July 2010      Non-prime auto        underwriting: Evolving for a                      changing marketAt a glanceAs the ec...
At the wheelPreparing for the future of automotive financeAs the economy begins its slow recovery, automotive financecompa...
Nonprime auto underwriting: Evolving for a changing marketWhy auto lenders should supplement their traditionalunderwriting...
Nonprime auto underwriting: Evolving for a changing market      they make sound credit decisions                       Als...
Nonprime auto underwriting: Evolving for a changing marketAlso referred to as         Consider the following example of   ...
Nonprime auto underwriting: Evolving for a changing market      Why is this? As a consumer                             Fig...
Nonprime auto underwriting: Evolving for a changing marketConducting applicant interviews is a practiceused by leading com...
Nonprime auto underwriting: Evolving for a changing market      Using the interview to help                            Inc...
Nonprime auto underwriting: Evolving for a changing marketAnother component of credit            Spend part of the meeting...
Nonprime auto underwriting: Evolving for a changing market      Subjective analysis could help auto lenders get a leg     ...
www.pwc.comFor more information, please contact:Michael StorkPricewaterhouseCoopersPhone: (612) 596-6407Email: michael.sto...
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Non prime-auto-underwriting

  1. 1. July 2010 Non-prime auto underwriting: Evolving for a changing marketAt a glanceAs the economy displaces many With the current and expected Incorporating subjective analysisformerly-prime borrowers into future growth of the non-prime into the credit decision processnon-prime status, the trans- segment, lenders should helps identify creditworthyformation may challenge current develop processes to borrowers, and can provideunderwriting methodologies determine non-prime a competitive advantage borrowers’ creditworthiness pwc
  2. 2. At the wheelPreparing for the future of automotive financeAs the economy begins its slow recovery, automotive financecompanies now face a new business landscape. To helpnavigate this challenging and sometimes unfamiliar road,PricewaterhouseCoopers is publishing a series of papersthat will explore important topics affecting the industry nowand in the future.In our latest paper, we discuss how the economic crisisleft behind a large and growing segment of non-primeborrowers — a key constituency for many auto lenders.Yet traditional underwriting alone is not a reliable indicatorof creditworthiness for these borrowers whose newly-blemished credit reports may not translate into a significantlyelevated or longer-term credit risk. This paper explores howlenders can develop a more nuanced credit decision processto identify which non-prime borrowers align with their risktolerance parameters.For more information, please contact any of the individualslisted at the back of the publication.
  3. 3. Nonprime auto underwriting: Evolving for a changing marketWhy auto lenders should supplement their traditionalunderwriting processes to capture the growingnon-prime market.The heart of the matter 10 percent over the same period The economic crisis did not change in 2008, and comprised almost the fact that non-prime customersIgnoring the growing non- 64 percent of new and used vehicle are a key constituency for many autoprime market could be costly, financing1. (See Figure 1.) lenders, and one that they cannotbut business as usual is not ignore. Doing so would significantlythe answer Indeed, lending to those with limit most lenders’ client base. But spotless payment histories, it also would overlook the new cropAs the economy takes its early steps long-term employment, and of non-prime borrowers who havetoward recovery, businesses are attractive FICO scores represents emerged as a result of the economicapproaching the future with cautious the antithesis of the events that crisis—potential customers whoseoptimism. Many auto finance preceded the economic crisis. newly-blemished credit reports maycompanies have shifted their lending But while auto finance lenders are not translate into a significantlystrategies, heavily targeting prime vying to attract prime and super- elevated or longer-term credit risk.and near-prime borrower markets as prime customers, the economyan answer to the lending practices has significantly reduced the size Yet the question remains: How dothat contributed to the economic of this customer base, creating lenders pursue non-prime borrowersmeltdown. In the fourth quarter intense competition for a dwindling without repeating the mistakes ofof 2009, super-prime and prime customer pool. the past? Furthermore, how doauto lending was up more thanFigure 1: New and used vehicle financing by credit tierVehicle Financing by Credit Tier Change in Vehicle Financing from 4Q2008 100% 15% 14.48 13.62 11.29 12.77 17.84 90% 10.55 10% 13.20 11.63 11.31 80% 12.38 12.15 12.34 70% 5% 10.08 13.35 12.50 12.15 0.04 13.29 60% 0% 13.19 13.30 13.29 12.48 50% -7.53 40% -5% -11.83 -14.32 30% -10% 49.06 52.71 50.28 45.68 45.15 20% -15% 10% 0% -20% 4Q2008 1Q2009 2Q2009 3Q2009 4Q2009 Super-prime Prime Non-prime Sub-prime Deep Sub-primeSource: Experian AutomotiveExperian Information Solutions, Inc., State of the Automotive Finance Market 2009 Year-End Review, 2010.1 PricewaterhouseCoopers 3
  4. 4. Nonprime auto underwriting: Evolving for a changing market they make sound credit decisions Also referred to as subjective Lenders should when the struggling economy has analysis, the practice of incorporating displaced so many applicants? variables outside of traditional consider supplementing Yesterday’s traditional, automated underwriting techniques helps their underwriting lenders reduce the degree of underwriting techniques have uncertainty surrounding an methods and factor in become outdated for many non-prime borrowers. Instead, applicant’s derogatory credit history components beyond the by uncovering missing data or lenders may need to develop clarifying ambiguous information credit score to ascertain a more nuanced decision- making process that is capable from a credit report. To obtain which non-prime subjective data, credit analysts of identifying creditworthy non- conduct a short applicant interview borrowers are prime customers who align to their risk tolerance parameters. to uncover missing default dates truly creditworthy. or to inquire if the applicant made This can be accomplished by payment arrangements on defaulted including subjective analysis in credit lines once they were back on the credit decision process; that their feet. By focusing on the dates is, interviewing applicants to help and events that were the cause of decipher unclear or ambiguous the derogatory credit rather than on information found in their credit the derogatory credit itself, analysts report, and factoring this in to the are better able to formulate a picture overall credit decision. of the applicant’s financial character and determine their future willingness An in depth discussion and ability to repay their debt. Subjective analysis, In addition to the character deconstructed assessment, the subjective analysis The unprecedented economic would examine whether the event(s) events of the last several years that caused the derogatory credit left behind a large and growing are over and if enough time has segment of automotive customers elapsed for the applicant to have for whom traditional underwriting recovered from their financial alone is no longer a reliable indicator setback. Typically, this separation of their creditworthiness. Because period may involve an objective the economic turmoil impacted measurement or matrix set by the so many, so swiftly, and in some risk department. The remaining cases, unexpectedly, lenders should question is whether the applicant consider supplementing their has the ability to repay, specifically underwriting methods and factor whether they have record of in components beyond the credit employment and income stability score to ascertain which non-prime that is reasonably certain to continue borrowers are truly creditworthy. through the term of the loan.4 PricewaterhouseCoopers
  5. 5. Nonprime auto underwriting: Evolving for a changing marketAlso referred to as Consider the following example of The main tools that lenders have incorporating an applicant interview long relied on to make lendingsubjective analysis, the and subjective analysis into the decisions—risk modeling and creditpractice of incorporating credit decision. An applicant’s credit scores—do not tell the whole story report indicates a recent bankruptcy when it comes to determiningvariables outside of filing and a less than satisfactory whether certain borrowers aretraditional underwriting payment history for the prior year. a viable credit risk. Traditional Before these events, the applicant’s risk models usually focus ontechniques helps lenders credit history was satisfactory and mathematical derivations of anreduce the degree the individual had been employed applicant’s “good” credit to their steadily for many years. During “bad” credit. The problem with thisof uncertainty the applicant interview, the credit approach is that models typicallysurrounding an analyst discovers the reason for concentrate on the effects of the the recent bankruptcy and credit applicant’s credit problem ratherapplicants derogatory problems stem from an unexpected than the cause. Furthermore, solelycredit history. layoff. Furthermore, the analyst relying on automated scorecards is learns the applicant has been no longer a viable option in many re-employed in the same line of cases because the economic work. With the information obtained downturn left little historical data to during the interview, the analyst create accurate scorecard models. can now consider that the applicant experienced a one-time, temporary Credit reports present another set of setback that blemished their challenges. Analyzing a less-than- otherwise clean credit history. With perfect credit report is significantly the appropriate risk-based pricing, more difficult today than just a this applicant could prove to be a few years ago. A prime or near- valuable customer. prime applicant’s credit report is fairly straight forward and provides Subjective analysis helps lenders an accurate, often indisputable navigate the gray area, where indication of a customer’s many non-prime borrowers timely payment history. Equally now fall indisputable is the credit report that is so poor that the risk of loss clearly Non-prime lending has always exceeds the lender’s risk tolerance. been more art than science. The However, there is a growing pool economic crisis has only magnified of applicants who fall into a gray this standing. Today, credit area—those whose credit reports decisions for non-prime customers alone may not fully convey their are considerably more complex than payment aptitude. just a few years ago. PricewaterhouseCoopers 5
  6. 6. Nonprime auto underwriting: Evolving for a changing market Why is this? As a consumer Figure 2: Examples of subjective factors experiences financial problems, credit defaults often occur at Factor Applying the factor to the interview and analysis staggered intervals as they make every possible effort to stay afloat. Credit card charge-off Timing and data inconsistencies in reporting to credit The more problem events and was assigned to a third bureaus often result when charged-off accounts are open credit lines a consumer party collection agency routed to third party collection agencies, which can be has, the more difficult it is to sort clarified with an applicant interview. through background information Derogatory utility bills Several utility collections that occurred over multiple to determine the true risk of time periods or that conflict with the applicant’s future default. Compounding the residence history may indicate instability, frequent issues, lenders often do not report moves, and difficulty managing obligations. derogatory credit in a consistent Medical collections Determine whether the medical bills were for the manner. For example, individual applicant or a family member. An applicant’s recent creditors may differ in how they medical bills could impact their ability to work and repay represent bankruptcy activity on a the loan. credit report or in the timeframe for assigning accounts to third-party If applicant has a Inquire whether the mortgage is a conventional 30-year mortgage, is it traditional fixed rate mortgage or an interest-only mortgage that collection agencies. The challenge or non-traditional the applicant may potentially have to refinance. for the credit analyst is to ascertain the timing of the event that led to Residence history/ Obtain a verifiable rental history with an apartment the borrower’s initial default. By Re-established credit complex or property management company as the time an account is seriously re-established credit. delinquent or charged off, this Auto insurance A satisfactory history of maintaining verifiable, full- becomes significantly more difficult, coverage auto insurance will strengthen the transaction due to the lack of data captured on and provide insight into the applicant’s willingness to the credit report. Figure 2 provides follow through with a contractual obligation. a sampling of subjective factors that Type of collateral Consider whether the collateral fits the applicant’s analysts may consider during the profile. Determine if the applicant has enough credit approval process. discretionary income to afford repairs for older vehicles, or to afford gas for larger vehicles. Incorporating subjective information into the credit decision-making process enables lenders to fill in the gaps and clear up questions that the risk model and credit report leaves, resulting in greater clarity regarding applicants’ creditworthiness.6 PricewaterhouseCoopers
  7. 7. Nonprime auto underwriting: Evolving for a changing marketConducting applicant interviews is a practiceused by leading companies to gather subjectivedata for credit decisions. The applicant interview, a new Scale the interview process for paradigm in the credit process maximum return Conducting applicant interviews is a Lenders can incorporate interviews practice used by leading companies into existing procedures so that to gather subjective data for credit they are not cost prohibitive and decisions. The interview is usually labor intensive. The interview conducted by phone and enables process should be relatively quick. the analyst to gather missing Interviews typically should last only data, clarify discrepancies, and a few minutes on average, which obtain supplemental information is sufficient time to gather the to help analyze a borrower’s credit necessary information. The applicant risk. Almost as important as the interview, when implemented information the applicant conveys appropriately, will add value, not during the interview is the analyst’s detract from it. ability to interpret how the applicant interacts. The goal is a two-way Limiting interviews to borrower dialogue, an open conversation segments that did not perform as in which the applicant is not expected can be a useful tactic. just answering questions, but is For example, scorecard data might explaining the context around their indicate a particular FICO band’s financial history with authenticity performance deviates from their and sincerity. expected performance by a greater The interview also serves as the first, margin than other FICO bands. It is and hopefully only, collection call. reasonable to strive for a It gives the analyst the opportunity 50 percent interview rate for to set repayment expectations this outlier segment. In four to with the potential customer, six months, you can revisit the review communication policies, scorecard data to measure the and discuss the need to maintain success rate of the interviews acceptable insurance coverage. and subjective analysis. PricewaterhouseCoopers 7
  8. 8. Nonprime auto underwriting: Evolving for a changing market Using the interview to help Incorporating subjective analysis fight fraud requires training and fine tuning An additional benefit of the Train analysts and underwriters applicant interview is its ability to serve as a fraud check. It affords Performing an interview, deciphering the analyst an opportunity to credit reports, and incorporating ascertain whether the transaction additional analysis into the is accurately represented. For credit review process will require example, the analyst should training. Analysts should learn question any inconsistencies which questions to ask and when. between the application and the Once the applicant information credit report, such as a discrepancy is gathered, they must retool in an applicant’s employment or their methodology to incorporate residence history. subjective analysis into their decision-making process. It is As an added fraud prevention important to note that the customer measure, analysts may consider interview is not intended to skirt the the overall reasonableness of the parameters of a lender’s established transaction, including the collateral, risk tolerance. Instead, it is a tool during the interview process. In this that lenders can use to help make context, the analyst can look beyond sound decisions for “on the fence” the applicant’s financial information deals, ultimately benefiting the for signs of potential fraud. For company while staying in line with example, is the potential borrower its risk guidelines. a single individual who already owns one or more cars? If so, this The analyst training should cover should prompt a question from the how to apply judgment to ask analyst. If the applicant is taking relevant and appropriate questions out a loan on behalf of an individual during interviews. When applying who isn’t creditworthy, that could subjective analysis, lenders be a potential red flag. When must apply sufficient policies, lenders establish a track record of procedures, and controls to looking beyond the financial factors comply with Regulation B-Equal of a transaction, dealers are less Credit Opportunity. likely to attempt to push through fraudulent transactions.8 PricewaterhouseCoopers
  9. 9. Nonprime auto underwriting: Evolving for a changing marketAnother component of credit Spend part of the meeting reviewingtraining should teach analysts credit decisions that did not benefithow to effectively communicate the company. Look at decisionscredit decisions to their dealers made within the previous yearand educate their dealer body that resulted in delinquencies oron their loan programs. During repossessions. Ask whether therethese times of increased lender was something in the customer’scompetition, it is more important portfolio that should have been a redthan ever for analysts to provide flag. Finally, examine these mistakesincremental value to their dealer. from a higher vantage point andIf an applicant is rejected or a determine if there are trends thattransaction is significantly scaled warrant a procedural change.back, the analyst must be preparedto communicate an explanation to What this means forthe dealer beyond a restatement your businessof the applicant’s credit score.When the analyst is knowledgeable In today’s competitive market,about the components that drive subjective analysis gives lendersa credit decision, they can have an edgea deeper conversation with the Conversations with prospectivedealer, in turn helping to develop a borrowers can help creditstronger relationship. analysts gain meaningful insight about the unclear or uncertainFine tune the process elements of their credit history. Portfolio delinquency and lossTo help strengthen the credit performance can improve as creditapproval process, analysts should analysts are able to make morehold regular meetings to review informed credit decisions and seta sampling of loan decisions, repayment expectations with theexamining why they made the prospective borrower.decision, whether any informationwas missed, and what they couldhave done differently to strengthenthe transaction. PricewaterhouseCoopers 9
  10. 10. Nonprime auto underwriting: Evolving for a changing market Subjective analysis could help auto lenders get a leg up in an intensely competitive market. Additionally, subjective criteria To some degree, a dealer must be can serve as an enhancement to able to predict a lender’s decision. the lender’s risk-based pricing Most customers shop for cars strategy. Lenders have traditionally outside of normal business hours. employed this strategy to gain The dealer’s ability to understand leverage by pricing the loan or loan a lender’s program will allow them pool according to its relative risk. to structure a transaction that Subjective analysis can improve is appropriate for the lender’s the lender’s overall credit risk guidelines. This could result in fewer management platform by providing restructurings, leading to increased additional data points to use in the dealer loyalty and satisfaction, analysis and fine tuning of future greater customer satisfaction, and risk models. higher contract capture rates. Elevating credit analysts’ knowledge Most importantly, subjective analysis and confidence will help increase could help auto lenders get a leg up lender transparency with dealers, in an intensely competitive market. auditors, and independent third Lenders cannot afford to disregard parties. This, in turn, strengthens the non-prime borrowers, nor can they important lender-dealer relationship. move forward using the same credit Over time, increased transparency procedures that existed prior to the could help reduce the cost of economic crisis. Leading companies application processing because are incorporating subjective dealers, with more knowledge criteria via applicant interviews to about the criteria used to make help determine which non-prime credit decisions, will be less likely to borrowers fit their risk management submit an application when it clearly parameters. To incorporate these falls outside of a lender’s credit changes, lenders should adopt a approval parameters. And in today’s specific, deliberate, and results- environment where transparency oriented approach. Market forces has been elevated from a buzzword are moving too fast to warrant an to a business imperative, increased experimental posture. After all, the visibility is no longer an option. competition will not wait.10 PricewaterhouseCoopers
  11. 11. www.pwc.comFor more information, please contact:Michael StorkPricewaterhouseCoopersPhone: (612) 596-6407Email: michael.stork@us.pwc.comBryan IgnozziPricewaterhouseCoopersPhone: (415) 498-6346Email: bryan.ignozzi@us.pwc.comManoj KashyapPricewaterhouseCoopersPhone: (213) 356-6344Email: manoj.k.kashyap@us.pwc.comPeter PolliniPricewaterhouseCoopersPhone: (617) 530-7408Email: peter.c.pollini@us.pwc.comMartin TouheyPricewaterhouseCoopersPhone: (617) 530-7447Email: martin.e.touhey@us.pwc.comDoug EkizianPricewaterhouseCoopersPhone: (949) 437-5454Email: douglas.c.ekizian@us.pwc.comCraig LeveringPricewaterhouseCoopersPhone: (512) 867-8703Email: craig.levering@us.pwc.com© 2010 PricewaterhouseCoopers LLP. All rights reserved. “PricewaterhouseCoopers” refers to PricewaterhouseCoopers LLP,a Delaware limited liability partnership, or, as the context requires, the PricewaterhouseCoopers global network or other memberfirms of the network, each of which is a separate and independent legal entity. This document is for general information purposesonly, and should not be used as a substitute for consultation with professional advisors. MW-11-0002.

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