Non prime-auto-underwriting

July 2010

Non-prime auto
underwriting: Evolving for a
changing market

At a glance
As the economy displaces many With the current and expected Incorporating subjective analysis
formerly-prime borrowers into future growth of the non-prime into the credit decision process
non-prime status, the trans- segment, lenders should helps identify creditworthy
formation may challenge current develop processes to borrowers, and can provide
underwriting methodologies determine non-prime a competitive advantage
borrowers’ creditworthiness

pwc

At the wheel
Preparing for the future of automotive finance

As the economy begins its slow recovery, automotive finance
companies now face a new business landscape. To help
navigate this challenging and sometimes unfamiliar road,
PricewaterhouseCoopers is publishing a series of papers
that will explore important topics affecting the industry now
and in the future.
In our latest paper, we discuss how the economic crisis
left behind a large and growing segment of non-prime
borrowers — a key constituency for many auto lenders.
Yet traditional underwriting alone is not a reliable indicator
of creditworthiness for these borrowers whose newly-
blemished credit reports may not translate into a significantly
elevated or longer-term credit risk. This paper explores how
lenders can develop a more nuanced credit decision process
to identify which non-prime borrowers align with their risk
tolerance parameters.
For more information, please contact any of the individuals
listed at the back of the publication.

Nonprime auto underwriting: Evolving for a changing market

Why auto lenders should supplement their traditional
underwriting processes to capture the growing
non-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 customers
Ignoring the growing non- 64 percent of new and used vehicle are a key constituency for many auto
prime market could be costly, financing1. (See Figure 1.) lenders, and one that they cannot
but business as usual is not ignore. Doing so would significantly
the answer Indeed, lending to those with limit most lenders’ client base. But
spotless payment histories, it also would overlook the new crop
As the economy takes its early steps
long-term employment, and of non-prime borrowers who have
toward recovery, businesses are
attractive FICO scores represents emerged as a result of the economic
approaching the future with cautious
the antithesis of the events that crisis—potential customers whose
optimism. Many auto finance
preceded the economic crisis. newly-blemished credit reports may
companies have shifted their lending
But while auto finance lenders are not translate into a significantly
strategies, heavily targeting prime
vying to attract prime and super- elevated or longer-term credit risk.
and near-prime borrower markets as
prime customers, the economy
an answer to the lending practices
has significantly reduced the size Yet the question remains: How do
that contributed to the economic
of this customer base, creating lenders pursue non-prime borrowers
meltdown. In the fourth quarter
intense competition for a dwindling without repeating the mistakes of
of 2009, super-prime and prime
customer pool. the past? Furthermore, how do
auto lending was up more than

Figure 1: New and used vehicle financing by credit tier

Vehicle 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-prime

Source: Experian Automotive

Experian Information Solutions, Inc., State of the Automotive Finance Market 2009 Year-End Review, 2010.
1

PricewaterhouseCoopers 3


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


Also referred to as Consider the following example of The main tools that lenders have
incorporating an applicant interview long relied on to make lending
subjective analysis, the and subjective analysis into the decisions—risk modeling and credit
practice of incorporating credit decision. An applicant’s credit scores—do not tell the whole story
report indicates a recent bankruptcy when it comes to determining
variables outside of filing and a less than satisfactory whether certain borrowers are
traditional underwriting payment history for the prior year. a viable credit risk. Traditional
Before these events, the applicant’s risk models usually focus on
techniques helps lenders credit history was satisfactory and mathematical derivations of an
reduce the degree the individual had been employed applicant’s “good” credit to their
steadily for many years. During “bad” credit. The problem with this
of uncertainty the applicant interview, the credit approach is that models typically
surrounding an analyst discovers the reason for concentrate on the effects of the
the recent bankruptcy and credit applicant’s credit problem rather
applicant's derogatory problems stem from an unexpected than the cause. Furthermore, solely
credit 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.



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.



Conducting applicant interviews is a practice
used by leading companies to gather subjective
data 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.



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.



Another component of credit Spend part of the meeting reviewing
training should teach analysts credit decisions that did not benefit
how to effectively communicate the company. Look at decisions
credit decisions to their dealers made within the previous year
and educate their dealer body that resulted in delinquencies or
on their loan programs. During repossessions. Ask whether there
these times of increased lender was something in the customer’s
competition, it is more important portfolio that should have been a red
than ever for analysts to provide flag. Finally, examine these mistakes
incremental value to their dealer. from a higher vantage point and
If an applicant is rejected or a determine if there are trends that
transaction is significantly scaled warrant a procedural change.
back, the analyst must be prepared
to communicate an explanation to What this means for
the dealer beyond a restatement your business
of the applicant’s credit score.
When the analyst is knowledgeable In today’s competitive market,
about the components that drive subjective analysis gives lenders
a credit decision, they can have an edge
a deeper conversation with the
Conversations with prospective
dealer, in turn helping to develop a
borrowers can help credit
stronger relationship.
analysts gain meaningful insight
about the unclear or uncertain
Fine tune the process elements of their credit history.
Portfolio delinquency and loss
To help strengthen the credit
performance can improve as credit
approval process, analysts should
analysts are able to make more
hold regular meetings to review
informed credit decisions and set
a sampling of loan decisions,
repayment expectations with the
examining why they made the
prospective borrower.
decision, whether any information
was missed, and what they could
have done differently to strengthen
the transaction.



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.


www.pwc.com

For more information, please contact:

Michael Stork
PricewaterhouseCoopers
Phone: (612) 596-6407
Email: michael.stork@us.pwc.com

Bryan Ignozzi
Phone: (415) 498-6346
Email: bryan.ignozzi@us.pwc.com

Manoj Kashyap
Phone: (213) 356-6344
Email: manoj.k.kashyap@us.pwc.com

Peter Pollini
Phone: (617) 530-7408
Email: peter.c.pollini@us.pwc.com

Martin Touhey
Phone: (617) 530-7447
Email: martin.e.touhey@us.pwc.com

Doug Ekizian
Phone: (949) 437-5454
Email: douglas.c.ekizian@us.pwc.com

Craig Levering
Phone: (512) 867-8703
Email: 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 member
firms of the network, each of which is a separate and independent legal entity. This document is for general information purposes
only, and should not be used as a substitute for consultation with professional advisors. MW-11-0002.

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