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Interest Rate Risk in an Auto Loan – Really?

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The competitive landscape for auto loans has fundamentally changed over the last 15 years.  There are more non-traditional lenders vying for autos and non-credit union lenders have been saturating the indirect lending market.

These trends put pressure on pricing and take a bite out of the auto lending pie.  As a result, financial institutions are getting creative with pricing and terms.  As this occurs, questions to consider need to evolve.

One example is the increase in 10-year auto loans, which we are seeing as we conduct interest rate risk simulations.

Consider:

  • How might prepayments differ from a shorter-term auto loan?
  • Is it reasonable to assume that a consumer wanting a 10-year auto will prepay the loan at the same rate as a 5-year auto loan?

There is not an abundant amount of prepayment data on this type of loan to answer the questions above, so, test the impact.  In the table below, notice the escalation in average life as well as the balance remaining after three years and five years.  If the prepayment rate on this term of auto loan is 10% then more than half of the balance would remain after three years, and nearly one-third would remain after five years.

10 Year Auto Loan Table SM 080416

So yes, these loans bring more interest rate risk.  If these types of loans become more prevalent, it will be important to change mindsets with respect to interest rate risk and auto loans, not to mention the risk of negative equity that comes hand in hand with the extended term.

Consider the potential impact of CECL on longer-term auto loans.  For example:

  • What if the auto loan is actually underwater for a material portion of the time it is outstanding?
  • Do the potential risks mean financial institutions should not do long-term auto loans?  There is no easy answer or one-size-fits-all response.  Each executive team needs to decide their product offering in light of their value proposition, appetite for risk, and financial strength.

What we do know is that the questions need to evolve to appropriately identify and manage the risk.

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Auto Lending: The Concerning Slow Decline

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Traditionally, auto loans have been the “bread and butter” of credit union loan portfolios.  However, 1st mortgages have claimed that honor with short- and long-term trends showing continued declines in auto loans as a percent of total loans for the credit union industry’s balance sheet.  Auto loans have been consistently decreasing from roughly 40% of total loans in 2000 to 29% as of June 30, 2011.  The green trend lines reflect distribution changes since 2000 (long dash) and since 2007 (short dash)—which show little fluctuation in trend.  If the trend since 2007 is realized, auto loans will be down near 24% by December 2014.

Keep in mind that year-to-date auto sales in 2011 are up by 10.4% compared to 2010 according to Ward’s Auto Group.  Also, according to the Wall Street Journal, Chrysler Group LLC said recently its sales leaped 31% in August, while General Motors Co. and Nissan Motor Co. each reported increases of just under 20%.  Ford Motor Co. posted an 11% gain.

While some meager growth in used auto lending has occurred for credit unions from Q1 to Q2, the industry’s auto portfolio overall is on track to shrink another 1.6% in 2011.  Consider that the banking industry (FDIC-insured institutions) is on track to grow autos around 13.6% in 2011 according to FDIC data.  While overall non-revolving loan market share for commercial banks has traditionally been around 3 times that of credit unions per the Federal Reserve’s G19 release, the difference in growth rates and the downward trend is still quite concerning.

What’s The Point?

Some credit unions may have lost their focus on one of the primary things that made them great in the first place—auto loans.  Additionally, the continuing trend of increased 1st mortgage balances (which could be significantly extending balance sheets) is somewhat alarming in light of interest rate risk concerns; 1st mortgage balances are positioned to grow almost 4% in 2011 for the credit union industry.  While Bernanke is on record “forecasting” an extended period of a low target rate, we know that forecasts do not always come true.  Consider this past quote:

Overall, the U.S. economy appears likely to expand at a moderate pace over the second half of 2007, with growth then strengthening a bit in 2008 to a rate close to the economy’s underlying trend.

Fed Chairman Ben Bernanke
Semiannual Monetary Policy Report to the Congress
July 18, 2007

Each credit union is unique and must be armed with the right decision information in order to focus resources appropriately.  Understanding local demand trends and being positioned to take advantage will be even more critical going forward as banks and captive auto finance companies continue fighting for (and dominating) this piece of the consumer pie.  As we see it, it may be time for credit unions to take up the fight to more aggressively attract some of the auto market back.