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Whenever an industry encounters problems, the natural tendency is to play the blame game. In the banking industry, credit risk managers are looking for who or what to blame for the tide of charge offs and delinquencies in their under-performing loan portfolios and in their commercial loan origination operations. Credit scoring has definitely taken it on the chin as an easy target during 2008. Is credit scoring the problem? Absolutely not! As with anything, the more complacent we become…and the more we “turn off our brains” and stop thinking…the more risk we assume. The more we solely rely upon the credit score alone, the more we subject ourselves to the risks inherent in “score and go” lending. We are all well aware that credit scoring measures propensity to repay and not capacity to repay. Over the past several years, the propensity to repay has been boosted by ever-increasing real estate values and by the refinance boom. For example, some consumers have been able to survive on a 50 percent debt–to- income due to constant use of credit cards …by paying off those cards with a home mortgage refinance. That set of behaviors would have shown a propensity to repay…but was it ever acceptable to have 50 percent of your income go to debt payments?! Statistically it may have worked for a few years, but once real estate values stopped escalating, the problem with lack of capacity to repay reared its ugly head. When it comes to risk management, let’s get back to reality and sound principles.
By: Tom Hannagan In my last post, I addressed the need for banks to advance their management of risk to include the relationship between capital and risk in their internal decisions and actions. While it is difficult for me to make this topic very exciting, it can’t be ignored. It very nearly resulted in bankrupting the global financial system. Beyond profitability, bank executives must measure and monitor their risk-based capital because: 1) equity capital represents the ownership interest in a bank; 2) equity capital is by far the most expensive source of funding; and 3) the risk associated with capital sufficiency and continued solvency is important. As Colonel Jessup might confirm, “Yes, we’re talking about mortal danger”. Many are scrambling to apply for the TARP (Troubled Asset Relief Program) capital infusion – and most are getting approved for these windfall funds. (Today’s investment advice from the experts: don’t buy common shares in any bank that applied and was turned down.) Let’s take a look at the impact of these funds. If we were, for example, a $10 billion total asset bank, with say $800 million in equity capital prior to TARP and had roughly $700 million in risk-weighted assets, we might get approved for $200 million in TARP-related preferred shares at a cost of 5 percent (after tax) for the next five years. If, our make believe $10 billion bank was earning an average pre-2008 economic-and-credit-crisis return on assets of 1 percent, or $100 million per annum, what are the implications of the added $200 million in capital on future earnings? That $100 million in “pre-crisis” earnings represented a return on equity of 12.5 percent on our original capital of $800 million. (Stay with me, now…) Since we need to pay the Feds (our new shareholders) $10 million in preferred dividends per annum in after-tax money, we need to earn an added $16 million in pre-tax operating income just to break even on the deal. That would mean, in our otherwise static model, that earnings need to move from $100 million to $110 million. More importantly, pre-tax income needs to move from say $150 million to $166 million, assuming about a 33 percent effective tax rate. We’ve got the fresh $200 million to work with, assuming we don’t need part of it to cover credit charge-offs or other asset write-downs. To earn $16 million from that $200 million investment, we would need an 8 percent pre-tax operating income (that’s after expenses, folks). I’m open to suggestions at this point…And you thought banking was easy. You do that the old fashion way — with leverage. You use the $200 million to get someone (depositors, the Federal Home Loan Bank, a Federal Reserve Bank, or anyone else) to give you more money to invest (at a critically important tax-deductible cost) along with your fresh $200 million in preferred equity. Remember, our bank is already operating with leverage, supporting $7 billion in risk-weighted assets, and $10 billion in total assets, with the pre-existing $800 million in capital. Unfortunately, leverage involves at least liquidity risk, and probably market risk — on top of whatever direct (credit, market, operational) risks are associated with whatever end investment you choose (…and the Feds hope you choose loans). Obviously, the fastest way to get the added leverage, along with a quick addition to earnings assets, is to go buy another bank (and absorb them more successfully than the two of you ran separately). Thus, a new round of consolidation has begun. Regardless of the method used to grow into the TARP money, any bank that doesn’t take into account the risks associated with these decisions/actions is merely kidding itself. TARP funding will not make any real headway in improving risk-adjusted earnings going forward. There is (and always has been) a direct relationship between actual risk and risk-adjusted return. It is now more important than ever for bank management to monitor and measure their organization’s activities (loan pricing and profitability, investing, deposit taking, investment management, credit risk modeling, buying other banks…and anything else they do) based on the relative risk of those activities and based on the equity capital realistically required to support those risks. This means using return on equity measurement internally as well as at the entity level. I look forward to your comments.
By: Tom Hannagan Much of the blame for the credit disaster of 2007 and 2008 has been laid at the risk management desks of the largest banks. A silver lining in the historic financial disaster of today may be the new level of interest in management of risk — particularly, of the relationship between capital and risk. Financial institutions of all sizes must measure and monitor their risk-based capital for three critical reasons. Ownership interest First, equity capital represents the ownership interest in a bank. Although a relatively small portion of the balance sheet, equity capital is the part that actually belongs to a bank’s owners. Everything else on the liability side is owed to depositors or lenders. All of the bank’s activities and assets are levered against the funds contributed by the equity investors. This leverage is roughly 10-to-1 for most commercial banks in the United States. For the five major investment banks, this risk-based leverage reached 30-to-1. Their capital base, even with new infusions, could not cover their losses. It is necessary and just good business sense to regularly let the owners know what’s going on as it relates to their piece of the pie—their invested funds. Owners want to know the bank is doing things well with their at-risk funds. Banks have a duty to tell them. Funding expenses Second, equity capital is by far the most expensive source of all funding. Transaction deposit funds are usually paid an effective rate of interest that is lower than short-to-intermediate-term market rates. Time depositors are competitively paid as little as possible based on the term and size of their commitment of funds. Most banks are able to borrow overnight funds at short-term market rates and longer-term funds at relatively economical AA or A ratings. Equity holders, however, have historically received (and typically expect) substantially more in the way of return on investment. Their total returns, including dividends, buybacks and enhanced market value, are usually double to triple the cost of other intermediate-to-long-term sources of funds. From a cost perspective, equity capital is the dearest funding the bank will ever obtain. Risk factor This brings us to the third reason for measuring and monitoring capital: the risk factor. A very large portion of banking regulation focuses on capital sufficiency because it directly affects a bank’s (and the banking industry’s) continued solvency. Equity capital is the last element of cushion that protects the bank from insolvency. Although it is relatively expensive, sufficient equity capital is absolutely required to start a bank and necessary to keep the bank in good stead with regulators, customers and others. Equity holders are usually conscious of the fact that they are last in line in the event of liquidation. There is no Federal Deposit Insurance Corporation (FDIC) for them, no specific assets earmarked to back their funding and no seniority associated with their invested money. We all know what “last in line” means for most shareholders if a failure occurs — 100 percent loss. There is a clear and direct relationship between equity risk and cost—and between equity risk and expected return. It is now more important for bank executives to monitor and measure their organization’s activities based on the relative risk of those activities and based on the equity capital required to support those risks. This means using return on equity (ROE) a lot more and return on assets (ROA) a lot less. Because of the critical need and high cost of risk-based equity and the various risks associated with the business of banking, decisions about the effective deployment of capital always have been the primary responsibility of bank leaders. Now, the rest of the world is focusing more on how well, or poorly, management of risk has been done. I’ll comment on using ROE more in later posts.
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With the National Automobile Dealers Association (NADA) Show set to kickoff later this week, it seemed fitting to explore how the shifting dynamics of the used vehicle market might impact dealers and buyers over the coming year. Shedding light on some of the registration and finance trends, as well as purchasing behaviors, can help dealers and manufacturers stay ahead of the curve. And just like that, the Special Report: Automotive Consumer Trends Report was born. As I was sifting through the data, one of the trends that stood out to me was the neck-and-neck race between Millennials and Gen X for supremacy in the used vehicle market. Five years ago, in 2019, Millennials were responsible for 33.3% of used retail registrations, followed by Gen X (29.5%) and Baby Boomers (26.8%). Since then, Baby Boomers have gradually fallen off, and Gen X continues to close the already minuscule gap. Through October 2024, Millennials accounted for 31.6%, while Gen X accounted for 30.4%. But trends can turn on a dime if the last year offers any indication. Over the last rolling 12 months (October 2023-October 2024), Gen X (31.4%) accounted for the majority of used vehicle registrations compared to Millennials (30.9%). Of course, the data is still close, and what 2025 holds is anyone’s guess, but understanding even the smallest changes in market share and consumer purchasing behaviors can help dealers and manufacturers adapt and navigate the road ahead. Although there are similarities between Millennials and Gen X, there are drastic differences, including motivations and preferences. Dealers and manufacturers should engage them on a generational level. What are they buying? Some of the data might not come as a surprise but it’s a good reminder that consumers are in different phases of life, meaning priorities change. Over the last rolling 12 months, Millennials over-indexed on used vans, accounting for more than one-third of registrations. Meanwhile, Gen X over-indexed on used trucks, making up nearly one-third of registrations, and Gen Z over-indexed on cars (accounting for 17.1% of used car registrations compared to 14.6% of overall used vehicle registrations). This isn’t surprising. Many Millennials have young families and may need extra space and functionality, while Gen Xers might prefer the versatility of the pickup truck—the ability to use it for work and personal use. On the other hand, Gen Zers are still early in their careers and gravitate towards the affordability and efficiency of smaller cars. Interestingly, although used electric vehicles only make up a small portion of used retail registrations (less than 1%), Millennials made up nearly 40% over the last rolling 12 months, followed by Gen X (32.2%) and Baby Boomers (15.8%). The market at a bird’s eye view Pulling back a bit on the used vehicle landscape, over the last rolling 12 months, CUVs/SUVs (38.9%) and cars (36.6%) accounted for the majority of used retail registrations. And nearly nine-in-ten used registrations were non-luxury vehicles. What’s more, ICE vehicles made up 88.5% of used retail registrations over the same period, while alternative-fuel vehicles (not including BEVs) made up 10.7% and electric vehicles made up 0.8%. At the finance level, we’re seeing the market shift ever so slightly. Since the beginning of the pandemic, one of the constant narratives in the industry has been the rising cost of owning a vehicle, both new and used. And while the average loan amount for a used non-luxury vehicle has gone up over the past five years, we’re seeing a gradual decline since 2022. In 2019, the average loan amount was $22,636 and spiked $29,983 in 2022. In 2024, the average loan amount reached $28,895. Much of the decline in average loan amounts can be attributed to the resurgence of new vehicle inventory, which has resulted in lower used values. With new leasing climbing over the past several quarters, we may see more late-model used inventory hit the market in the next few years, which will most certainly impact used financing. The used market moving forward Relying on historical data and trends can help dealers and manufacturers prepare and navigate the road ahead. Used vehicles will always fit the need for shoppers looking for their next vehicle; understanding some market trends will help ensure dealers and manufacturers can be at the forefront of helping those shoppers. For more information on the Special Report: Automotive Consumer Trends Report, visit Experian booth #627 at the NADA Show in New Orleans, January 23-26.
The automotive industry is constantly changing. Shifting consumer demands and preferences, as well as dynamic economic factors, make the need for data-driven insights more important than ever. As we head into the National Automobile Dealers Association (NADA) Show this week, we wanted to explore some of the trends in the used vehicle market in our Special Report: State of the Automotive Finance Market Report. Packed with valuable insights and the latest trends, we’ll take a deep dive into the multi-faceted used vehicle market and better understand how consumers are financing used vehicles. 9+ model years grow Although late-model vehicles tend to represent much of the used vehicle finance market, we were surprised by the gradual growth of 9+ model year (MY) vehicles. In 2019, 9+MY vehicles accounted for 26.6% of the used vehicle sales. Since then, we’ve seen year-over-year growth, culminating with 9+MY vehicles making up a little more than 30% of used vehicle sales in 2024. Perhaps more interesting though, is who is financing these vehicles. Five years ago, prime and super prime borrowers represented 42.5% of 9+MY vehicles, however, in 2024, those consumers accounted for nearly 54% of 9+MY originations. Among the more popular 9+MY segments, CUVs and SUVs comprised 36.9% of sales in 2024, up from 35.2% in 2023, while cars went from 44.3% to 42.9% year-over-year and pickup trucks decreased from 15.9% to 15.6%. 2024 highlights by used vehicle age group To get a better sense of the overall used market, the segments were broken down into three age groups—9+MY, 4-8MY, and current +3MY—and to no surprise, the finance attributes vary widely. While we’ve seen the return of new vehicle inventory drive used vehicle values lower, it could be a sign that consumers are continuing to seek out affordable options that fit their lifestyle. In fact, the average loan amount for a 9+MY vehicle was $19,376 in 2024, compared to $24,198 for a vehicle between 4-8 years old and $32,381 for +3MY vehicle. Plus, more than 55% of 9+MY vehicles have monthly payments under $400. That’s not an insignificant number for people shopping with the monthly payment in mind. In 2024, the average monthly payment for a used vehicle that falls under current+3MY was $608. Meanwhile, 4-8MY vehicles came in at an average monthly payment of $498, and 9+MY vehicles had a $431 monthly payment. Taking a deeper dive into average loan amounts based on specific vehicle types—as of 2024, current +3MY cars came in at $28,721, followed by CUVs/SUVs ($31,589) and pickup trucks ($40,618). As for 4-8MY vehicles, cars came in with a loan amount of $22,013, CUVs/SUVs were at $23,133, and pickup trucks at $31,114. Used 9+MY cars had a loan amount of $19,506, CUVs/SUVs came in at $17,350, and pickup trucks at $22,369. With interest rates remaining top of mind for most consumers as we’ve seen them increase in recent years, understanding the growth from 2019-2024 can give a holistic picture of how the market has shifted over time. For instance, the average interest rate for a used current+3MY vehicle was 8.0% in 2019 and grew to 10.2% in 2024, the average rate for a 4-8MY vehicle went from 10.3% to 12.9%, and the average rate for a 9+MY vehicle increased from 11.4% to 13.8% in the same time frame. Looking ahead to the used vehicle market It’s important for automotive professionals to understand and leverage the data of the used market as it can provide valuable insights into trending consumer behavior and pricing patterns. While we don’t exactly know where the market will stand in a few years—adapting strategies based on historical data and anticipating shifts can help professionals better prepare for both challenges and opportunities in the future. As used vehicles remain a staple piece of the automotive industry, making informed decisions and optimizing inventory management will ensure agility as the market continues to shift. For more information, visit us at the Experian booth (#627) during the NADA Show in New Orleans from January 23-26.
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typesetting, remaining essentially unchanged. It was popularised in the 1960s with the release of Letraset sheets containing Lorem Ipsum passages, and more recently with desktop publishing software like Aldus PageMaker including versions of Lorem Ipsum.