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INDIRECT LOANS:
DO YOU REALLY KNOW WHAT THEY ARE YIELDING?
Emily Hollis, CFA
CEO
Results from our loan analyses are sometimes surprising to clients. It is not abnormal to show
higher occurrences of negative yields in “A” paper, versus “B” and “C” which is somewhat
counterintuitive. In many cases, higher quality indirect pa per is just priced too low. In order to
assess whether indirect loan programs are profitable, analysis incorporating dealer fees and the
risk of prepayments are essential.
A loan profitability analysis can ascertain whether a financial institution is truly making money on
indirect loans. Profitability is measured as a net yield over the life of the loan which includes
historical results as well as projected.
For car loans in
general, poor
performance can be
masked by
seasonality or
growth. And loan
analyses which just
show monthly net
yields can be very
misleading. Defaults
and delinquencies
are dependent not
only upon the credit
criteria of the loans,
but also their
seasonality. Normally defaults and delinquencies can be represented by a “bell curve.” In other
words, within a portfolio of loans, loans that have a few months to mature tend to experience
minimal defaults while those in the eighteen to thirty month range normally show the maximum
losses of a particular pool. For indirect loans, determining the realized yield is more complex,
due to the indirect fees, which must be written off due to prepayments or defaults.
Let’s discuss calculating yields for indirect loans. A true realized yield must take into
consideration the fees, servicing costs, delinquencies, and losses associated with the
origination of the loan. Some credit unions prefer to compare the yield to the marginal cost of
raising funds (e.g., a share certificate promotion) or alternative investment choices.
A $400 fee to the dealer for a three percent four year $20,000 loan (2%) can be fairly costly
representing 99bps for a net yield of 2.01% before assessing labor and delinquency costs. If
the borrower prepays the loan after six months, the $400 dealer fee represents a whopping
4.19% leaving the credit union with a net negative yield of 1.19%. Assuming 30bps in labor
costs and 25bps in charge offs (credit costs), the net yield is negative 1.75%. The numbers are
based upon a three percent loan. On occasion we see indirect loan rates even lower.
Obviously volume will not make that product line profitable!
Loan profitability analyses can be as detailed and performed as often as the user desires
(normally they are executed on an annual basis). Analyses can be conducted where pools are
categorized by credit rating or loan type (i.e., indirect used or new autos, direct used or new
autos). Profitability is measured as a net yield over the life of the loans or the pools of the loans.
The analysis might show that it is better for the credit union to forgo a particular loan type and
promote another. On the other hand, although competition normally drives pricing, the credit
union can choose to promote a product knowing that it is yielding less for certain business
reasons, at the expense of a lower yield today; but in order for this to be a good business
decision, ultimately it must lead to positive value in some manner.
To sum, indirect loans can be profitable if priced correctly; however, if not, an institution can be
experiencing lesser yields due to the upfront fees associated with them than simply maintaining
funds in short term investments. At worst, the credit union could experience negative yields after
assessing the costs of an indirect program. These funds could have more productive,
alternative uses.