Automobile Loans – Is Opportunity Knocking?
By Tom Farin
What do I do in winters like 07-08 when Madison has broken its all-time winter snowfall record and has posted multiple handfuls of days when the temperature never cracked zero? I certainly didn’t sit outside in zero weather at Lambeau field in January and watch my Packers get whipped by the Giants in the NFC playoffs.
No, I use the cold slow Wisconsin winter months to update examples in my PowerPoint slides for Loan Boot Camp and Deposit Boot Camp. And with the 125 bp Fed cut in January, the examples required major updates. Along the way, a few hit me right between my eyes. “Farin, do you believe what the iPrice model is saying?” The following is just one of a number of loan pricing anomalies explored in our updated Loan Boot Camp series.
Take the 72 month new car loan. On March 26, 2007, bankrate.com indicated the national average 72 month new car origination rate was 6.69%. Considering amortization and a 25% annual prepayment speed (close to the national average) duration of 72 month new car paper is right around 2 years. So let’s assume for argument purposes that our 72 month auto loans price off the two year point of the Treasury yield curve.
Between March 26, 2007 and February 18, 2008, rate on the two year Treasury dropped 270 bp. So you’d expect that new car rates might have dropped by a roughly similar amount. But had you logged onto bankrate.com on February 18, 2008, as I did, you would have found 72 month new car rates had increased by 52 bp to 7.21%. Yow !!!
Has the 270 bp drop in the Treasury rates been more than offset by a dramatic increase in the cost of servicing auto loans from 20 bp to over 300 bp? Not likely! By an increase in credit risk on “well qualified borrowers” from 10-25 bp to over 300 bp? Not with Farin customers’ “well qualified borrowers”! By an increase in the option risk premiums the market is demanding on auto paper from 35 bp to over 300 bp? That would imply auto loans have twice the prepayment risk as 30 year fixed-rate mortgages !!!!!
So what’s going on? Figure 1 contains the Investment Benchmark Analysis for three different strategies run using our iPrice software. All three show the results from modeling 72 month new car loans with a prepayment speed of 25% per year. First, let me explain the numbers. Then I’ll get back to the opportunity Figure 1 showcases.
The left most-analysis looks at national average rates as of March 26, 2007. The two on the right side look at national average rates as of February 18, 2008.
Line 1 of each analysis displays the risk free rate in the economy on that date. You will notice in Figure 1 that we have elected to use the Treasury yield curve as a source of risk free rates. So the rate on line 1 is the rate for the 1 month Treasury which was 4.69% on 3/26/07 and had dropped to 2.04% on 2/18/08.
The purpose of the tool being illustrated is to calculate a benchmark rate the loan must meet or beat to be considered “well priced.” Otherwise, the institution is better off investing in a security alternative. The investment benchmark is one of four profitability tools used by iPrice in assessing whether a loan is well or poorly priced. Two focus on how the securities markets would view the loan and the other two look at profitability on the institution’s balance sheet. I chose the Investment Benchmark tool for this article because it showcases an opportunity that exists right now because of what has been happening in the bond markets.
The investment benchmark tool starts with a risk free rate and adds adjustments for interest rate risk, option risk, credit risk, and servicing cost. When the risk free rate is added to adjustments for risk and cost, a retail equivalent benchmark rate results (line 9). The rate on the loan is compared to the benchmark. The 3/26/07 loan at 6.69% (line 10) beats its benchmark by 1.079% (line 11). The 2/28/08 loan (middle analysis), beats its benchmark by 2.182%. We’ll get to the third benchmark analysis a bit later in this article.
The risk free match on line 3 of the analysis is the weighted average yield for a laddered pool of Treasury securities. The laddered Treasury pool is constructed so the maturing cash flows coming off the pool exactly match the anticipated amortization and prepayment cash flows coming off the loan being modeled. The weighted average yield of the Treasury match pool as of 3/26/07 was 4.958%. The spread between the weighted average Treasury match and the 1 month Treasury (line 2) of 26.8 bp is the interest rate risk adjustment the market is demanding for the interest rate risk in the Treasury pool – which (because cash flows are matched) is the same as the interest rate risk in the loan being modeled. As of 2/18/08 the yield on the Treasury match (middle columns) was 2.304%, a drop of 2.654% from the rate assigned to the match a little less than a year earlier (left columns). In the 11 months between the two dates, the interest rate risk adjustment hadn’t changed by a material amount (line 2), but the 1 month Treasury had fallen 2.65% (line 1).
You will note we are using the pool rate on a AAA Auto Index as the Investment Benchmark on line 5. The investment benchmark should be a security that as similar to the loan being priced as possible. The AAA auto Index is a yield curve Farin constructs from asset-backed auto securities issued by the captive auto finance subsidiaries like GMAC, Ford Motor Credit, Chrysler Credit, Honda Credit, Toyota credit, etc. These asset-backed auto securities are backed by automobile loans purchased from dealers as supplementary collateral. The collateral is very important to the bond ratings of these securities as the bond ratings of GMAC, Ford, and Chrysler’s financing subsidiaries have been downgraded substantially in recent years. The only way they can receive AAA ratings on their auto paper is to back the paper with additional collateral. Ironically it is the credit ratings and collateral of the little people buying the manufacturer’s new cars that enhance the credit ratings of the captive subs’ paper back up to AAA.
The paper we use to construct this pool has a very interesting feature. These are pass-through securities. As the principal and interest cash flows come in from the auto loans backing the securities, the principal cash flows are passed through to the bond holders, paying down the bonds. Because the principal payments are made up of both amortization and prepayments, bond holders are paid back more slowly in rising rate environments (prepayments on the auto loans slow) and are paid back more quickly in falling rate environments (accelerating prepayments). In other words, the bonds exhibit the same interest rate risk characteristics and option risk characteristics as the underlying auto loans. In fact the bonds are nothing more than a pool of auto loans in securitized form. That’s as close an investment match to the auto loans you are originating as we can get. The market prices the option (prepayment) risk into the yield on these bonds.
In coming up with the investment benchmark, we construct a laddered pool of these AAA rated pass through bonds so the amount and timing of their principal cash flows match the amortization and prepayment cash flows of the loan being priced. Sound familiar? We did the same thing earlier with the Treasury pool. We then calculate the weighted average yield of the pool, giving us our investment benchmark.
As you can see from line 5 as of 3/28/07 the investment benchmark weighted yield was 5.311%, 35.4 bp over the yield of the Treasury match with identical cash flow (and interest rate risk) characteristics. We’ve always assumed this 35.4 bp difference (line 4) was the premium the market was demanding for the option risk caused by the uncertain estimated cash flows on the AAA rated paper as opposed to the absolutely certain cash flows from the Treasury pool. Of course we’ve always known that a portion of this spread was due to the additional credit risk of the AAA rated issuer, but separating the option risk portion of the premium from the credit risk portion would have significantly complicated the analysis and the spread of only 35.4 bp seemed too small to matter. Why did this so called “option risk adjustment” jump from 0.354% to 2.424% in less than a year? I’ll be addressing the reason in a few paragraphs.
Sticking to the left column, once the investment benchmark is in hand, we need to account for the risks and costs in the loan that don’t exist in the security. On the A credit loan priced on 3/28/07 we assumed an adjustment of 10 bp (line 6) for credit risk (net annual charge offs) and 20 bp for servicing (line 7). The retail equivalent benchmark on 3/28/07 (line 9) was 5.611%, the wholesale benchmark (line 5) plus 30 bp for credit risk and servicing. The national average 72 month new car yield of 6.69% (line 10) beats the benchmark by 1.079% (line 11).
Of course, this isn’t really a fair comparison. BankRates.com weighted average new car rate (line 10) is an average rate for a national pool of loans, presumably made of some combination of A, B, and C credits. They don’t explain the credit composition of this pool on their Web site, so I’m speculating a bit on the composition. On the other hand the credit risk adjustment (line 6) to the benchmark rate is institution’s loss experience on A paper. So some of the line 11 spread is represented by the difference in credit risk between the national average new car rate and the institution’s A credit benchmark. But the line 9 benchmark rate in the left column does imply that an institution could have offered an A credit 72 month new car rate on 3/28/07 as low as 5.6% and matched or beat its closest investment alternative. And at that point in time, A credit loans were available to “well qualified buyers” in the national markets at rates in the range of 5.5% to 5.75%.
I can sense some of you beginning to drift off because of math in the last dozen or so paragraphs. So before I’m greeted with a chorus of snores, I need to regain your attention. The investment benchmark analysis suggests the roughly 100 bp spread that existed less than a year ago has doubled and may have quadrupled in 11 months !!! Got your attention now?
Let’s compare the analysis in the first two horizontal areas of Figure 1. As you may recall from earlier in this article, rates on our risk free matched Treasury pool (line 3) dropped from 4.958% to 2.304% in 11 months, a drop of 265.4 bp. At the same time, the captive auto subs’ cost of raising funds from issuing matched pools of asset backed AAA paper (line 5) only fell from 5.311% to 4.728% a drop of only 58.3 bp. The differential between AAA matched paper and Treasury matched paper (line 4) has grown from 35.4 bp to 242.4 bp. “But its AAA rated paper,” you might say. “We’ve never seen these kinds of spreads between Treasuries and AAA paper. Farin, there must be something wrong with your numbers.”
Actually, nothing is wrong with the numbers. What you are seeing in the numbers is collateral damage from the sub-prime mess. You see, the so-called “AAA rated” sub-prime mortgage backed securities everyone has come to hate are also pass-through securities but issued with home loans rather than auto loans as collateral. They looked like a really good deal based on their yields and their AAA bond ratings a year ago. Now they are blowing up in investment portfolios all over the world.
So when GMAC and the other auto subs attempt to sell their securities to into bond portfolios, once a potential purchaser realizes they are trying to sell asset-backed AAA rated pass through paper they say, “No thank you! Everyone knows that’s crappy paper!” The only way to get the market to accept paper it doesn’t want is to raise the rate till the market says, “OK, I’ll take it at that rate”. So spreads have opened up between the captive auto subs funding rates and Treasuries. The resulting high funding rates makes it difficult for the captive auto subs to compete by offering aggressive auto loan rates - except when their parent subsidizes the rate or bribes customers to rake their paper in some other way.
As my old buddy Tom Parliament, who grew up on the streets of New York” likes to say, “When you have a good man down, kick him!” So why aren’t we kicking those captive auto subs by undercutting their rates? After all, we don’t issue asset backed securities to fund our loans, we raise the funds from consumers and businesses. Ahh, could it be because we are used to looking to the biggest issuers of auto paper to set rates for the market. “They haven’t cut their rates so we won’t cut ours.”
What I did in the third analysis is back out 180 bp (line 8) of 242.4 bp “option risk adjustment” (line 4) to reflect the penalty the auto subs are currently paying to clear paper because of the market’s perception of their credit risk. They have this risk and you don’t. I’m pricing your loans, not theirs. I’m assuming the remaining net option risk adjustment (242.4 bp less 180 bp = 62.4 bp) is the true market adjustment for prepayment risk in the auto loans. That’s higher than it was in March of 2007 (Line 4 – 35.4 bp), but option risk premiums rise when the markets become more volatile. Backing out the subs 180 bp of additional credit risk (which you don’t have) opens up the spread to the benchmark to nearly 400 bp (line 11). Loan spreads relative to investment benchmarks in the 400 bp range are as rare as hens with teeth. Yes, there’s a credit risk mismatch between the benchmark rate and the national pool rate. But 400 bp? No way!
So why aren’t you banks and credit unions slashing auto rates to kick the guys who stole the auto loan business while they are laying on the floor, knocked senseless by the sub prime mess?
Oh! You say you have your own cost of funds problems? How could I forget? After all, I’ve been pointing out the 90 day lag between the movement in wholesale rates and our industry’s reaction with retail deposit rates from the podium for over two years. Eyes glass over as Farin pontificates about this “theoretical” relationship. Well, it is playing all over the country right now with big time practical implications.
Late January, 2008, in communities all over the country, bankers and credit union executives exclaimed, “Wow, the Fed dropped rates 125 bp in eight days. What to do?” Then they all gathered around a big community table in a stare-down contest, waiting for the first institution to blink by cutting rates. Of course nobody blinks for 90 days. Then the quarterly financial results are posted. “Let’s see, loan yields are down, but cost of deposits isn’t. I wonder if that’s why my net interest margin is in the toilet?” Then some anguished soul buckles, saying, “I can’t afford to wait for the other guy to blink any more”, and blinks, cutting rates. Others at the table, whose net interest margins are also in the toilet, breathe a big sigh of relief and blink and cut their rates too. Of course this self-inflicted margin-damaging lagging 90 day lag response cycle continues as long as the Fed continues to cut rates. Ninety days after the Fed is done, relative sanity always reasserts itself in retail deposit pricing. But things will continue to be bloody while the Fed is still cutting rates. Oh yes, forecasters are predicting another 100 bp of Fed rate cuts by June. Sanity in deposit pricing may still be two quarters off.
Am I overstating my case? Figure 2 shows the recent pricing history on 10-15 month CDs for one of our east coast customers. The iPrice graph tracks weekly deposit pricing decisions between 8/6/2007 and 1/28/2008. The yellow band is the range of competitive rates reported by the shop’s survey firm for regular CDs and specials with maturities between 10 and 15 months. The green line is the median competitive rate reported. The black line is the 1 year FHLB advance rate, our pricing benchmark for this sector. The red lines are rates paid by the institution for its 12 month CD (lower line) and its off-maturity special (top red line).
Note that the FHLB benchmark dropped in late October, stabilized, then began a significant decline in late December. Of course, one of the drivers in the January FHLB rate decline was the 125 bp Fed rate cut that happened in mid January. In spite of the significant drop in wholesale rates, the top competitor CD special in the market had responded downward only slightly as of 1/28/2008.
Our customer attempts to keep his regular CD near the market median and his off maturity special near the top of the market but not materially higher than the FHLB benchmark. From August through October, this pricing strategy allowed him to keep his CD special near the top of the market.
When the FHLB advance rate dropped in late October, the customer responded by cutting rates on his CD special to keep the special close to the FHLB advance rate. This, of course, impacted negatively on his pricing relative to competitors who cut rates only slightly, slowing CD growth. He responded to the significant drop in the FHLB 1 year rate in January by cutting both regular CD and special rates moderately. But he now finds himself even less competitive, while paying special rates well above FHLB advance rates. In fact the market median and his regular CD rates were close to the FHLB benchmark on January 28.
This is not an isolated example. We’re seeing examples like this throughout our iPrice customer base all over the country. One of the issues we cover extensively in Deposit Boot Camp is how to deal with pricing both CDs and non-maturity deposits during the lag period we are currently experiencing.
Now I can understand why a whole bunch of financial institutions who are used to looking at the captive auto subs to set auto rates in their community are reluctant to undercut their rates. “After all, the auto subs are the market leaders, are big and sophisticated, and they haven’t cut their rates. Maybe they know something I don’t know.” Does this sound familiar? Less than a year ago we were saying the same thing about big bank credit underwriting - before they recently revealed their ineptness in managing their credit risk.
Actually, some of the captive auto subs are getting pretty desperate. If you don’t believe me go to Edmunds.com and check out the Ford rebate program on the F-150 pickup. Through the end of February they are (were) offering a $3,000 rebate, but only if the vehicle is financed through Ford Motor Credit! “You mean, I need to finance through Ford Credit to earn the REBATE? You’re kidding, right?” I guess that’s one way to sell auto paper at crappy rates to the buying public!
Not only that, as Figure 2 illustrates, your cost of funds is still up there because of the lag factor. So we all whisper to each other, “I’ll take these high auto loan rates as long as I can get them. I need the yield to cover my high funding cost. Farin, please don’t tell anyone else auto loan rates are too high.” Sorry folks, I’m letting the cat out of the bag.
Certainly the market leaders (captive auto subs) can’t afford to cut their rates. So they won’t drive unsubsidized loan rates down. I believe retail financial institutions will lead the charge in reducing auto rates as their cost of funds comes down. Yes, you, not GMAC, we reassert pricing control over auto rates. The drops your auto loan rates are inevitable given recent moves in wholesale rates and the lag factor. Auto loan rates look very attractive relative to benchmarks right now. They won’t look nearly as attractive in six months once deposit pricing has returned to sane levels and auto rates are where they should be relative to benchmarks. Opportunity is pounding on your door so loudly right now the fist is about to break through the wood. Are you listening?
In your shoes, I’d be giving serious thought to dropping auto loan rates now, undercutting the competition, including those hated auto subs who can’t afford to match your rate moves. In 3-6 months your funding costs will be down and you will still be basking in the glow of a nice portfolio of very well priced auto loans. And I don’t think the funding problem for the captive auto subs is going away any time soon.
Am I suggesting you drop A credit rates to the 3.892% benchmark shown in the right-most analysis in Figure 1? No, you don’t need to. All you need to do is undercut the competition. In a brief look at rates in a variety of markets in the last few days I saw a number of players offering rates as low as 5.25% to “well qualified buyers.” Of course we don’t really know what they think is a “well qualified buyer” till we actually apply. Personally, I’ve been told a number of times I’m not a “well qualified buyer” in the last few years even though my credit score puts me in the A credit range for most of my customers.
But let’s assume for a second that a “well qualified buyer” is this shops definition of an A credit and that competitors are offering rates of 5.25%. This shop could undercut them by 25 bp to 5.0% and still be 100 bp above their A credit benchmark. Could the captive subs match this A credit rate? With a funding cost of 4.728%, their spread would be an unimpressive 27.2 bp. And out of the spread they would need to cover credit risk, servicing costs and make a buck. No, they can’t match that rate without a manufacturer rate subsidy, or a bribe like Ford Motor credit is handing out.
Would you make money with 5% auto paper over the short haul. Maybe not with your lagging funding cost. But you have a similar problem with all your loans. But six months from now, you will be making money on these loans as your funding costs drop to saner levels.
And now, a brief promotional announcement. If you want to learn more about using pricing models to identify well priced loans, check out the upcoming April Loan Boot Camp at our web site. If you want to learn how to price deposits in this lag period, you might also want to pencil in the upcoming dates for Deposit Boot Camp (April) and our new Advanced Deposit Boot Camp (May). All three are jointly sponsored by the Financial Managers Society, so you’ll also find information at their Web site. If you want to learn more about the software I used to produce Figure 1 and 2 and most of the slides in the boot camps, ask us for an online iPrice demo.
“By the way, don’t try this stunt at home with a pencil and paper. This analysis was performed by a trained professional using a sophisticated pricing model accessing market rates that are being updated continuously.” At Farin, we can provide the training, the consulting support while you are getting up to speed, and we can deliver the model with continuously updated market rates.
Tom Farin