Give me your tired, your poor, your huddled masses, but more importantly, give me your C-, D-, and E-paper loans. Car buyers with bad credit have a savior in Bob Schroeder, the CEO of Illinois Community Credit Union (Sycamore, IL, $97M), who since the mid-1990s has offered subprime auto lending to members. In the past five years, Illinois Community expanded its subprime lending to include new relationships outside the credit union’s membership.
Finding the credit union flirting with a 50% loan concentration in real estate, Schroder became concerned about that exposure.
“It was just getting a little bit too high for my comfort level, even though most were really low- rate loans,” he says. “So we made a concerted effort to chase down the auto loan business.”
With their smaller balances and shorter terms, auto loans require less of a financial commitment than mortgages and home equity loans. Auto loans also come with a lower interest rate risk, making them more appealing to many credit unions.
“I’d rather commit the dollars for five-year loans instead of 15- or 20-year loans,” Schroeder says. “The interest rate risk is a lot better on the auto loans.”
The executives at Illinois Community made a conscious effort to dilute real estate loans as a percentage of total loan composition. The plan was to finance auto purchases, but then consumers stopped buying cars.
Let’s Make a Deal
During the credit freeze of 2008, people couldn’t secure sufficient credit to buy cars. The credit freeze created a difficult situation for dealerships and the credit unions that relied on auto lending for a significant portion of their loan composition. At Illinois Community, auto lending accounts for nearly 53% ($42.7M) of the loan portfolio.
“The credit freeze in 2008 caused us to loosen up and contact some of these car dealers we’d been fighting with for 15, 20 years,” Schroeder says. “We finally said, ‘Hey listen, let’s put our differences aside. You need to sell cars, and I need to finance them.’”
CU QUICK FACTS
Illinois Community Credit Union
HQ: Sycamore, IL
12-Month Loan Growth: 22.99%
12-Month Share Growth: 15.76%
Schroeder worked out a mutually beneficial deal with local car dealerships to respond to the credit crisis. Instead of referring customers to specialty lenders such as Santander Consumer USA and paying the accompanying acquisition fee of $500 or $1,000, the dealer could turn to Illinois Community, where loan officers would consider the loan without charging a fee.
For A and B papers, the acquisition fee is a revenue source for dealers, because banks and credit unions compete for consumers with good credit and pay the dealership for the privilege of taking on the loan. Financial institutions are less enthusiastic about higher risk C, D, and E papers, so an acquisition fee is often charged to the dealership and ultimately passed on to the consumer. With Illinois Community’s program, purchasing a car became more affordable by eliminating the acquisition fee. The dealership sold the car, and the credit union made the loan on the condition that Illinois Community would reap the rewards from the sale of any additional auto-related financial products such as an extended warranty.
CU FAST FACTS
Illinois Community doesn’t make much money on A- and B-paper loans. The credit union’s net loan yield after losses for A+ paper loans is 5.6%. Once the 4.5% expense ratio and the 1% cost of funds are accounted for, the credit union is barely breaking even on the transaction.
“You’re not going to sell the extended warranty, you’re not going to sell any kind of payment protection, because I’m going to get all that,” Schroeder says. “But you can sell a car without the acquisition fee.”
Illinois Community hired five former car industry professionals to help develop and strengthen the credit union’s relationships with dealerships and facilitate the lending.
The Subprime Advantage
Though many lending institutions prefer or even exclusively serve A- and B-paper loans, Schroeder likes taking on C, D, and E paper because that’s where he can make money for his members.
That strategy has paid off in a big way for Illinois Community with an auto loan growth rate that is off the charts, from a respectable 5% in 4Q 2010 to a whopping 40% in 4Q 2012. Meanwhile, the credit union’s delinquency rate from consumer loans (excluding credit cards) has remained below 5%.
In this market, Illinois Community doesn’t make much money on A- and B-paper loans. The credit union’s net loan yield after losses for A+ paper is 5.6%. After factoring in the 4.5% expense ratio and 1% cost of funds, Illinois Community barely breaks even on the transaction.
“I don’t want to commit assets knowing that I’m going to take a loss,” Schroeder says. “So the lowest rate I have for the A and B member for a car loan is 4.75%.” If a member with good credit can get a better rate elsewhere, so be it because Schroeder reels in more profit with subprime loans.
I don’t want to commit assets knowing that I’m going to take a loss on it. So the lowest rate I have for the A and B member for a car loan is 4.75 and if they say they can beat it, have at it, that’s a great rate. They should take it, because I don’t want to lock my money up at a loss for that period of time.
“They’ll love you and pay 15% interest,” he says. “So that’s the direction that we’ve been moving in. It’s almost necessary for survival. How else are you going to make money in this market?”
Closing a subprime auto loan requires a different tactic — a blunt, hard-nosed conversation — that many credit union loan officers may be unaccustomed to having. Loan officers and collectors especially need to be trained to accommodate loan applications from credit-challenged borrowers. Before closing the deal, Schroeder makes sure his loan officers discuss these key points:
Explain that other financial institutions are unwilling to risk lending to this person. Your credit union is giving this person an opportunity not only to secure a loan but also to begin rebuilding credit.
Be clear about the consequences of missed payments. Explain that the car can be repossessed, the person’s credit score will continue to fall, and the next time he needs a loan he will have to pay punitive interest rates if he qualifies for a loan at all.
Offer your support by telling the borrower that you can rebuild the person’s credit score together and that in six months or a year or two, he may be able to refinance at a lower rate.
Illinois Community goes a step further by discussing strategies with these borrowers to improve a weak credit score and then prescribing a plan of five or six tasks to be completed over a period of about six months. If the new member follows the guidelines, Illinois Community will refinance the loan at a lower rate based on the new credit score.
The people that you are able to work with and take them through that process, they are very loyal members for years.
Schroeder’s approach may be forceful, but he considers it a necessary part of the process for subprime borrowers to get financing. And there’s a huge payoff for credit unions that has nothing to do with money, he says.
“The people that you take through that process, they are very loyal members for years.”
UPDATED: We at creditunions.com appreciate feedback and engagement from our readers. After posting “Road To Redemption” on March 4, we received a lot of questions about the long-term sustainability of the auto lending program we outlined at Illinois Community. ICCU does have a plan; I just could have done a better job articulating it in the story. In an effort to provide the most useful information, we went back to Bob Schroeder at Illinois Community and got the full details on his strategy to protect his credit union’s members.
As expected delinquencies and charge-offs are increasing along with the increase in C-, D-, and E-paper auto loans. To protect the credit union, Schroeder says the key is monitoring and pricing. When Illinois Community moves more of its assets from A and B to C, D, and E—delinquencies and losses do increase, but earnings increase as well.
“If net loan yields in any of these categories start declining, we adjust the gross loan yields to make up the difference to insure profitability,” Schroeder says.
Illinois Community also has many discretionary expenses ready to disappear in the event ICCU starts suffering from excessive losses. These include:
1. Executive bonuses
2. The 8.5% of pay into profit sharing contribution into all staff’s 401(k)
3. Board travel
“I believe our model has a better chance of long term sustainability than those chasing “subprime” yields,” Schroder says. “I would much rather have 10% yields with 4% losses than 6% yields and 1% losses.”