1. Factors Influencing Auto Finance Risk
Ability & Stability
A consumer’s ability to pay cannot be predicted for the term of a any loan. The factors
herein should be examined to help determine what the likely of default may be.
• Ability (Income)
• Multiple Income Sources
• Overtime if consistent and measurable
• Co applicant if living at the same residence
• Sources of income with a different intended purpose such as child
support and disability should not be considered
• Disposable income – Money available for auto payment
 Measured by Debt-to-Income (DTI) & Payment-to-Income (PTI)
ratios
 Standard rules usually are < 50% DTI and < 20% PTI
 These are not perfect measurements and should be set differently
based on loan programs and income ranges
• Stability (Employment & Residence)
• W2 job or guaranteed income such as retirement is optimal
• < 1 year on current job, history of job gaps, < 3 year employment history,
or seasonal work are indicators of future inability to pay
• Consistent track record in the same occupation or industry helps to
minimize risk
• Residence history is used as a stability indicator. < 1 year at current
residence and < 3 year in area may be indications of instability.
Character
The best indication of a consumer’s desire to pay (character) is their past credit
performance.
• Thorough review of the credit bureau report is imperative
• FICO scores below 500 will perform poorly
• Length of credit file is important. Should be >3 years if not First Time
Buyer
• Look for ghosts or credit repair applicants
• Look for potential bankruptcy candidates
• Don’t finance dismissed bankruptcy within past year
• Positive closed end installment loans and use of revolving credit are
the best indications for past credit performance
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2. Collateral
• Loan to Value Ratio.
– Amount financed divided by invoice or wholesale book value is LTV
– Higher amounts are typically caused by tax, title, license, warranty, GAP,
dealer profit, and/or negative equity.
– LTV measures the exposure from the unsecured portion of the loan
– Unsecured portion is the difference between auction value and loan
balance.
• Depreciation Increases Exposure
- Residual vehicle value decreases faster than the balance pays down
• Collateral Performance
– If a car stops running some customers may justify not paying because the
vehicle they bought is no longer working
– When they go to get another car there is sometimes not enough disposable
income to cover both payments so they default on the non-working car
– Restricting mileage and age of collateral will minimize this issue
Special Finance Exposure
• Prime borrower collateral exposure is minimal because the incidence of default
and repossession is minimal
• Special Finance borrowers have a higher instance of default and repossession so
percent of dollars lost becomes an issue.
• Regardless of borrower type, auction value will be the same.
– Vehicle with a book value of $10K financed for $12K (120 LTV) or $14K
(140 LTV) will recover approximately $7K at auction a year later
– Severity - the loss per vehicle as a percent of outstanding loan balance not
recovered at auction can be significant depending on:
• Original Loan to Value (LTV) - Amount Financed / Book Value
• Depreciation of the vehicle
– Vehicle Make & Model and if New or Used
– Manufacture Rebates which may suppress future values
• Prime Borrower: 1% unit loss * 40% severity = 40 bps of unit loss
• Special Finance Borrower: 10% unit loss * 40% severity = 400 bps of unit loss
Competition
• Being a first choice lender for your core dealers and giving a reasonable response
in a quick and timely manner will get you first look business
– Getting second look business typically has the best loans removed
• Loan application distribution systems make price competition unavoidable and
commoditize the loan product
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3. Verifications
• Funder must insure application verifies as submitted and information is correct
External Source Verifications
• Employment – Directly with Current Employer
– Verify a minimum of 1 year continuous employment with current
employer and ensure you have a 3 year employment history
• Residence – Through written documentation in contract package
– Verify 1 year at current residence and ensure you have a 3 year residence
history
• Insurance – Directly with insurance agent
– Verify that the vehicle being financed is currently insured
– Verify policy carries approved minimum deductable amounts
– Verify no other parties are insured that are not on contract
– Verify American Acceptance is listed as loss payee
Verification of Contract – Directly with Borrower(s)
• Personally speak with the borrower(s) to verify the following:
– Contract terms: down payment, payment, due date, first payment due date
– Vehicle: year, make, model, mileage, equipment adds
– Insurance: agent, policy number
– Residence: time, address, home phone, cell phone, email, rent amount
– Employment: time, position, salary, direct contact number
• Give the borrower our payment address, customer service phone number and
remind them of the importance of timely payments. Verify borrower will be
making first payment on or before the due date.
Other Factors
• Fraud
– False information is provided by dealer or customer to obtain financing
• Straw Purchase
– Higher risk customer will have a joint applicant who is not the intended
driver placed on the loan to obtain financing
• Uninsured Vehicle
– In the event of an accident, an uninsured borrower can have an impact on
performance because they typically fail to repay the defaulted balance
because they are paying for the replacement vehicle and not the damaged
vehicle
• Customer Life Changes
– Unforeseen changes in peoples lives which impact their ability to pay
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4. Measurements
• Vintage Performance
– Performance must be analyzed on a vintage basis as growth has a tendency
to mask delinquencies and can distort results
– Look at performance from time of origination.
– Growth Loss curves within risk tiers tends to follow the same proportional
shape so performance can be extrapolated to obtain lifetime losses.
• This trend starts to become apparent after 6 to 8 months but should
not be relied upon until after 12 months
• Duration and Months on Books
– Despite the longer loan terms of special finance loans the majority of
borrowers do not reach their term because of new vehicle purchases,
refinances, or default
– Knowing the duration (average life of an outstanding dollar) helps to
annualize one time costs and fees
– Average duration of special finance loans is less than 30 months
• Annualized Results
– Cash flows from loans are not linear and understanding what the life of the
loan pool will look like with defaults and repayments helps track to
lifetime loss expectations
– These lifetime loss expectations should then be annualized in order to
make sure annual returns are within loss expectations
• Standardized Reporting
– Borrower Characteristics: to measure FICO distribution, income, pay-
to-income and dent-to-income ratios, LTV distribution and time at job and
residence
– Loss Prevention: to measure first payment defaults delinquency, and 12
month lagged charge-offs
– Static Pool Analysis: to measure losses by quarter on a monthly basis
related to originations that month
– Risk Management Score Card: to measure efficiencies, average deal
characteristics and return expectations
Summary
The following steps should be taken to provide effective management oversight:
• Ensure automobile lending policies establish specific underwriting guidelines that
encompass FICO credit scores, debt-to-income ratios, payment to income ratios,
interest rates, amortization periods, loan-to-value ratios, diversification standards,
and concentration limits (from a single dealer).
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5. • Compare auto lending trends to strategic plans for consistency, including growth
rates, risk levels, and anticipated rates of return on that risk.
• Determine that the control structure provides sufficient oversight in the lending
decision process.
• Verify that auto loans are adequately covered in independent loan reviews and
scopes of internal/external audits.
• Ensure collection procedures and the repossession process is independent of any
personnel involved in the originations process or the original credit decision.
• Verify that potential loss evaluation methods have some relation to the behavior
of the portfolio.
• Validate that lending practices conform to approved policies through re-
underwriting and re-verification of a sampling of funded loan files.
• Ensure that vehicle repossessions are identified, tracked, sold in a timely manner
and auction sales prices are validated on a sampling of repossession files.
• Verify that information technology systems are used effectively to create a
database capable of capturing a number of variables for regression analysis (credit
scores, dealers originating the paper, debt and payment coverage ratios, and
vehicle identification numbers).
• Besides averages, distributions of key metrics should be examined to spot points
of exposure
• Seasonality will affect performance and needs to be adjusted accordingly.
• Comparing losses since origination date on a monthly or quarterly basis gives a
better picture of true performance.
FOR ADDITIONAL INFORMATION
PLEASE CONTACT
Frank Mercer, CEO
CU Auto Lending Services
6609 Convoy Court
San Diego, CA 92111
(O) 858-874-6748
(C) 858-408-7111
fmercer@cuals.com
www.cuals.com
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