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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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Evaluating Derivatives―Part V: Economic Value Declines Over Time

Credit unions purchase derivatives to receive value: interest rate risk protection. This blog series set out to help decision makers understand the variety of outcomes they could observe over the life of a derivative, and how those outcomes will ultimately determine the value realized.

Over its life, derivative economic value is impacted by two forces:

  • Changing rate environments – which can increase or decrease economic value
  • Time – which continuously decreases economic value gains

Prior blog articles discussed the impact of changing rate environments on economic value. Regardless of the rate environment, economic value of a derivative will converge to zero at maturity. The value of the protection diminishes as the remaining time to maturity becomes less. Using our prior example of the 7-year swap, the chart below shows the economic value on day 1 and each year thereafter:

Note:  $s in 000s
Derivatives analytics provided by The Yield Book® Software.

The chart demonstrates the economic values for the various rate shocks as the time until maturity shortens. Compare the highest shocked environment shown, +500, the initial value of $26.4 million to the year 1 shocked value of $22.8 million. The year 1 value is materially lower because the swap only offers 6 remaining years of protection. Independent of the rate environment, by the end of year 7 the swap no longer has value since it matures.

Why is this important? If the swap was originally purchased to address a volatility issue in the credit union’s financial structure and that volatility persists, then over time the credit union will need to either adjust the underlying structure or will need to purchase additional swaps to maintain the same level of protection. It can be important to be clear about the objectives of the derivatives. Is the purchase designed to offset an existing risk and buy time until the root interest rate risk can be addressed? On the other hand, is the intent to, ongoing have, a business model incorporate additional interest rate risk and perpetually utilize derivatives to offset the risk?

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Rate of Growth and Loan Concentration Limits

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As you consider establishing concentration limits on loans, it is important to know how the rate of growth could impact risk.

We understand that loan growth is anemic for many financial institutions.  However, at some point, loan demand will increase and the rate of growth is something decision makers will need to consider.  In fact, some credit unions may need to consider their rate of growth now as we are seeing a rapid increase in indirect lending (often called “point of sale” lending).

The following shows the change in loan concentrations as a percent of assets for two credit unions that no longer exist.  Each experienced brutal losses in the portfolios that grew unmanageably.

credit union A

credit union B

Aside from absolute concentration limits, factoring in a threshold for change (growth) in concentration can serve as an early warning sign that a business line may threaten the credit union’s safety and soundness.

Taking the two example credit unions above, extraordinary growth was experienced year-over-year-over-year—yet no effective action was taken to understand the risk and/or stop the growth before it was too late.

As the economy improves and lending demand grows, it will be necessary to perform continuous, rigorous analysis as a portfolio is growing.  Management should constantly step back and ask questions such as:

  • Why is this portfolio growing so fast?  Are we experiencing “too much of a good thing”?
  • What is missing from our current analytics?
  • Are our assumptions too optimistic?  What if our assumptions are wrong?
  • What forces are out of our control that could cause this business line to go south—and go south fast?
  • Are we making more exceptions in our underwriting?  Is there a pattern with a particular loan officer and/or third party?
  • Are we relying on this line of revenue to the detriment of our other lines of business?  What can threaten this line of business, and how fast can we recover should it be dramatically reduced?
  • Are our internal controls rigorous?  How can we test this to ensure we are adhering to our standards?

When evaluating options for concentration limits, credit unions should also consider establishing guidelines for portfolio growth.  While we have shown only two examples, these situations occur all too often.  The message is that rapid growth in a particular asset class can play a key role in creating unacceptable risk.

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Loan Concentration Risk Survey

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In our continued efforts to help the credit union industry, we are currently gathering information on how credit union executives view loan concentration limits in light of NCUA Letter to Credit Unions 10-CU-03 on Concentration Risk.

We encourage executives to complete the following short, two-question survey: c. myers loan concentration risk survey

Please note that this survey is completely anonymous unless you provide identifiable information in your response.

Thanks in advance for your participation!  It should only take a few minutes of your time.

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Weighing Credit Union Investment Strategies

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Given the flight to safety combined with sustained low loan demand, threats to non-interest income and NCUSIF assessments, many credit unions are reevaluating their investment strategy.

The problem is not enough credit unions are evaluating their investment strategy in light of their entire financial structure and strategic objectives.  They are evaluating one investment at a time. In other words, this investment seems to be a good deal today. But how long will it be a good deal?  And, if/when the decision needs to be unwound, what will be the viable options?  How does it fit with the credit union’s strategic objectives and financial structure?

Let’s take an example using callable bonds.  We are seeing credit unions purchase callable bonds with final maturities of 10 and 15 years.  The reasoning too often is, we need to do something, and they are going to be called anyway, so we may as well get the extra yield today.

Typically, people say they will sell it before rates become unfavorable, therefore they won’t be stuck with it.  The only reliable way that this could happen is if the credit union could accurately forecast rates.  A strategy assuming that you know what will happen in the market, before the market occurs, is fraught with danger and has burned many institutions.

Some say that if rates go up they won’t need to sell low-yielding investments because loan demand will be so good, the yields on new loans will offset the risk of the lower-yielding investments.  This could happen.  However, it is important to keep in mind that rates can go up without economic recovery.

Stating the obvious, there is a tremendous amount of uncertainty—there always has been.  Yet decisions have to be made.  Just make sure your decision framework is sound.  Stick with the basics:

  • Make decisions in light of your entire financial structure.
  • Agree on how long you are willing to live with your decision if things don’t go as planned.  In the above example, answer:  are we willing to live with this decision for the next 10 or 15 years?  If not, how are we going to know it is time to unwind before it results in unacceptable risk for our credit union? This thought process should be followed when making any decision with potential long-term consequences.
  • Don’t assume that the future will be brighter or more forgiving than the present.  Isn’t that part of the mindset that got us here in the first place?
  • Document the rationale for major decisions.  Memories are short, so it’s important that key players remember why the decision was made in the first place.  Especially if the changes in the environment result in unfavorable financial performance.
  • Test drive your investment strategy before you implement it by using your A/LM model.  Don’t just look up +300 basis points either.  Remember, rates were 500 basis points higher just three years ago.  By rehearsing tomorrow today, you can understand the potential risk of what you are buying and can decide if that risk is worth today’s reward.
  • Agree on your appetite for risk for your entire enterprise, stick with it and manage to it.

This writing is not intended to say that callable bonds are bad, we are using them for example purposes only.  Our philosophy is that every decision has a trade-off; it is critical to understand the trade-off before implementing decisions.  It is up to decision makers to understand how each investment they purchase works not only today, but as the environment changes.  Decision makers must also understand how investments complement or compound issues in their entire financial structure and risk profile.