Successful Indirect Auto Lending Programs Build on Credit Union Strengths in Relationship and Portfolio Management Preface Auto lending is a significant part of the credit union loan portfolio. Nationally, auto loans account for 29% of credit union loans outstanding which represented $166 billion dollars in the third quarter of 2011. 1 Since vehicle loan values are dwarfed by the average home loan value, it is no surprise that first mortgages account for the bulk of credit union loans outstanding (i.e., 41% of total loan dollar volume). However, in terms of unit loan volumes, vehicle loans account for the largest share of credit union loans outstanding at 32%, in contrast to first mortgages, which comprise 4% of the total loan volume for all credit unions nationwide. 2 As of the third quarter of 2011, indirect auto loans accounted for 43% of credit union auto loans outstanding versus 37% for the same quarter of 2007. 3 Given that the majority of auto buyers arrange their new or used vehicle financing at the dealership, it stands to reason that it behooves credit unions to have a greater top-of-mind presence at the point of purchase in order to secure a larger share of auto loans completed at U.S. dealerships. Although many credit unions have successfully delved into indirect auto lending programs, there are some that have not done so or have struggled to make the program meet their initial expectations. Some credit unions have been wary of entering an indirect lending program for fear that loans conducted via an external channel would be harder to control. However, the credit union does have the ability and authority to enforce dealer agreements, which establish credit union lending guidelines and proper procedures to determine member eligibility. Having reports that provide loan metrics at the dealer level also give credit unions the ability to manage and review indirect lending portfolios, making early intervention and corrections possible to ensure loan quality. 1 Callahan & Associates Peer to Peer software. 2 Ibid. 3 Approximation based on the assumption that most indirect credit union loans reported on NCUA call reports are for automotive loans. This value was estimated by taking the dollar volume of total indirect loans from the NCUA call reports and dividing it by total credit union auto loans. Callahan & Associates Peer to Peer software was used to obtain total values. 1
Some credit unions may also be apprehensive about indirect lending because of higher indirect delinquency rates that occurred during the height of the recent recession. Prior to the credit crunch of 2008-09, credit union indirect delinquencies and charge-offs hovered near or below 1%. However, as consumers began to feel the impact of the recession and unemployment climbed, delinquencies and charge-offs also rose. In late 2008 through the 4 th quarter of 2009, the national average for credit union indirect delinquencies rose to new highs between 1.34% and 1.45%, while indirect charge-offs rose to levels between 1.36% and 1.74%. Higher delinquencies and charge-offs across the entire lending portfolio resulted in tightened underwriting standards among all lender types as credit availability contracted. The tightening of credit extended to auto loans, contributing to annual new vehicle sales declines that hit a 27-year national low in 2009. As new vehicle sales shrank from their pre-recessionary levels of 16 million to just under 11 million, many lenders pulled back from automotive lending. Although auto lending industry default rates rose during the peak of the recession, the automotive portfolio fared far better than first and second mortgages. For example, a study of industry default rates released in 2011 concluded that automobile loans actually outperformed mortgages during the 2004-2010 timeframe. 4 Consequently, in 2010, credit unions as a whole started to see their indirect delinquencies and charge-off rates fall. As the chart indicates, both credit union indirect delinquencies and charge-offs began to fall in 2010 and have been below 1% for the past 3 consecutive quarters. 4 Risk-Weighting of Automobile Loans, Grant Thornton and Auto Finance Council, 2011 White Paper. 2
Indirect Charge-Offs Indirect Delinquencies Q2 Q3 Q4 Q1 Q2 Q3 Q4 Q1 Q2 Q3 Q4 0.87 0.9 0.97 1.16 1.23 1.32 1.36 1.8 1.8 1.72 1 0.82 1.05 1.18 1.12 1.08 1.22 1.52 1.34 1.39 1.39 1 Credit Union Indirect Delinquencies and Charge-Offs Data as of September 30, 2011 for all U.S. credit unions 2.0% 1.72% 1.5% 1.0% 1.05% 1.32% 1.22% 1.39% 1.26% 1.14% 0.92% 0.90% 0.84% 0.5% 2007 2008 2009 2010 2011 Q2 Q3 Q4 Q1 Q2 Q3 Q4 Q1 Q2 Q3 Q4 Q1 Q2 Q3 Q4 Q1 Q2 Q3 Indirect Charge-Offs Indirect Delinquencies Source: Callahan & Associates Peer to Peer software The improvements reflected in the default rates suggest that credit unions were able to make changes to their indirect lending programs that resulted in healthier portfolios. Furthermore, the credit unions interviewed for this white paper supported this finding, as they provided insights as to what practices have helped them make their indirect lending programs successful. These credit unions attest to how indirect auto lending can be a beneficial product that not only adds to their loan portfolio s diversity, but also provides a needed service to members, while bringing additional revenue to the credit union. When properly managed, indirect auto lending can be a viable part of a credit union s lending portfolio and provide a convenient service to their membership base during the automotive financing process. As with any loan product, regular monitoring, reporting of key metrics, and financial reviews of the underlying loans in the automotive loan portfolio should be conducted to ensure adherence to underwriting guidelines and to remain compliant with regulatory requirements. 3
Objectives In light of the fact that a significant opportunity exists for credit unions to capture auto loan market share through an indirect lending platform, such as the one provided by CUDL, we sought to understand what helps make an indirect program successful for credit unions. In this regard, CU Direct used Lending Insights, a risk management portfolio tool that allows credit unions to upload their actual loan origination data to review credit union delinquencies and charge-off rates for indirect and direct auto loans. Based on the Lending Insights data, CU Direct identified several credit unions that had lower charge-off and delinquency rates for the indirect auto lending program when compared to the national average for credit unions obtained from Callahan & Associates Peer to Peer software. The following insights on what makes an indirect program successful were drawn from the interviews conducted with small to large credit unions that are making indirect auto lending a successful part of their lending portfolio. Base Credit Unions Credit Union Asset Size # of Members Indirect Delinquency (%) Indirect Charge-Offs % Auto Loans / Total Loans Q3 09 Q3 10 Q3 11 Q3 09 Q3 10 Q3 11 Q3 10 Q3 11 A 1B+ 100K-199K 0.63 0.83 0.70 1.36 1.10 1.03 49.1 44.4 B 1B+ 500K+ 1.12 0.90 0.50 2.22 1.54 0.76 20.0 17.6 C 1B+ 100K-199K 0.89 0.44 0.12 1.42 0.93 0.51 31.9 31.0 D 500M-999M 100K-199K 1.35 0.55 0.27 1.72 0.76 0.53 60.5 63.2 E 200M-499M 10K-19K 0.17 0.16 0.03 2.90 2.75 1.74 28.8 33.1 F 1B+ 100K-199K 1.03 0.76 0.45 2.55 1.44 0.89 37.6 41.7 The interviews conducted with these credit unions dealt with the following areas of key importance to developing and refining an indirect auto lending program: The primary reasons behind starting an indirect auto lending program Maintaining visibility and accountability Keeping the program relevant and on target Recommendations based on key lessons learned 4
Background: The Auto Lending Environment Credit Union Auto Loan Portfolio Trends Although some credit unions pulled back during the crisis, many still continued to provide direct and indirect lending to meet member demand for automotive loans, as finance companies, banks, and captives reduced their auto loan originations. This was evidenced by the fact that credit union market share rose to new highs during 2008-2009, when monthly market share values rose from 18% to 24%. 5 Once automotive lending started to recover in 2010-11, with finance companies, captives, and banks re-entering the automotive lending market, credit union auto loan market share began to return to more normal, pre-2008 levels of 17% to 18%. 6 Since the 2009 credit union indirect lending peak of $76.4B, indirect loan volumes have also returned to pre-2008 2005 levels. 2006 2007 2008 2009 2010 Q3 2011 Region 1 65.4 70.9 70.5 75 76.4 71.7 71.1 Point of Purchase loans outstanding for all U.S. Credit Unions Data as of September 30, 2011 $80 $60 $65.4 $70.9 $70.5 $75.0 $76.4 $71.7 $71.1 $ Billions $40 $20 $0 2005 2006 2007 2008 2009 2010 Q3 2011 Source: Callahan & Associates Peer to Peer software 5 Experian s AutoCount. 6 Ibid. 5
Reasons for Starting an Indirect Auto Lending Program With so many vehicle loans being transacted at the dealership, indirect auto lending offers credit unions the ability to increase auto loan penetration, secure more members, improve the loan to share ratio, and consequently, diversify and grow the balance sheet. As competition for auto loans ramped up in a low interest-rate environment, and new technologies provided consumers with greater convenience and more lending options, fewer members were obtaining vehicle financing at a credit union branch office. Therefore, many of the credit unions interviewed sought to obtain auto loan growth through an indirect program. Moreover, credit unions mentioned entering into an indirect program to capitalize on its potential to grow their loan portfolio. As a result, several credit unions had a higher volume of indirect auto loans versus direct loans, simply due to the greater proportion of vehicle buyers that secure financing at the dealership. True to the cooperative spirit, credit unions exist to provide their members with competitive financial products, and being at the point of purchase provides a convenient way to meet this need. Field of membership expansions resulting from a community charter change also made it imperative for a few credit unions to establish an indirect lending program, simply to meet the demands of a larger geographical footprint. Contributing Factors to Program Strength Among the factors identified for running a smooth and successful indirect auto lending program were consistency, visibility, and accountability. These three central themes were apparent throughout the discussions and were applicable to all areas that make a program successful from reporting and analysis, communication, dealer relationship management, underwriting guidelines, staff development and training, pricing, and portfolio management. Reporting and Analysis In order to stay on top of an indirect program s performance, it is imperative to measure, track, and monitor metrics that report the overall health of the program, in addition to more detailed reports at a branch, dealer, loan officer, and underwriter level. Clearly, you cannot manage what you do not measure. Therefore, reporting and analysis of the key metrics is essential to remain proactive and address any issues as soon as they surface. All of the credit unions we interviewed asserted that they use reporting tools, such as Lending Insights, to help identify issues early on. 6
There is constant analysis in addition to the analysis of the dealership s portfolio and the trends that it s showing across the board... projected loss, historical loss and delinquency... We do a lot of segmenting of our performance data... our loss and delinquency and repayment data. So that we can find anomalies and take action. It s more analytically driven than we were in the past... (and so) we re much quicker to make adjustments than we were in the past. The most common reports mentioned provided details related to pricing, loan volume changes, credit risk changes, in addition to late payments, delinquencies, and charge-offs. Thorough reporting and sharing of information provides consistency in the process, buy-in from staff and dealers, accountability at all levels, and clear visibility of the program fundamentals to lending staff and management. In addition, a review of poor performing loans can help identify issues that, if left unresolved, could lead to an undesirable trend. Regularly timed reviews can identify areas for improvement in underwriting, dealer relations, staff education, and program processes. Certainly, the various reports used by credit unions on the Lending Insights system provide them with a useful tool when preparing for NCUA examinations. As NCUA lending specialist Victoria Bennett stated at the 2011 CU Direct Lending Conference, the NCUA is very much in favor of indirect lending... we re just concerned that it s a well-run program. Portfolio management and reporting tools that provide the ability to drill down to fine levels of detail, offer the means to help management keep their indirect lending programs on track. 7
Communication When establishing an indirect auto lending program, consistency in communicating the credit union s program requirements and expectations, the indirect business model, underwriting policies, and the consequences of what will occur if these requirements are not met, is key to having a solid road map for dealers to follow. Communicating these expectations and guidelines is essential to keeping all parties up-to-date with program specifics. Although program specifics, such as credit tiers and ranges, may be realigned to meet market demands, communicating these changes quickly and efficiently is essential to maintain program adherence and foster mutual respect. Open communication between departments, various levels of management, and dealers was emphasized throughout the discussions. Having open, two-way communication with dealers also provided benefits such as: Keeping the credit union top-of-mind, Understanding dealer needs, Learning about market changes, Discovering information related to competitive actions, and Staying informed of dealer programs. All respondents interviewed provided examples of the importance of communication both internally (i.e., with line staff and management) and externally (i.e., with dealers). We have open lines of communication across delivery channels and that works to the member s benefit... It (communication) was something that we focused on to make sure that we are all working towards the same goal. From the onset, and on an ongoing basis, communicating program guidelines, price changes, and expectations is of key importance to promote and grow the partnership. The purpose isn t to stronghold the dealer, but to have a clear understanding that the program is a partnership that requires a concerted effort from both parties to meet dealer and credit union requirements for the program to be profitable and sustainable. 8
Dealer Relationship Management All of the credit unions interviewed, regardless of asset size, devoted time to managing the dealer relationship. Credit union participants emphasized a number of important aspects related to managing dealer relations, such as the importance of having a liaison or representative that was responsible for communicating program changes to the dealership and discussing program details with dealers. The credit unions also noted that establishing a working relationship with F&I staff, responding to day-to-day inquiries, and fostering the relationship to encourage dealer participation and loan volume growth in terms of keeping the credit union s loan products top-of-mind, were key to managing dealer relations. Regardless of the amount of staff involved in an indirect program, all credit unions expressed the importance of addressing dayto-day issues as they are encountered with a dealer, and proactively managing them through the process. In some cases, credit unions had restricted a few dealers to serving the existing credit union membership base if problems in loan quality arose. A few credit unions restricted dealers during the early introduction of their indirect auto lending program, however, once credit union management felt comfortable with the dealer s loan performance, the credit unions began to allow their contracted dealers to add new members. Most of these restrictions occurred either in the early days of the indirect auto lending program when the credit unions were not yet on the CUDL platform or during the peak periods of the financial crisis. In recent years, very few dealers had to be eliminated from the auto lending program due to repeated violations of the dealer master agreement or the credit union s program guidelines. Nevertheless, credit union management invoked their right to terminate a dealer agreement when a dealer did not meet the program guidelines. Holding dealers accountable ultimately fosters respect among all parties, as it reinforces the credibility of the agreement, the credit union s resolve to uphold its lending standards, and engenders confidence that both parties are committed to sustaining a mutually-beneficial, long-term partnership. It s all about that constant reinforcement, building that trust, assisting when they need help, cleaning up problems on delays for funding. Just working hand-in-hand with them is huge. We want a lot of business from those dealerships, but we want quality business. If there are any issues, we have the reps... to manage those relationships closely. You constantly have to be aware of the business that your dealers are sending you, the performance of that business, and make sure they are held accountable if they don t follow the rules. 9
In addition to establishing a strong working relationship with the F&I manager, credit unions should make an effort to expand their relationships to other pertinent dealer staff to include dealer principals, owners, and the general manager, so they can also have a better understanding of the value that the credit union provides to their business. Cultivating the Member Relationship One of the greatest challenges to membership expansion is cultivating the relationship so that the new member uses and adopts other credit union products and services. Because the nature of indirect lending involves obtaining the member through a third party, the full magnitude of the credit union s products, membership advantages, and history are often not brought to the attention of the indirect borrower at the time they sign up for membership. Once a new member comes on board with the credit union via the indirect auto lending channel, an opportunity exists for the credit union to welcome the new member and introduce them to the credit union s services, in addition to answering any questions. The acquisition of a new membership provides a reason to reach out to the member via a welcome letter and/or a direct telephone call to help solidify the relationship. A noteworthy method that a credit union had to provide such a welcome was via an outbound telephone calling campaign structured as a courtesy call. The courtesy call had the benefit of introducing the new member to a credit union representative that ensured the member s account was set up correctly and confirmed their preferred loan payment method. The call also provided a good opportunity to answer any questions about the credit union or their auto loan, and afforded an easier avenue to inform the customer on a one-on-one basis about other benefits of their membership, such as the credit union s financial products and services. We have shown that it can be successful, simply with an outreach program that shows them we care... and we want to serve them in more of a capacity and we ask for the business... on the basis of a service call. 10
Underwriting Guidelines & Reviews As mentioned previously, communicating loan and member eligibility requirements to dealers is critical to maintaining a smooth working relationship with dealers. Consistency in underwriting is equally important, so that the ultimate lending decision is the same regardless of which underwriter evaluated the loan package. However, when market conditions require underlying guideline changes, communicating the changes to dealers quickly is vital to assure seamless implementation. Adoption of the policies makes the underwriting process flow more quickly. If we are making an underwriting change, we let them know... we don t make them guess, so if they send us a bunch of business over the weekend and we changed our underwriting parameters, they are not caught off guard... (this helps) foster loyalty and allegiance. Furthermore, auditing indirect loan packages (i.e., member eligibility as well as loan documentation) and underwriting decisions helps to curtail fraud, as well as establish that the credit union is committed to protecting its members and its dealer network from practices that could jeopardize its viability. Several credit unions mentioned that loan reviews are routinely performed to ensure that decisions are not biased. In order to keep lending decisions unbiased, those who manage dealer relationships are not given lending authority or the ability to rehash deals. You want to maintain the monitoring of your underwriters and their individual portfolios to make sure that there is no bias for them in any specific relationship. Our reps have no lending authority. They do not benefit monetarily whether a dealer sends additional business our way or not... Their best interest... their incentive is on the overall credit union goals. My department manager does a loan officer underwriting review on each officer... on a quarterly basis and it has ongoing coaching with actual loans... it includes their charge-off rates... and identifies opportunity, whether missed or whether we overlooked information that could have affected the decision on the deal. 11
Pricing All of the credit unions interviewed stated they have regularly scheduled meetings to review not only portfolio performance, but also pricing guidelines. Committee reviews are commonplace to discuss performance and evaluate their pricing to ensure that it optimally covered costs, while providing the proper balance between risk and return. I m a fan of getting all the players in the room on a regular basis, monthly. We talk about pricing, performance, performance by dealer, and credit tier. We may change our credit tiers once a year... just based on how they are performing. At least twice a year we run a profitability analysis on our indirect lending (program) to make sure that we are pricing appropriately to cover the level of cost and losses that we expect to take on each tier of that portfolio. Although the goal appeared to bring indirect and direct pricing closer to one another, pricing was usually a bit higher for indirect in order to cover channel costs, and to some extent, risk. Nevertheless, several credit unions over time had been able to narrow the gap based on gained efficiencies, improvements to processes, and through higher quality loan production from their participating dealers. Pricing also had to match with the credit union s strategy for indirect lending. While the philosophy for some provided the ability to react to competitive rate changes, others were less reluctant to match rates or fee structures solely based on the actions of an aggressive market lender. We don t jump in and out of the market with what we re buying or special promotions or paying more reserve. For others, regular evaluation of market changes and gains in program efficiency warranted changes to the fee structure. We used to have a larger spread on direct and indirect auto lending. The reason we have been narrowing the gap is that we ve been going more to a flat fee schedule with dealers. 12
Staff Development and Training Providing the right training and education to indirect lending staff was also mentioned as a success factor that helped these credit unions achieve a well-run indirect auto lending program. Not only was staff knowledge of indirect lending processes and procedures important, but so was the clear communication of goals and responsibilities. For example, it was essential for credit union staff to understand the credit union s philosophy on how to deal with competition for member auto loans between branches and dealerships. For the most part, credit unions acknowledged that branch offices and dealers are inherently in competition to some degree for member business, however, they put the member s needs first and also emphasized the importance of not damaging a deal that had already been in progress. Moreover, the credit unions understood the importance of supporting the dealer relationship and crediting the appropriate channel with the sale. We made it clear to staff that if they are doing something that jeopardizes a deal, to circumvent the member who s been working with the dealer, that s not allowed. We don t want to jeopardize the dealer relationship. The way we ve handled that problem is that even if a member goes out to a dealership and then the member comes to the branch... we still pay the reserve to the dealership. It doesn t happen much now... over the years we ve explained to the branches how it impacts our relationship with the dealers. In addition, the credit unions had clearly separated loan volume goals from employee incentive plans to help avoid improprieties due to conflict of interest. The credit unions also provided training and coaching to empower their employees and give them the skills needed to work with dealers in an indirect lending environment. We ve also had a stable staff... they are all well-trained and knowledgeable and they all know how to work well with dealers. They ve also been heavily indoctrinated to raise a red flag whenever anything looks at all suspicious with an application or package. We decided... to put them (reps) through all the training to become a loan officer, but not the authority. Just to give them a feel for what we re looking for on the underwriting side... (however), they (reps) are never going to get underwriting authority. 13
Approved communication procedures varied among credit unions on the practices for rehashing a deal. Some credit unions allowed dealers to contact the underwriter or loan officer directly to follow up on a decision, whereas other credit unions established a policy that only management could be reached to rehash a deal. Portfolio Management In addition to the aforementioned reports that keep management informed of the indirect auto loan portfolio s performance, several credit unions noted running additional types of analysis, such as risk-based portfolio analysis, static pool analysis, and segmenting based on credit risk to uncover opportunities and issues. Some credit unions used multiple scoring methods such as a FICO score, indirect pooled risk models, and bankruptcy score to help them in the loan-decision process. All of the credit unions that shared their successes and insights use the Lending Insights tool to provide them with the data they need to proactively manage their indirect and direct auto lending programs. Although some had dedicated departments to focus on indirect lending, most managed both direct and indirect much the same way to maintain consistency between the channels. In summary, portfolio management involved: staying on top of the auto loan portfolio to balance risk and return, evaluating loan performance by dealer and loan officer, auditing loan packages and underwriting decisions, regular reviews of the program and pricing, as well as taking corrective action when needed. Set a business plan with standards and expectations and definitely get this program with Lending Insights for the analytics, because you can be completely proactive rather than reactive with that product. I think by introducing several different dimensions into how we re approaching the risk has helped us cut out some of the risks that some of our competitors still have inherently within the way they are doing their underwriting and decisioning. It s important to manage this channel from every possible perspective. Monthly, if not weekly. It s a constant, ongoing, multiple point control... We are constantly looking at all parts of it. Monitoring on a daily and weekly basis... 14
Mitigating Losses during the Collection Process As with any lending program, mitigating losses is a key part of a lender s goals. In the loan origination process, prudent underwriting guidelines are followed to curtail the likelihood of default, but when late payments occur, the credit union must also have procedures in place to minimize losses. Although most credit union executives noted that indirect and direct loan collection methods are very similar, some also mentioned methods they employ to help curtail indirect auto loan charge-offs. We implemented a risk-based collection program... regardless of channel, we do quarterly risk analysis on the entire portfolio and we have an internal model... to assign a risk rating to each loan. If an indirect or direct loan falls into a high risk rating level, they are bumped up to a higher priority in the collections queue. New members are handled differently than a direct loan with a late first payment... with new members signed by the dealer we find that a missed first payment is usually due to not knowing the lender or where to go to make a payment. The (collections) department focuses on indirect auto lending more than any other product to make sure that we re keeping a handle on those... we have a dialer process where 3 times a week we send out unattended phone calls to all delinquent accounts on day 11 of delinquency... at day 30 of delinquency we use the preview dialer... and those would be attended campaigns. 15
Recommendations To summarize, credit unions that have successfully implemented an indirect lending program did so by clearly outlining realistic expectations of the indirect auto lending channel and incorporating measures and the infrastructure to increase the likelihood of its success. Such measures encompassed: Outlining the goals for the channel, Setting expectations for staff and dealers, Having policies in place to address issues and corrective procedures to remedy them, Developing their staff and educating them on the processes, Keeping a clear segregation of responsibilities between decisioning and dealer-relations staff, Incorporating corporate incentive plans for indirect lending staff instead of individual volume-driven goals, Obtaining a robust loan portfolio reporting tool, Reviewing loan performance at all levels on a regular basis (i.e., loan performance by dealer, underwriter, loan officer, origination year, risk tier, etc.), and Constantly working toward fine-tuning the program. In addition, credit unions want dealers to succeed and obtain the profit that they need to sustain their business. Rather than seeing the indirect channel and dealers as an adversary, they view the relationship as a true partnership. Providing excellent customer service to the dealer is also important in terms of loan response times, decisioning, and funding when the dealer has met his responsibilities in providing a complete loan package. Now that many credit unions have entered and established indirect auto lending programs, those that are considering an indirect program should utilize the resources available to them to learn from other credit unions. Doing the necessary homework can provide the credit union with the policies and procedures that have worked for others, while establishing their own infrastructure to support an indirect auto lending program. Lastly, the credit union must understand how indirect lending will fit into the credit union s overall strategy. Acknowledgements We d like to thank each of the participating credit unions for their time and consideration while developing this white paper. To learn more about how your credit union can advance its indirect auto lending program visit www.cudl.com for more information. 16