The growth in the auto finance market is dependent on auto sales supported by strong economic fundamentals such as rising incomes, well-structured labour market, favourable tax rates, low-interest rates, low fuel prices and investments in automotive factories and their capacity expansion. The auto sales in the US recorded a volume sales of more than 17 million units in 2015 and reached 17.91 million in YTD October 2016. This grew at a CAGR of 7% between 2010 and October 2016.
In the US, outright purchase comprises 13% to 15% of new vehicle sales, while the rest is financed/leased by multiple parties, including banks, captive OEM financiers, non-banking financial institutions, BHPH (Buy Here Pay Here) and credit unions.
These different types of institutions cater to distinct customer segments. For instance, while banks had about 1/3rd of the market share in both new and used financing market, captive OEMS were more active in new finance with greater than 50% of the market share in 2015. Moreover, captive OEM financiers are more focused on lease financing (almost 1/3rds of new vehicles are leased) which is low in banks. The captive OEM financiers account for more than 80% of the automobile lease financing in the US. On the other hand, BHPH and other financial institutions cater to buyers with a low credit score (less than 600) and focus more on used car financing in comparison to banks and captive OEM financiers.
As per the above graph, the risk distribution is directly related to delinquency ratio of different categories of auto lenders. Televisory compared 60-day delinquency among the auto lenders, it was observed that the delinquency ratio was lower for captive OEMs and credit unions as they were mostly lending to prime and super-prime borrowers. However, the delinquency rate was higher for lenders financing low credit score consumers impacting their profitability negatively. High delinquency ratio increases cost in terms of allowance for loan losses and loss severity per unit, thereby putting downward pressure on margins.
A finance to low credit score consumers (subprime and deep subprime) involves a higher credit risk and entitles the lender to charge a higher interest rate on auto loans. Auto lenders charge different APR (Annual Percentage Rate, the interest rate on loans) depending on the type of finance and a borrower’s credit score. A high credit score consumer is charged a lower interest rate. Similarly, consumer auto finance loans have lower interest rates than lease finance. A high APR translates to high-interest income, revenues and drives margins upwards. One can notice from the charts that APR for captive OEMs is lower in the retail financing segment. This is due to the subvention programmes (promotional offers) offered. A few major captive OEM financiers such as Ford Motor Credit Co. and Toyota Motor Credit Corp. offer a 0% APR for retail financing to attract customers. In most cases, the gap between the subvented interest rate and the actual interest rate is borne by the parent OEM, thus having little or no impact on the captive financier. On the other hand, captive OEMs charge a higher APR in the lease financing segment, but a little lower than banks. This is a result of sound technical knowledge that helps them capture the residual value of leased vehicles better than banks or other FIs. Further, a complete support of the OEMs in both retail and lease finance proves to be beneficial to both parties as the OEM can push its sales higher and the captive would have low customer acquisition costs as it can attract customers with better pricing and niche products.
While the APR impacts interest income, the cost of debt/funds impact interest expense, on the other hand, the cost of debt needs to be managed well in order to generate consistently high profits. Most of the debt in captive OEMs is from their parent company i.e. the OEM itself, whereas the source of funding for banks is from public deposits. However, a comparison of the average cost of long-term debt in overall market reveals that captive OEMs are still performing slightly better than banks and other FIs.
If one considers all the three factors together such as high APR, low cost of debt and the low delinquency ratio, which would increase profit margins. All these three factors are more favourable to captive OEM financiers than to banks and other FIs. Although banks are an important player in auto lending, captive OEM financiers would continue to dominate the US auto finance market by being the market leaders in lease financing and new car financing. They attract customers by offering lower interest rates and niche products and leveraging on sound technical knowledge on vehicles.