of catalyzing another financial crisis.  Even though loans to borrowers collateralized by autos reached an unprecedented level by the end of 2017, auto loans still only make up approximately 9% of debt in America, compared to 68% for mortgages.

How Did We Get Here?

The intense competition for loans on the secondary market placed stress on what is an inherently flawed marketplace relationship between the dealer and the lender financing the purchase and acquiring the loan from the dealer. For years, the subprime auto industry employed an indirect lending model that relied on separate entities for the sale of the vehicle and another for the financing of it. The concept was one of specialization where each focused on their core expertise to deliver what was assumed to be an exceptional and consumer-centered experience.

This means that the retailer sourced used vehicles, reconditioned them, certified or issued additional warranties on them in some cases, and then set prices for sale to buyers. The financing company performed underwriting, paid bounties or fees to retailers, and managed loan processing and collections.

But rather than deliver an exceptional experience, this bifurcated model lost its shine somewhere between concept and delivery. Instead of working in service to the consumer, the two parts of the process worked in opposition to one another with no consequence to the other for its adverse actions. During this last overheated cycle, the supply-demand relationship favored the dealer as lenders bid up to successfully acquire loans. In turn, the lender assessed higher interest rates to meet its expectations for profitability.

This dynamic resulted in a negative experience for the borrower. Rather than being financed with affordable terms providing an opportunity to rebuild or restore damaged credit, the borrower had to overcome unrealistic, or even predatory, terms.

At the same time, this indirect lending model led to inferior automobile quality. This is because most loans are acquired from dealers on a non-recourse basis, meaning the dealer has no incentive to provide a quality vehicle. In turn, inferior vehicle quality and mechanical failure drive greater defaults, creating a vicious circle leading to even more credit losses in the subprime auto ABS market. Additionally, poor quality collateral leads to lower recoveries and higher net losses for lenders.

A More Sustainable Subprime Model

The lack of alignment between dealer and lender has created an opportunity for an integrated sales and finance model to emerge within the subprime auto segment.  Successful execution of this direct lending model allows the customer experience to become the focus, as the needs for quality transportation and affordable financing can be addressed through an integrated approach.

The traditional “buy here-pay here” (BHPH) model has been considered predatory for its escalation of costs and poor vehicle quality. However, innovative operators are scaling this as a new Professional BHPH – or direct lending – model that aligns the marketing, sales, and risk processes.

At the root of this model is the more sophisticated capability of these firms to segment potential borrowers and predict loan performance through advanced risk processes and underwriting.

This ability to effectively segment customers by ability and willingness to pay, even absent a credit history, can also unlock a powerful advantage in marketing strategy – reaching lower risk customers with attractive and affordable terms at less cost. When combined with a commitment to superior vehicle reconditioning, this integrated direct lending or Professional BHPH approach delivers a positive and empowering customer experience. Ultimately, the firm wins when happy customers with high-quality vehicles can pay off their loan in full.

In the short term, the subprime lending space will likely continue to see customer defaults and pullbacks in credit. But as more and more companies embrace the direct lending model, we will see a slow turn back towards quality vehicles and reasonably priced loans. As customers, investors, and advocates climb aboard this trend, we can finally move away from the boom and bust subprime auto cycle and instead build an industry that works for everyone.

Daniel Chu currently serves as founder and chief executive of Tricolor Auto Group and Ganas Holdings. Chu has distinguished himself as a successful entrepreneur, having founded six companies over the past 25 years, including two which became public. Chu currently serves as the founder and chief executive of Ganas Holdings, a national used vehicle retailer focusing on the integrated sale and financing of vehicles to Hispanic consumers. The branded chain of thirty dealerships across twelve metropolitan markets operates in Texas as Tricolor Auto Group, and in California as Ganas Auto Group. The company has been recognized by Inc. magazine for five consecutive years as one of the fastest growing companies in America, while also receiving distinctions as one of the ten fastest growing privately-held companies in the greater Dallas-Ft. Worth area.

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