Race to make auto loans squeezes lenders' margins.

NationsBank Corp.'s "preferred" customers in Texas recently received a letter inviting them to lock in a pre-approved five-year car loan for up to $20,000. The 7.49% annual percentage rate comes with 100% financing and no down payment.

A bit generous? Perhaps. But the NationsBank offer, good until June 30, is by no means unusual in today's auto lending market. For the past year and a half, ever since the economic recovery began, auto lenders have been going fender to fender in ferocious competition.

The good news for banks is that indirect auto loans -- those made at the dealership -- have fueled some impressive consumer loan growth over the last few quarters, helping overcome the lack of opportunity in other areas such as commercial real estate.

The bad news is that the competition shaved profit margins on these loans to the bone and forced some lenders to stretch a bit on credit to maintain market share.

Low Margins Accepted

"In my 15 years in the car business I've never seen a period of time like now, where financial institutions have been willing to accept such low margins," says Nick Stanutz, senior vice president with Huntington Bancshares in Columbus, Ohio.

"It's simply a matter of not enough loans being available to satisfy the banks' appetite," says Walter R. Day, senior vice president with Mellon Bank in Pittsburgh. "Indirect auto loans are somewhat of a commodity based on pricing, so it's one place, assuming you price attractively in the marketplace, where you can grow relatively quickly."

Fueling the surge in auto loans has been renewed demand by American consumers. Sales of cars and light trucks reached 13.9 million last year, up from 12.3 million in 1991. They are expected to exceed 15 million both this year and next.

"People have been holding out the last few years, keeping the vehicle they have longer than they would traditionally drive it," says Jim Avery, senior vice president of marketing for First South Federal Credit Union in Millington, Tenn. "Some of this built-in obsolescence is finally surfacing. Some people, just out of necessity, are going to have to make a purchase decision."

Trouble Ahead?

The danger is that a few years down the road, when the boom has ended or slowed, some of the more aggressive lenders will be boosting their loan-loss reserves to repair the damage. Delinquency rates are currently at historic lows, but that won't last forever.

"As long as the portfolio keeps growing, everything looks rosy," says Randall McCathren, an executive vice president with Bank Lease Consultants in Nashville. "Over time, as we have a downtick in the economy or the portfolio stops growing, the delinquency and loss rates are going to shoot up."

Rising delinquencies will call into question margins that might be deemed acceptable today. "Those institutions that choose to participate at low margins are only putting themselves in jeopardy of reducing their overall profitability downstream," says John Abadie, president of NationsBank's dealer financial services group.

Mr. Abadie, who manages a $7 billion auto portfolio, the largest of any bank, says NationsBank keeps its rates in line with funding costs. "NationsBank has chosen not to participate in those low margin loans," he says.

But clearly, some players in some markets are stretching. According to Bank Rate Monitor, the average rate on four-year new car loans fell about 200 basis points in the 18 months through December, to 7.9%. It has since edged up to 8.15%.

Phillip Sbrochi, senior vice president for retail lending at Banc One in Columbus, Ohio, recently compared the 6% CD rates advertized by out-of-town competitors with those same banks' 7% auto rates.

He says the paper-thin 1% spread would quickly dissolve after subtracting loan losses, loan-acquisition fees and the cost of deposit gathering.

"That's new math I never took," Mr. Sbrochi says. "Frankly, if we chose to follow some of those competitors, our margins would be zero,"

Competition Fierce

Mr. McCathren, the consultant, says competitive pressures are worse today than they ever have been. Even as banks are driven to build their consumer loan portfolios, nonbank competitors such as captive finance companies and credit unions are muscling into more of the business.

"Usually, in a declining-rate environment, everybody makes more money for a while," Mr. McCathren says. "You want to build up your spread a little so you can partly make up for the other side of the curve.

"But that really didn't happen very much this time because of the aggressive need for assets. The rates came down and they stayed down. And now we're in a rising-rate environment and there's an awful lot of pressure on people."

By being aggressive, commercial banks have been able to wrest back some market share from the finance companies. Banks originated 44% of all auto credit last year, up from 42% in 1992.

The problem is that indirect lending, where banks are gaining, constitutes only one of the four major delivery channels used by auto lenders. The other three are direct, leasing, and equity lines of credit.

Leasing, where the finance units of the major auto companies enjoy competitive advantages, captured 23% of the market in 1993, up 3% from 1991.

Banks have a hard time matching the incentives the "captives" can provide consumers on certain products. These incentives typically involve inflating the residual value of the leased car, which keeps monthly payments down. Automotive News has reported that Ford spends up to $2,000 per vehicle to support leases on some models.

Rather than compete on those particular vehicles, banks that are active in leasing, such as NationsBank, focus their efforts on cars that don't receive the residual-value subsidies. Many other banks stay out of the leasing market altogether.

Role of Credit Unions

Credit unions constitute another competitive threat, particularly in California and Texas, where they are unusually strong. Traditionally, credit unions only made direct auto loans but more are now participating in the indirect channel by using preapprovals.

The customer takes his preapproved loan to the dealership, which then faxes the application back to the credit union for processing.

Longer term, all auto lenders are concerned about demographic trends. The average annual growth rate in the driving-age population (16 and over) was 1.9% during the 1970s. During the 1980s, that rate slipped to 1.1% and is forecast to average out at 0.8% for this decade, slowing auto sales accordingly.

"Demographic factors drive this machine, regardless of what the Federal Reserve does or anybody else," says Thomas W. Trotter, senior vice president and group executive with Wachovia Corp.'s sales finance division.

Banks have responded to all of these competitive pressures by trying to cut their costs and improve efficiency. Every basis point shaved off the cost of delivery can be applied to lowering the rate.

"Because auto lending is a low-margin business, every ingredient that goes into it has to be managed very close to the vest," says Ralph Cassell, senior vice president for national consumer lending at Compass Bank, Birmingham, Ala. "It's a simple business plan that is sometimes hard to execute. You have to have very low expenses, you have to be right on the edge of technology, and you have to have low losses."

In the last five years, banks have focused resources on technological improvements in collections and loan application. With the use of credit scoring, banks can process a faxed application from a dealer in half an hour.

"The next cutting edge is the ability to make lending decisions in an automated fashion without a person looking at it. Everyone is experimenting with that to one degree or another," says Anne Tonks, senior vice president and director of Bank-America Corp.'s dealer lending division.

Ms. Tonks, who is also chairwoman of the Consumer Bankers Association's technology task force, says the newer systems can automatically handle the very best and very worst customers.

The trick is to build enough information into the credit scoring system so that the computer can make those decisions unaided.

"Eventually, we're all going to be hooked up on-line with each other," Ms. Tonks adds. "The dealerships will be on-line with financial institutions and probably able to get credit decisions 24 hours a day. But we're not there yet."

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