SAN FRANCISCO - The market for new car loans may be leveling off with higher interest rates, but few see a fall-off in the overall demand for auto financing. Montgomery Securities analyst Joe Jolson says that may not be all good news for many banks. Indeed, banks remain the dominant player in making loans to the most creditworthy buyers of new cars, but many observers expect that to be the slowest growing segment of the $350 billion-a-year auto loan market.

The real challenge, argues Mr. Jolson, is not volume, but quality. Best known for his coverage of California thrifts, Mr. Jolson says the evolution toward a growing used car market and an ever-increasing number of subprime borrowers will test banks anxious to maintain market share.

Q.: What is your outlook for the auto finance market and the role of banks in it?

JOLSON: From our point of view, the auto finance business is large and still growing. Last year, it was about $350 billion in size. We think that in 1994 the market grew about 15% to 20% over 1994. Looking ahead, we expect it to grow in the 10% to 12% range in each of the next five years on average.

Q.: You believe that new car sales have plateaued. Where will the growth come from?

JOLSON: A number of analysts who follow the automakers had been projecting higher and higher new car sales this year. I think the reason they were optimistic is because they were focused on this trend line of normal demand and the industry was running below that and they were expecting it to catch up because of pent up demand. But more and more it is being satisfied by late model used car. The reality is the U.S. consumer just can't afford a new car. It has just gotten beyond their means.

Q.: Focusing on the banks that have moved down the credit scale, how significant are the potential problems?

JOLSON: Let's talk about history. The banks have a history of, at different points in the cycle, particularly when they are making a push in the consumer area, to get extremely aggressive. Let me give you an example. First Interstate Bancorp was the most aggressive auto lender in California in the mid-1980s. They really ramped that business up, and when the economy slowed down they had huge writeoffs and exited the business. I don't know if history can predict the future, but there are a large number of banks that have tried this business, failed at it, and left it. Unfortunately for the independents, there are lots more banks out there.

Q.: Based on history, how will banks be affected by this shakeout?

JOLSON: It depends on the depth of any recession. If we have a soft landing, I don't think we'll have many big blow-ups. There are two issues on the pricing and underwriting by banks. One is just getting creamed because of unexpected losses and the other is just not making any money because they had higher losses than expected. In the case of most of the banks I am talking about, it is probably going to be that second one. It may drag their profitability.

Q.: Could you expand on that?

JOLSON: They were funding them short on the yield curve. In the last year, short-term interest rates are up significantly and the banks have lagged in repricing deposits. A lot of these guys fool themselves when they price their loans with marginal pricing versus their usual pricing. So a lot have put on what is effectively a two- or three-year auto loan. If they put them on at 9% or 10% in 1994, thinking their cost of funds was 3% but now it is 6%, that's a big difference. They were clearly pricing for market share. I think they are a victim of their own cultures. Banks have become price leaders, not service leaders, and that is not much to build a franchise on.

Q.: Will that pressure more banks to move into the subprime market?

JOLSON: Not many banks are going to go deep into the subprime market because it's not their customers. Most banks target the middle-class customer. The subprime customers is the middle-class and down. Most of these people don't even have checking accounts and those that do probably bounce a lot of checks. While I think there is a good opportunity there, most banks don't want to hassle with that kind of customer.

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