/nwsys/www/images/PBC_1059724 FINANCIAL INSTITUTIONS SECTOR IN-DEPTH 27 March 2017 Contacts Jason Grohotolski 212-553-1067 Senior Credit Officer jason.grohotolski@moodys.com Bruce Clark 212-553-4814 Senior Vice President bruce.clark@moodys.com Jingjing (Nicky) Dang 212-553-4801 VP-Sr Credit Officer jingjing.dang@moodys.com Brian L. Harris 212-553-4705 Senior Vice President brian.harris@moodys.com Robert Young 212-553-4122 MD-Financial Institutions robert.young@moodys.com Auto Finance - United States Credit Risk Increases for Lenders, with Negative Equity at an All-time High Summary A stretch of robust new-vehicle sales since 2010 was a stable source of loan growth and profits for auto lenders, driving strong competition in the market. Now that new vehicle-sales have plateaued, the competition for remaining loan supply will intensify, driving increased credit risk for auto lenders. » New-vehicle loans will no longer be a strong source of growth for lenders. Increased competition among lenders for remaining loan supply could cause them to further loosen loan terms and loan to value criteria. » Lenders have taken on significant risk. We believe that accommodative financing has supported loan growth over the past several years. Lenders have extended loan terms and increased loan to value in line with increasing vehicle prices and borrowers’ appetite for newer or more expensive models. » The percentage of trade-ins with negative equity is at an all-time high, as is the average dollar amount of that negative equity. Lenders are increasingly faced with the choice of taking on greater risk by rolling negative equity at trade-in into the next vehicle loan. We believe they are increasingly taking this choice, resulting in mounting negative equity with successive new-car purchases. This “trade-in treadmill” generates higher loan to value ratios, slower principal amortization and higher loss severity when defaults occur. » Manufacturers’ response to softening sales will help determine how risky the “trade-in” treadmill becomes for lenders. Recent increases in incentive spending, growing industry inventory and rising interest rates point to challenges ahead for manufacturers. If manufacturers respond with increased incentives through loan subvention and cash rebates, this could ultimately weaken their profitability, with negative repercussions for used car values that lenders would need to consider for future underwriting standards. If lenders continue to be accommodative to car buyers, asset quality will weaken, with negative implications for lenders’ profitability. MOODY'S INVESTORS SERVICE FINANCIAL INSTITUTIONS Significant loan growth from robust new vehicle sales is ending The US auto market has enjoyed robust new-vehicle sales growth since the last recession ended in 2010, resulting in decent but thin profitability for auto finance companies because of the highly competitive market. We expect US new-vehicle sales to decline to 17.4 million units in 20171, increasing the risk that lenders will be more accommodative and accept riskier loans on new-car sales to remain competitive and maintain or increase loan volumes. Exhibit 1 Plateauing Sales Raise Risk that Lenders Will Accept Riskier Loans US new vehicle sales Sources: Bureau of Economic Analysis (BEA), Moody’s Forecast Lenders have taken on significant risk Since the beginning of 2010, lenders have accommodated borrowers by extending original loan terms across most credit buckets (Exhibit 2), slowing principal amortization for the sector at large. The average original loan term for a new vehicle has risen steadily to 68 months from 62 months over this period. Prime credit quality loans now have an average original loan term for new vehicles of approximately 69 months, while nonprime, subprime and deep subprime loans have average original terms of 72 months. In the fourth quarter of 2016, 32.1% of loans for new cars had terms between 73 and 84 months compared with 29.0% just one year earlier2. These highly extended terms, which continue to increase in volume, increase loss severity at default. Exhibit 2 Loan Terms Are Lengthening to Accommodate Lower Monthly Payments Average term on new vehicle loans 58 60 62 64 66 68 70 72 74 Average Deep Subprime Subprime Nonprime Prime Super Prime Source: Experian This publication does not announce a credit rating action. For any credit ratings referenced in this publication, please see the ratings tab on the issuer/entity page on www.moodys.com for the most updated credit rating action information and rating history. 2 27 March 2017 Auto Finance - United States: Credit Risk Increases for Lenders, with Negative Equity at an All-time High MOODY'S INVESTORS SERVICE FINANCIAL INSTITUTIONS Monthly payments on new auto loans were flat from 2010 to 2012, tracking with subdued household income growth as lenders likely accommodated buyers with strapped budgets. Only in the last three years have monthly payments increased3 along with improved median household income growth. The stronger income growth over the last three years likely gave consumers the confidence to assume higher car payments than before. The increase in monthly payments over the last few years has only marginally mitigated lenders’ credit risk, since at the same time they have been lengthening loan terms to accommodate borrowers’ appetite to finance more expensive vehicle purchases at an affordable monthly payment. The growth in borrowers’ income made a case for underwriters to take on larger principal balances. However, this case has been undermined by the fact that growth in average amount financed for a new car from 2013 to 2016 has outpaced growth in median household income over this period. Exhibit 3 Amount Financed has Outpaced Income Year-over-year change -4% -3% -2% -1% 0% 1% 2% 3% 4% 5% 6% Dec-07 Dec-08 Dec-09 Dec-10 Dec-11 Dec-12 Dec-13 Dec-14 Dec-15 Dec-16 Median Household Income Avg Monthly Payment - New Cars Avg Amount Financed - New Cars Sources: U.S. Census Bureau, Experian Negative equity at trade-in is at an all-time high Record levels of negative equity at trade-in expose lenders to more risk. Last November, Edmunds reported that about 32% of all trade-ins towards the purchase of a new car were underwater, the highest rate observed. The average negative equity at trade-in was also at a record high of $4,8324. Between 45% and 50% of new vehicle sales have been accompanied by a trade-in over the last several years5. With auto sales plateauing, auto lenders assume more risk by underwriting new loans with high negative equity rolled into them from the prior loans’ unpaid balances. By doing so, auto lenders increase the collateral deficiencies in their portfolios, raise their average loan to value ratios, and thereby increase loan-loss severities, upping the pressure on their already thin profitability. Trade-in treadmill generates increased credit risk for lenders The following is a stylized example of how negative equity is created and how it can grow with each successive new car purchase/loan, adding risk to a lender’s portfolio and the sector. In the early years of a loan, negative equity arises from rapid vehicle depreciation and limited amortization of loan principal. As a result, car owners that want a new vehicle every two to three years commonly will have loans with a principal balance outstanding that is greater than the value of the vehicle. Take the following three successive car purchases and new loans, all by the same borrower, and each with growing negative equity. 3 27 March 2017 Auto Finance - United States: Credit Risk Increases for Lenders, with Negative Equity at an All-time High MOODY'S INVESTORS SERVICE FINANCIAL INSTITUTIONS Car #1 and Loan #1 The purchase price of the first car was $30,000. The first loan has an original term of 72 months, a loan to value (LTV) of 100%, an annual percentage rate (APR) of 5% and a $483 monthly payment. Despite the 72-month original loan term, the buyer returns to the car dealership after 30 months for a new vehicle. The negative equity on the trade-in after 30 months is approximately $1,000, but the dealer finds a lender willing to include this amount in the balance of the loan financing the new vehicle purchase. Car #2 and Loan #2 The price of the second car is $31,500, 5% higher than the price of the first car. The borrower finances this along with the negative equity from the first loan ($1,000). The LTV increases to 103%, and the loan term needs to be extended to 84 months from 72 months to keep the monthly payment unchanged at $483. The new loan has a 6.5% APR (up from 5.0%) to account for the added risk. The buyer returns to the car dealership after 30 months in the second car and has negative equity (i.e., loan collateral deficiency) of $4,000, a $3,000 increase from the first loan. The buyer hops back on the trade-in treadmill for a third new vehicle and third loan. Car #3 and Loan #3 The price of the third car, $33,075, is 5% higher than the price of the second car. The borrower finances this in addition to the $4,000 negative equity from the second loan, producing an LTV of 112%. The loan term would again need to be extended to 102 months from 84 months to keep the monthly payment unchanged at $483. The new loan has a 7.0% APR (up from 5.0% and 6.5% on the first two loans, respectively) to account for the added risk. The negative equity/collateral deficiency if the borrower defaults after the first 30 months of this loan balloons to $8,900. Note: a 102-month loan is not widely available in the market, but this is the new loan term that would be required in the scenario above to keep the buyer’s monthly payment unchanged, raising the question of where lenders will draw the line. The effect of the trade-in treadmill is increasing lender risk, with larger and larger loss-severity exposure. Each successive loan has greater rolled-over negative equity, higher APRs, longer original loan terms and higher LTVs. Rolled-over negative equity increases collateral deficiencies and the higher APRs and longer loan terms slow amortization (Exhibit 4). Exhibit 4 Trade-in Treadmill Generates Increasing Collateral Deficiency with Each Successive Loan $0 $5,000 $10,000 $15,000 $20,000 $25,000 $30,000 $35,000 $40,000 0 5 10 15 20 25 30 35 40 45 50 55 60 65 70 75 80 85 90 Principal-1st Loan Principal-2nd Loan Principal-3rd Loan Car Value-1st Loan Car Value-2nd Loan Car Value-3rd Loan Source: Moody's 4 27 March 2017 Auto Finance - United States: Credit Risk Increases for Lenders, with Negative Equity at an All-time High MOODY'S INVESTORS SERVICE FINANCIAL INSTITUTIONS Auto manufacturer and lender responses to the treadmill will determine credit outcomes Consumers will eventually have to get off the trade-in treadmill, and the responses of manufacturers and lenders will help dictate how painful it is. Lenders have been very accommodative to consumers, and any tightening in underwriting standards would force manufacturers to reconsider their sales’ strategies. A weaker economy would drive lenders to tighten underwriting and would test manufacturers’ willingness to increase incentives. If lenders tighten underwriting, car buyers may no longer have flexible terms to rely upon for their next purchase. These buyers may eventually be forced to settle for a less expensive vehicle, which could be harmful to manufacturers’ profitability since more expensive vehicles generally have larger margins. Alternatively, the buyer may need to place a down payment on their next vehicle or the manufacturer may need to offer an incentive to lower the purchase price or loan balance. In the trade-in treadmill example above, the first loan transitions from a collateral deficiency to a collateral surplus after 36 months, assuming the buyer held on to that car rather than buying a new car after 30 months. The second loan transitions from a collateral deficiency to a collateral surplus after 57 months, assuming the buyer held on to that car rather than buying a new car after 30 months. The escalating collateral deficiency with each subsequent loan puts this car buyer further away from their next vehicle if there is not someone willing (manufacturer, lender or buyer) to provide an accommodation. Among the accommodative steps the industry could take to manage consumers’ monthly payments are: Potential Manufacturer Accommodations Manufacturers could increase subvented loan activity with their captive finance companies or participating lenders to lower borrowers’ monthly payments. Manufacturers could also increase cash-on-the-hood incentives to lower the purchase price. Either of these actions would reduce manufacturers’ profitability. Increasing cash-on-the-hood incentives from already high incentive levels would indicate that car buyers do not have the cash on hand to make an affordable purchase, although such incentives could lower the negative equity from a prior loan. Potential Lender Accommodations Lenders could lengthen loan terms further, which could perpetuate the treadmill, or lower annual percentage rates to make monthly payments affordable. Extending loan terms creates credit risk for lenders because slower loan amortization increases potential loss severity. In addition, the loan will be outstanding longer and be more susceptible to default. Potential Buyer Response If Manufacturers or Lenders Do Not Accommodate Sales Absent any manufacturer or lender accommodations, consumers could drive their current vehicles longer until their loan no longer carries negative equity. Alternatively, consumers could purchase cheaper vehicles to offset the negative equity from prior loans. These actions would weigh on manufacturers’ sales volumes and margins accordingly. Consumers could also purchase their next vehicle with a larger down payment to offset the prior loan’s negative equity. This would be beneficial but also relies on solid economic conditions, particularly employment and income growth. 5 27 March 2017 Auto Finance - United States: Credit Risk Increases for Lenders, with Negative Equity at an All-time High MOODY'S INVESTORS SERVICE FINANCIAL INSTITUTIONS APPENDIX Credit crisis leasing decline is a possible engine of the trade-in treadmill The significant decline in leasing during the credit crisis may have jump-started the trade-in treadmill. The decline in leasing from 2008 to 2010 likely placed many car buyers without preferred leases into a cycle of regularly renewing their loans with negative equity at trade-in. In 2008 the credit crisis brought the ABS market to a temporary halt, removing a major funding avenue for leases and driving volumes down sharply. Funding access was also hampered by concerns that possible manufacturer bankruptcies would have spill-over effects to vehicle values. Finally, a gas price spike sparked volatility in used car prices, creating impairments for lenders and questions over the amount at which new residual values should be booked. The limited leasing options during this period likely led many would-be lessees to instead settle for loans with lengthier terms. However, to mimic the typical three-year replacement cycle of a lease, many of these consumers may have brought these cars back to dealerships for trade-in well before the loan matured and in a negative equity position. We believe that the trade-in treadmill would still be running today, regardless of this decline in leasing volumes, but it likely gave added impetus to the increase in negative equity leading up to the present day. Exhibit 5 A Light Leasing Market from 2008-10 Turned Would-be Lessees into Buyers with Loans New leases and leases to total sales (units) Sources: Manheim Consulting, Moody's Analytics 6 27 March 2017 Auto Finance - United States: Credit Risk Increases for Lenders, with Negative Equity at an All-time High MOODY'S INVESTORS SERVICE FINANCIAL INSTITUTIONS Endnotes 1 Moody’s, “Automotive Manufacturing Industry-Global-Outlook Moves to Negative as US, China Demand Softens,” 6 October 2016 2 Experian quarterly State of the Automotive Finance Market (Q4 2016) 3 Experian quarterly State of the Automotive Finance Market (2011-2016) and Edmunds Used Vehicle Market Report (February 2017) 4 Edmunds,“More Car Shoppers Are Underwater on Their Trade-Ins Than Ever Before, Reports Edmunds.com,” 14 November 2016 5 Edmunds, “Q3 2016 Used Vehicle Market Report,” 14 November 2016 7 27 March 2017 Auto Finance - United States: Credit Risk Increases for Lenders, with Negative Equity at an All-time High MOODY'S INVESTORS SERVICE FINANCIAL INSTITUTIONS © 2017 Moody’s Corporation, Moody’s Investors Service, Inc., Moody’s Analytics, Inc. and/or their licensors and affiliates (collectively, “MOODY’S”). 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