As a follow up to our Saturday post on the record number of negative equity or “underwater” used car trade-ins, (see: “It Just Gets Worse And Worse”: A Record 32% Of Used Car Trade-Ins Are Underwater”), we present an article submitted by auto industry strategist Daniel Ruiz, who explains what the current state of used car prices, and stretched loan terms, tell us about the real state of the economy.
Time to Equity
My approach to analysis consists of starting with a specific sector of the auto industry then peeling back one layer at a time until I truly understand how it works. More often than not, I find used vehicle values staring back at me by the time I get to the core of various sectors. This is why I’ve said many times that used vehicle values are the foundation for the entire auto industry. I’ve devoted a lot of time and effort in the search for data to support this theory.
I knew that if successful, I could use that data to better understand the cyclical nature of the industry and to more accurately predict future performance. I now feel very confident that I’ve found what I was searching for. I’ll start with a quick recap for those that are unfamiliar with my work.
Why Used Vehicle Values?
I believe that only jobs and credit are more important than used vehicle to the health of the automotive industry. I say this because 86% of new-vehicle sales are financed, and under normal conditions, those vehicles are traded within three years.
Knowing that most car loans have a 60-72 month duration, we can assume that the majority of vehicles traded at the 3-year mark are not paid off. The level of equity in these loans directly affects consumer behavior and in large part determines when the vehicle will be traded for another new vehicle. The frequency, with which this very large group of consumers replaces their vehicles has a direct impact on new-vehicle sales velocity.
The Search For Evidence
I thought to myself, the theory sounds good, it makes sense, I’ve seen it in action many times throughout my career in retail automotive sales, but is there any evidence out there to support it? To find this evidence, I knew that I would have to figure out a way to measure equity on new vehicle loans at the 3-year mark. So how do I do that? Well, I started by constructing loans using average new vehicle transaction prices, average interest rates and average loan terms for each year going far back as I could. I then took that information and plugged it into an amortization calculator. But there was one still one missing piece, the average value of 3-year-old used vehicles (Luckily I know someone who’s a bit of an expert on that subject). After many hours of research and brainstorming, I developed a formula that very accurately measures the historical value of 3-year-old vehicles. I then went back to the amortization chart, compared the principal balance owed at 36 months to the average value of a 3-year-old vehicle for each calendar year and PRESTO! I had my answer to the equity question. From that point, a little further analysis was necessary to find the month in which the value of the vehicle exceeded the principal balance owed on the loans. The end result is what I will refer to from now on as time to equity.
Does Time To Equity Impact The Performance Of Auto Loans?
While discussing my theory about used vehicle values and how they affect the health of the auto industry, I couldn’t help but notice the growing concerns about subprime auto loan delinquencies. I began to wonder if the value of the asset which backs the loans might have some thing to do with it. So I decided to compare subprime delinquencies at auto finance companies to my time to equity calculations. The results were encouraging to say the least.
As a general rule, the longer the loan, the higher the risk of default, since the ability of the borrower to repay the is more likely to change. However, when one takes into consideration that few auto loans are held till maturity, I think it’s fair to say that time to equity is more relevant to risk than than the length of the loan. So what’s most capable of changing how long a loan reaches equity? You guessed it, used vehicle values.
Aside from credit worthiness and employment status, auto lenders rely mostly on LTV ratios and maturity variations to measure risk. However, little attention is given to the performance of the asset that backs the loans. In my opinion, this leads to reactive lending behavior with a tendency to tighten credit standards when risk is at its lowest and to loosen when risk is at its highest.
Perhaps some good used vehicle value analysis could be of value…
Higher Prices Come With Consequences
Time to Equity is affected by more than used vehicle values. The ever-increasing price of new and used vehicles has forced consumers to extend their loan terms to all-time highs in order to afford their monthly payments. Extending the length of a loan slows down the rate at which the principal balance is payed down and therefore increases the time to equity. Here’s a look at what’s to come:
Could Credit Scores Provide Further Clues And Tie It All Together?
I want to be very clear that what I say next is an observation of behavior and not an attack on people with poor credit scores. I am well aware that bad things happen to good people (job loss, illness, etc) and a bad credit score can be the unexpected result. With that said, the data clearly shows that borrowers with credit scores <620 tend to be less responsible than those with higher credit scores.
The longer it takes borrowers with credit scores <620 to reach an equitable position on their auto loans, the higher the risk of default. On the other hand, the borrowers with higher credit scores don’t tend to default on their loans when it takes longer to reach an equitable position; they keep their vehicles longer which slows new-vehicle sales velocity.
In simple terms:
- Less Time to Equity = Lower Credit Risk and a Faster Velocity of New-Vehicle Sales.
- More Time to Equity = Higher Credit Risk and a Slower Velocity of New-Vehicle Sales.
I hope this article was helpful. As always, thank you for your time and consideration.