NEW YORK, N.Y. — In a recent report, Fitch Ratings announced it expects the economic weakness that occurred in the second half of 2007 to continue its downward pressure on credit metrics for the U.S. auto finance industry, leading to further worsening of asset quality.

Moreover, Fitch indicated the industry's fairly recent decision to expand to 72-month loans will also likely increase loss severities in relation to other cyclical downturns.

"Furthermore, lenders are expected to slow portfolio growth in 2008 as dislocations in the bond insurance and capital markets raise concerns about funding costs and liquidity," officials explained. "Slower portfolio growth will tend to inflate credit metrics further."

All this and more were addressed in Fitch's recent report called "U.S. Auto Finance: Road Work Ahead."

"Asset quality deterioration, higher funding costs and uncertain ABS market conditions could result in negative rating action for some non-captive lenders; however, the larger lenders benefit from significant business line diversity and stable deposit funding," the analysis said.

"AmeriCredit, an undiversified lender, is more susceptible to rating action, given its reliance on the capital markets for funding and its focus on higher-risk subprime borrowers," the report continued.

Meanwhile, officials also mentioned that due to decreased vehicle demand, along with other challenges, the domestic captives received negative rating action in recent years.

"Asset quality and funding costs are a concern in 2008, but asset quality deterioration should be less severe than in non-captive portfolios given the prime focus of the captives business," executives indicated.

"Further rating action at the captives will be driven by their parent's ability to navigate through a difficult operating environment and ward off increased competition from foreign manufacturers," they continued.

General Market Trends

One major trend the paper pointed to is that competition between captives is stronger than ever.

"While the auto finance market remains relatively fragmented, there has been a significant amount of consolidation in the non-captive area," officials highlighted.

Citing data from J.D. Power and Associates, the report said the top 10 non-captives grabbed 26 percent of originations in 2006, compared with 14 percent in 1999.

"Captives have gained some market share back from the non-captives in recent years, which Fitch believes reflects the growing presence of the foreign captives," analysts wrote.

"Captives accounted for 42 percent of total auto originations in 2006, compared to 36 percent in 1999," they added.

When the economy weakens, like other segments of retail, the auto industry tends to suffer.

"Demand for new cars tends to weaken when the economy slows and car manufacturers offer more incentives in order to move inventory off the lot," executives pointed out. "Still, many consumers may prefer to purchase used cars because prices tend to decline when the economy slows."

Moreover, officials said, "The growth of Internet-based used-car Web sites, like CarMax, which offer certified pre-owned vehicles, make it much easier for consumers to shop for reliable used vehicles without dealing with ‘notorious' used-car salesmen."

Employment Trends versus Demand

Given the necessity of a vehicle for transportation, particularly when it comes to holding down a job, Fitch drew a correlation between sales and the employment marketplace.

"The unemployment rate has been relatively low from a historical perspective in recent years, and auto loan credit metrics have been relatively consistent," the company noted.

However, based on Fitch's Auto ABS Annualized Net Loss Index, prime and subprime losses bottomed out at 0.52 percent in June 2006 and 3.27 percent in May 2006, respectively.

The ratings firm went on to point out that the employment rate jumped 30 basis points in December 2007, hitting 5 percent. Officials said this is the highest rate in two years.

The prime and subprime loss index worsened further to 1.34 percent and 7.56 percent in December, respectively, from 0.83 percent and 6.60 percent for the same period in 2006.

"Signs of continued weakness in the economy will pressure consumers further, and Fitch believes prime and subprime auto losses could increase above 2 percent and 11 percent, respectively, in 2008," analysts indicated.

Recovery Rates, Repos

Discussing recovery rates for repossessions, the company said, "Fitch anticipates pressure on used-car values seen in 2002/2003. Pressure on used-car values were particularly high around that time, as rental car companies like Avis Budget and Hertz de-fleeted following the drop in airline travel after the terrorist attacks of Sept. 11, and the used-car market was flooded with increased supply from a large volume of maturing leases.

"Lease volume is materially lower today and rental car companies continue to expect some modest level of enplanement growth in 2008," Fitch continued.   

Also affecting recovery rates are losses on contracts longer than traditional lengths.

"Gone are the days when the standard auto contract lasted 36 to 60 months. Competition in the industry has significantly lengthened the average term of an auto loan," Fitch stated. "A 72-month contract has become an industry standard, and some lenders are extending terms as far as 84 months.

Citing data from the National Auto Dealers Association, the company said average maturity for a new-vehicle loan was 62.3 months in 2006, up from 52.7 months in 1999.

Basically, Fitch noted that longer loan terms mean it takes longer to repay the principal.

"Therefore, in the case of repossession and disposal in the auction market, the dollar recovery as a percent of the unpaid principal balance is naturally lower. Therefore, Fitch expects lenders with a greater proportion of 72-month loans to experience higher loss rates and more profitability pressure," officials wrote.

Re-Aging Delinquent Accounts

Another interesting trend the company touched upon is "re-aging delinquent accounts." This means that in an effort to postpone account losses, finance companies reset account status to current without collecting principal, interest and fees that are contractually due.

"AmeriCredit, for example, at times, will offer payment deferrals, which allow the consumer to move up to two delinquent payments to the end of the loan for a fee, which typically equates to the interest portion of the payment deferred, depending on state law," officials explained.

"Approximately 50 percent of accounts historically comprising AmeriCredit's managed portfolio received a deferral at some point in the life of the account," executives added. "While Fitch believes re-aging understates the delinquency levels, it can be an effective collections tool."

The company noted that regulated banks can not use this option as much as non-regulated lenders due to FFIEC re-aging guidelines.

Funding for Companies

According to Fitch, auto ABS issuance volume came in at $75.1 billion in 2007, down 20.6 percent from 2006. Officials also indicated that last year's figure was 35.4 percent below the peak of $116.2 billion in 2005.

"In terms of number of deals, issuance volume declined to 74 deals in 2007, compared to 87 deals completed in 2006," the company stated. "Prime auto loans continue to dominate the market at about 48 percent of total issuance in 2007, but auto lease/rental issuance accounted for 12 percent of the market, up 5 percent from the prior year."

Additionally, Fitch reported that the Big 3 accounted for almost 30 percent of ABS issuance volume last year. As for foreign captives, they garnered about 13 percent. The remaining portion by banks and independents was backed by prime assets (32 percent) and non-prime assets (25 percent).

As for non-captives, officials reported, "In addition to ABS debt, auto lenders often used deposits and corporate debt to fund their portfolios. Fitch believes deposit funding, which is more common with the non-captive lenders, is a relatively inexpensive, stable source of financing and has been used increasingly in recent years as other sources of funding have become more expensive."


Fitch indicated that on the domestic side, Ford Motor Credit and GMAC have the largest U.S. retail portfolios, coming in at $55.8 billion and $49.8 billion, respectively. However, as noted earlier, foreign captives' portfolios are climbing.

"The portfolios of domestic captives have been steadily shrinking since 2003, while the foreign captives have been growing at a double-digit clip, which speaks to the financial strength of the parent and the relative demand for vehicles from certain manufacturers. (GMAC's portfolio size is impacted by whole-loan transactions,)" executives explained.

"Toyota has the largest portfolio of the foreign captives at $38.9 billion, while Honda has grown at the fastest pace, with a compound annual growth rate of 20.7 percent since 2002," officials continued. "Portfolio growth in 2008 will be linked to the health of the economy and the consumer, and the relative performance of parent manufacturers."

The company said that overall net charge-off ratios were relatively stable for the last few years; however, Ford Credit received a special nod as it has "made significant improvement in portfolio performance since 2003."

Net charge-offs declined to 0.64 percent for the nine-month period ended Sept. 30, 2007, compared with 1.91 percent in 2003 thanks to Ford Credit reducing its subprime risk, Fitch highlighted.

"Fitch believes the company has been less aggressive on lengthening loan terms, which contributes to higher loss severity," the report said. "The decline in net charge-offs is even more noteworthy given the shrinking receivables portfolio, which would tend to skew the metric up.

"Honda has the best relative credit quality, with net charge-offs averaging 0.47 percent over the past six years, followed by Toyota hovering around 0.69 percent. The remaining lenders report losses near 1 percent," the company continued.

Continuing on, Fitch indicated that while delinquency rates of 30 days or more are slightly different by lender, they tend to average about 2.25 percent. The only exception to this is Honda, which posted delinquencies of 1.3 percent as of Sept. 30, 2007.

"Nissan and GMAC have the highest 30-day rates at 2.64 percent and 2.52 percent, respectively," analysts wrote.

On the other hand, Fitch said "Delinquency rates of 60 days or more do not necessarily line up with actual credit losses, which could speak to the quality of company collection practices. Toyota, for instance, has the highest average 60-day delinquency rate at 0.64 percent, but reports some of the lowest credit losses."

Fitch also indicated that captive lenders have seen delinquency growth in 2007, with the majority of credit metrics coming in above six-year averages. This is, of course, due to the weakened economy, according to the ratings firm.

"Some captive auto lenders repossess vehicles on delinquent accounts when they become 60 days or more past due, while non-captives may wait a little longer," officials explained.

"Recovery rates are dependent upon vehicle type, car condition and used-vehicle pricing levels in the wholesale vehicle market," the company noted. "Repossession levels at the large captives were generally flat in 2007, compared to 2006 levels; but Fitch believes rising delinquencies will translate into higher repossession activity and ultimately losses."

Breaking it down, the company said Nissan and GMAC have the highest 30-day delinquency rates and the highest repossession rates.

As for floor planning, Fitch indicated that captives with large floor-plan portfolios usually show better consolidated credit metrics, as this type of loan generally posts low loss rates.

"This is because the loans are well secured and because the dealership strives to maintain a good relationship with the manufacturer supplying its inventory," analysts explained.

"Still, Fitch believes loss rates on wholesale financing may begin to tick up as dealership profits fall."


Basically, Fitch reiterated its point that the auto finance industry is extremely competitive across all credit borders.

"As a result, the development of economies of scale can serve as a significant competitive advantage," the company stated. "Many of the non-captive lenders have increasingly focused on cost-containment in recent years in an effort to boost bottom lines. Operating expenses as a percentage of managed receivables is one metric Fitch uses to analyze a lender's efficiency."

Looking at this measurement, Fitch found that Capital One Auto Finance is the most improved, declining from 3.43 percent in 2004 to 2.46 percent last year.

"Fitch views its efficiency positive; however, the cost cuts to date indicate that the company's ability to return the auto segment to profitability will be more dependent on credit quality improvement than COF's ability to further reduce expenses," officials wrote.

Meanwhile, J.P. Morgan Chase & Co. (Chase Auto Finance) is the most efficient, according to Fitch's report. This is even though its ratio has increased a bit in recent years.

"Still, as discussed the assignment of costs has some management discretion," executives indicated.

Moreover, the company said AmeriCredit's operating efficiency has remained fairly consistent throughout the years, with operating expenses, minus lease depreciation, coming in at 2.51 percent of managed receivables for its last fiscal year.


Looking ahead to the rest of 2008, Fitch noted that the U.S. auto finance industry has some work ahead of it.

"As with other consumer asset classes, the auto finance business will face some significant road work in 2008," the report indicated. "A weakening economy, rising unemployment, geographic weakness, residential mortgage spillover and a highly leveraged consumer, all pressured credit metrics of U.S. auto lenders in the second half of 2007.

"Fitch believes the same headwinds will lead to further asset quality deterioration in 2008, and the industry's relatively recent push into 72-month loans is expected to increase loss severities relative to other cyclical downturns," officials wrote.