Opportunity? Yes, But It's The 'S' Word

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PEORIA, Ill.-This year should offer opportunities for credit unions to make money in subprime auto lending, according to Keith Reynolds.

Reynolds is the community president of $4.4-billion CEFCU's San Jose, Calif., division (the Illinois credit union giant acquired Valley CU from NCUA at end of 2008), and sits on the CUNA Lending Council's executive committee. He reminded CUs that, statistically, the country is in an environment where 25% of borrowers have credit scores under 600. "Obviously, there is some regionality as some areas are more distressed than others," he said. "Used car purchases have been down for a year or two, and Cash For Clunkers took a lot of used cars out of the market, so I believe there is pent-up demand for used cars."

This is an opportunity, he asserted, because many of the traditional subprime lenders raised capital by issuing instruments on Wall Street, but demand for those products has waned.

"It is not clear that the capital will be there to make those loans, so credit unions can step in if they have the analytics to price those loans properly," Reynolds said. "They also need the underwriters to be trained and disciplined to make the proper approvals, and the patience and persistence to collect on those loans."

There is a danger of responding to declining income from investments and a loss of fee income by making more loans without thinking through those three factors, he added, saying CUs should not wait until May when they see an opportunity. "Start thinking about those things now," he urged.

One lesson learned in the last five years, Reynolds reminded, is it is very difficult to layer risk and get away with it. He offered subprime mortgage lending as an example: borrowers had a high debt ratio, intermittent employment and little or no cash down, perhaps even a past bankruptcy.

"Auto lending is the same: if people have a high debt ratio and they haven't been on their jobs long, the credit union must be disciplined in underwriting to identify what is reasonable risk and what is unreasonable risk."

The assessment process is akin to running bathwater, Reynolds said-running just the hot water doesn't work, running just the cold water doesn't work; a balance is needed. "Credit unions must be constantly educating their underwriters as to the trends they are finding," he counseled. "It has to be an interactive process between collections and lending."

With subprime borrowers it is important to interview them to gain an understanding. Reynolds argued a FICO score is a "great tool," but it is a means to an end, not an end in itself.

Credit unions, he said, need to do their best to avoid layering risk. "Get the story behind the borrower's credit score. There will be 580 credit scores you'll want to lend to, if you understand the risk and don't layer the risk, because those loans will be very valuable. And other lenders are not making those. But if you make a lot of loans to 580s without understanding the process, it can get a lender in trouble."

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