Wednesday, December 27, 2017

The Trade Equation

The armchair financial advisors of the internet have two favorite words for those that have become deeply entrenched in negative equity:  uneducated and unintelligent. They’re wrong more often than they are right. Like it or not, higher amounts of negative equity have become a necessary evil for a wide swath of the American population. There are two main factors that usually play into the creation of unrepairable negative equity: trading in vehicles with an existing lien and choosing loans with high interest rates. Factor in a recent across-the-board drop in used car trade values, and you have a recipe for an upside-down cake.

Everyone knows the concept of negative equity, but many people cannot tell you why the numbers tend to get so high. I can, however, because I help create those numbers everyday. When a car dealer structures a deal to send to the bank, the loan-to-value (LTV) percentage is a large factor. Lenders have began allowing higher and higher LTV on new and used vehicles because otherwise they won’t be able to meet their targets for loan volume. Some “captive” lenders (those affiliated directly with a manufacturer) are allowing the LTV to be as high as 135% on new cars, while some other lenders are allowing 125% on new and used also. 

These banks are not totally treacherous. The high end of the maximum LTV chart is reserved for “prime” creditworthy customers of the captive lenders, while deep subprime customers are still restricted to sub-100% in most cases. That being said, most lenders will give most of us more money than the car is valued at. 

Here is a real life scenario I encountered back in late 2016: A guy comes into the store around 7 o’clock in the evening. He is driving a 2015 Nissan Altima, an unremarkable “S Special Edition” that had 45 thousand miles, roughly a $25,000 MSRP car when new. I called NMAC to get an accurate payoff for his vehicle and nearly passed out when I heard the number: over 31 thousand dollars. Now let me break this down for you, he owned this vehicle for over a year, had a FICO just below 700, yet his payment was around $600 per month. Now where this situation goes completely askew is the fact his car was only worth $12,000. So now he was a whole $19,000 in debt already before he even got started. I asked him how did he manage to borrow so much money on that car. He told me he had an Infiniti G35 that had the transmission go bad, so he ended up transferring a few grand in negative equity on top of the new car. Then he managed to also fit in a warranty and a protection plan. The dealer kept the rebates.

That scenario is an outlier right now for sure, but I see more and more of them everyday that are or will be just as bad. This is where my lack of optimism for the industry as a whole begins. There’s a “magical wall” of $10,000 negative equity where most lenders simply will not approve a new-car loan. There are exceptions, most of them for people with credit scores north of 750 and after-tax income of more than $3k a month, but they are rare. 

When a customer is “stuck” due to negative equity, it leads to one of two things happening. Either the customer waits longer before they buy a new vehicle, or the dealership encourages the customer to “kick” their trade-in. The process of kicking a trade is simple: get a bank to approve a loan for the car with no trade-in, then lightly suggest that the customer let the bank repossess their current vehicle. Presto! The negative equity disappears… at least until the customer is called into court by their previous lender.

Only the least credit-conscious of new-car customers will accept “kicking” the trade, which means that more and more customers will simply be forced to sit on their current vehicle until they’ve paid off the negative equity. Often, this process can take three or four years. For the consumer, it makes a lot of sense. After all, most new cars are 150,000-mile reliable nowadays. Very few people would suffer a genuine negative outcome if they just made all the payments on their current car before trading it it. 

For the manufacturers, however, this process drastically cuts the “churn” of new-car sales. If customers are trading in every six or seven years instead of two or three, it cuts sales to that customer group in half. Which might lead to the manufacturers facing a bit of “negative equity” themselves. Ask yourself: will those armchair financial experts call them “uneducated” when it happens?

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