In avoiding subprime auto loans, are CUs shunning their roots?
This story is part of Credit Union Journal’s ongoing special report on auto lending, which will run throughout the month of May. More coverage can be found here.
Fears of a recession or economic downturn may be holding credit unions back from subprime auto lending, and some observers say the industry may be shying away from its roots in the process.
“Credit unions may be fearful of potential borrower defaults if the economy were to face a downturn in the future,” said Kevin Chiappetta, SVP-investment services at Corporate Central Credit Union of Muskego, Wis., noting that the majority of credit unions right now are staying out of the subprime auto market and sticking to traditional loan underwriting.
Recent data from the Federal Reserve Bank of New York shows that as of Q3 2018, subprime borrowers made up just 14% of credit unions’ auto loan portfolios. In comparison, about 25% of big banks’ and 50% of auto finance companies’ portfolios were going toward consumers with subprime credit.
Credit unions have largely been immune from rising auto delinquencies in comparison to much of the competition as a result of shying away from subprime borrowers. But the industry has historically touted its willingness to lend to consumers of modest means or those who may struggle to otherwise access affordable financial services, leaving some observers asking why CUs haven’t entered the subprime market more heavily.
Bob Schroeder, a consultant at Lending Solutions Consulting Inc., a firm that provides loan management and consumer lending advisory services to credit unions, said many institutions stay away from subprime borrowers as a risk mitigation strategy.
While a few credit unions have failed or been conserved partly due to high concentrations in subprime auto lending, most of those occurred around the time of the financial crisis, and Schoeder said those institutions’ fates can serve as a learning opportunity for the industry.
John Caddell, manager of credit and lending at CO-OP Financial Services, pointed out that the percentage of subprime loans issued by credit unions overall has dropped in the last decade.
“Credit unions haven’t had to make riskier loans with an auto market that hit record highs for new auto sales in 2016-2017,” he said. “Also, credit unions are making deals to near-prime borrowers that aren’t considered subprime, but are a bit riskier. The big reason for this is that consumer credit scores have been on the rise over the last few years following the Great Recession.”
According to FICO, the average credit score in the U.S. as of April 2018 was 704, rising from 687 in 2009. FICO scores range from 300 to 850.
Chiappetta said while lending to borrowers with lower credit fits with the overall credit union philosophy, many shops are still very conservatively run organizations and need to stick to proven methods of evaluating and granting credit.
“Providing financial services to consumers of modest means is a large part of the mission of credit unions, but not the entire mission,” he added.
At Town and Country Credit Union in Scarborough, Maine, about 21% of the CU’s total auto loan portfolio is made up of subprime borrowers.
“Our philosophy is to avoid the labeling of prime or subprime since anyone can get into a challenging situation, and most will work themselves out of with time and some assistance,” David Libby, president and CEO of the $391 million-asset institution, said via email. “We believe it’s the mission of credit unions to understand that and help when people need it the most.”
ROA and pricing
With growth slowing and margins narrowing, many sources indicated that credit unions that avoided the subprime auto market in recent years may find themselves entering that arena eventually as a way to maintain profitability.
Adding subprime loans to an institution’s mix could help increase volume, said Caddell, but he advised CUs to be as “creative as possible” when setting lending guidelines for those borrowers.
“There’s a lot more data revolving around consumers than what is just on the credit bureau nowadays,” he said. “Credit unions need to tap in to other data-driven items for these riskier borrowers.”
Schroeder, former president and CEO of Illinois Community Credit Union, pointed out that if more credit unions measured their success based on ROA, then offering subprime auto loans would make sense.
“Many credit union boards focus and measure their success on delinquency and charge-offs,” he said. “If you want the lowest delinquency and charge offs you certainly would not want to serve the subprime auto market.”
He added that credit unions with the highest ROAs in the industry tend to have higher loan yields and higher fee incomes. Both of which, he said, are a result of serving the subprime auto market.
Chiappetta said many CUs he’s spoken with that avoid subprime do so because they are focused on their overall credit risk exposure. But some do offer loans to subprime borrowers through indirect channels.
“Loans sourced from an indirect lending program where the credit union is further removed from the borrower and maintaining a strict underwriting standard to higher credit worthy borrowers seems to be the norm,” he said.
Sources suggested credit unions new to subprime lending ensure staff is properly trained before getting started, along with adequate net worth level and risk mitigation limits.
Caddell recommended proceeding with caution with subprime borrowers, especially if that person is a new member and has no previous relationship with the institution.
“If the subprime auto loan is with a member who has a lending relationship with the credit union, I definitely would [pursue it],” he said. “The key is for credit unions who create tiers for subprime scores to actually use them and not let them be idle. This means they have to price them correctly.”
He added not enough credit unions price their riskier tiers correctly and end up giving borrowers with poor credit a lower rate than they should, thereby not actually offsetting that risk.
“Credit unions should be pricing these risky tiers higher even if it means getting into the double digit rate areas of 10 to 15 percent,” said Caddell. “Credit unions need to realize that 15 percent is a great rate for their members compared to 25 percent or even higher were the member to go to another lender. So, when credit unions don’t see a good return (due to their not pricing those lower tiers correctly), they start shying away from the subprime scores.”
Schoeder concurred. Too many CUs, he said “cringe at the thought of charging 18%,” when that “is a great rate for those with less than 550 FICO scores.”
He added, “The result, if you do it successfully, is higher ROAs and increasing membership.”