Macro Level

Auto finance is big business. The total principal balance of outstanding U.S. automotive loans approaches $1 trillion, meaning there is about $3K of auto debt for every man, woman, and child in the land. This shouldn’t be a shock when you consider that the average person’s first- or second-most valuable possession is his or her car, and that 85% of new cars and 55% of used cars are financed.

I won’t bore you with too much detail here. There is a lot of easily accessible information out there. In particular, Experian publishes a quarterly slide deck that contains reams of helpful auto finance data. I recommend that you read it in full.

The subprime and deep subprime lending categories—loosely defined by credit scores below 600 and 500 respectively—represent about a third of the market, measured both by originations and by outstanding principal balance. The mix of auto loans by credit score is volatile during the economic cycle, but seems to be pretty stable when averaged out over the cycle (with the exception of the ultra-prime category):

Subprime auto loans have typically performed very well in recessions. Because transportation is so important to employment and family life, borrowers will usually prioritize paying auto loans above all others, including mortgages. In NICK’s worst-ever year (fiscal 2009), the provision for loan losses was only 7.9% of revenue, and NICK still earned 6% on equity for the year.

The auto lending industry is cyclical, although historically the cycles have been driven by access to capital more than by loan performance. The typical cycle, starting from the trough, works something like this:

• Phase 1: Capital is tight, limiting the number of competitors. Since competition is minimal, lenders are able to lend at advantageous terms. Loan yields are high, loan losses are low, and the net returns on loans are very good.
• Phase 2: Backwards-looking measures of profitability suggest industry health is robust. Access to capital improves. New competitors with access to capital are attracted to the industry by the high returns on loans. Leverage levels increase because backwards-looking measures of profitability are positive. The industry enters a boom phase characterized by a litany of new entrants, strong loan volumes, and a modest decline in loan yields.
• Phase 3: New competitors continue to enter the industry at a high rate. The increased competition leads to less advantageous loan terms, and looser loan eligibility requirements. Lenders must compromise, or lose market share. Almost all lenders choose the former option. The cycle is nearing its peak and animal spirits drive continued increases in leverage levels as well as fraud and abuse.
• Phase 4: The accumulation of bad lending, and/or an external economic or financial shock to the system, causes loan losses to increase beyond a tolerable threshold. These increasing losses (as well as possible external economic deterioration) spook the banks and capital markets. Access to credit tightens considerably. The combination of increasing losses and expensive capital creates an industry brushfire, clearing out all the lenders who were marginally profitable and/or unsustainably levered.
• Phase 5: Return to Phase 1.

The cycles are abundantly clear in the financial statements of the lenders. Since the average age of a loan in the portfolio is about 2 years, the worst financial performance comes a few years after the peak of the cycle, and the best financial performance comes a few years after the trough. For instance, here is the performance of NICK’s loan portfolio over time:

Based on this chart, we appear to be exiting Phase 3 and entering Phase 4. I’ll talk more about this later.

Micro Level

Regarding the loans themselves, the average subprime auto loan bears an interest rate ranging from the mid-teens to the mid-twenties. Usury laws and other regulations prohibit the final interest rate on an auto loan from getting much above 23% or 24%. The average subprime loan term is from four to six years. The average subprime auto loan principal is $10-12K at origination, with another $5-6K in interest owed over the life of the loan. The average monthly payment, which combines principal amortization and interest, is above $300.

Auto lenders are typically “indirect” lenders, meaning they do not interact directly with the consumer. Rather, the car dealer is formally the lender to the customer, but immediately following the sale of the automobile, the dealer sells the loan to the financial lender at a price arranged prior to the sale of the vehicle. The process works this way so that the customer can interact with a single counterparty (the dealer) rather than a multitude of them (each individual subprime auto lender).

In the next section I will look at the different kinds of lending business models.