Credit Acceptance: State AGs Likely to Push For ‘Ability to Repay’ Analysis, a Material Negative for Deep Subprime Business Model

September 17, 2020 – Capstone believes state attorneys general (AGs), as part of their ongoing investigations into Credit Acceptance Corp.’s (CACC) business practices, will attempt to force the company to conduct an “ability to repay” (ATR) analysis before offering each loan. An ATR requirement would have a material negative impact on the company’s profitability and underlying business model, eliminating one of the company’s key competitive advantages: “approval for everyone.” Our review of CACC’s portfolio shows uniquely poor consumer outcomes, gauged by basic metrics such as portfolio loan delinquencies and a high average interest rate. These factors make CACC a more attractive target for consumer advocates than other subprime lenders, such as Santander Consumer USA (SC), likely resulting in greater headwinds from an ATR requirement.

Capstone has previously written about the regulatory challenges emerging for CACC, including recent lawsuits by the Massachusetts and Mississippi AGs and the apparent multi-state AG investigation into the company (see “Credit Acceptance: AG Allegations Exceed Other Subprime Auto Cases; Greatest Risk is Changes to Underwriting, Collections” September 11, 2020). We have noted the investigations appear aimed at the core of CACC’s business model and believe conduct provisions from any legal resolution are likely to be materially impactful to the company, despite manageable financial penalties for other subprime lenders in state AG settlements.

Santander, a CACC competitor, agreed to an ATR analysis in its 2020 settlement with 35 state AGs, which is unlikely to disrupt its core business model. In this note, we highlight the significant differences in the typical loans for the two companies, which account for CACC’s outsized risk if AGs require an ATR analysis. We believe if CACC is forced to act like a more “typical” subprime auto lender, it would likely have to reinvent its business model or at least refuse credit to its riskiest borrowers. We estimate, based on the company’s repossession rates, that CACC borrowers default on loans over twice as often as Santander borrowers, who more closely reflect the subprime industry’s average.

Below, we highlight key data disclosed by CACC and Santander regarding outstanding loans. When available, we utilized company data from the end of 2019 to not be skewed by the impact of COVID-19, which included voluntary and government-mandated deferrals and limits on repossessions. CACC does not regularly disclose its repossession rate, but it did so in its earnings conference call for the third quarter of 2015.

Exhibit 1: Credit Acceptance and Santander Key Performance Metrics

As shown in Exhibit 1, CACC operates in a deeper subprime portion of the auto market than competitors such as Santander, which contributes to a higher rate of repossessions (~35% for CACC versus mid-teen percentages for competitors such as Santander, Exeter Finance, DriveTime, and American Credit Acceptance) and delinquent loans. We expect it also results in a higher interest rate for the consumers. While CACC does not disclose its average annual percentage rate, Santander had an average APR for its retail installment contracts (auto loans) of 16.3% in 2019 and 17.3% in 2020. The recent Massachusetts lawsuit against CACC claims the “vast majority” of loans in the state have interest rates of 20.99%, just below the state limit of 21%.

A DEEPER LOOK      


Background

We believe a comparison of CACC’s business model to other subprime lenders demonstrates the increased risk to the company from regulatory or legal action, particularly a requirement to conduct a thorough “ability-to-repay” analysis. We expect a requirement to evaluate the consumer’s ability to repay the loan, similar to that agreed to by Santander in its multi-state AG settlement, could force CACC to operate more like most other subprime auto lenders, which would limit the company’s ability to make loans to all consumers and generate significant profit through its collections and repossession activity despite a high loan default rate.

Profitability Likely to be Impacted by Changes to Model

CACC’s current model is highly profitable. For example, at the end of 2019, the company had a return on assets (ROA) of 9.31%, while Santander’s ROA was 2.12%. Additionally, CACC’s revenue has outgrown Santander and the subprime market. From 2016 to 2019, total subprime auto loan originations grew at a CAGR of 0.7% according to data from the Federal Reserve Bank of New York. Over that same period, Santander’s revenue grew at a CAGR of 5.5%, and Credit Acceptance grew at a CAGR of 15.4%. We believe the changes likely to be sought by AGs investigating the company would have a material impact on growth and profitability beyond the near-term impact of any financial penalty.

Repossession Rate Likely Well Above Market Average

As with other auto lenders, CACC utilizes repossessions to maintain its profitability and offset the negative impact of a borrower’s default on a loan. According to the Massachusetts AG, when a high-risk borrower defaults, CACC receives an average of 18% of the total loan value through repossession and post-default recoveries. In the company’s 2020 first-quarter earnings conference call, management stated repossessions account for 6-7% of total cash flows.

In 2015, CACC’s management team indicated that the company’s repossession rate—the percentage of loans that eventually end in repossession—was around 35%. In their respective lawsuits, both the Massachusetts and Mississippi AGs focused on the company’s failure to consider the potential that a borrower defaults on a specific loan and the negative impact repossession has on a borrower. While the company has not publicly disclosed the rate since 2015, we believe the 35% rate is likely a conservative estimate for current operations (not considering the recent impact of COVID-19). According to the Massachusetts AG’s complaint, the company’s expected collection rate for loans originated in the state in 2015 was 71.8%, which dropped to 66.0% by 2019. The trend was similar nationwide, where the rate dropped from 72.0% in 2013 to 64.0% in 2019.

At the end of 2019, Santander reported its repossession rate was 15.7%, down from 16.3% at the end of 2018. We believe this is likely comparable to the subprime lending average given Santander’s delinquency rate on loans—which are in line with the broader industry—and the high correlation between that metric and repossessions. Given the Massachusetts and Mississippi AGs argue that a loan is unfair if a lender does not reasonably believe it will be repaid, we anticipate any corrective action would attempt to move CACC’s default/repossession rate closer to industry norms, which could require the company to evaluate its operations to reduce defaults by roughly 20 percentage points.

Loan Delinquencies Trend is Similar to Repossessions

At the end of the first quarter of 2020 (before the most significant impact from COVID-19), CACC reported 34.7% of its loans were delinquent by 11 days or more (14.8% were delinquent by over 90 days). By comparison, Santander reported 14.8% of loans were delinquent by 30 days or more for the same period, with 5.1% of loans delinquent by over 59 days.

In Exhibit 2, we compare the data from CACC’s filings with a number of subprime lenders’ securitization data as of March 31, 2020 (CACC’s delinquency data was not included in the securitization information we reviewed). We found that companies that lend to a similar average FICO score had lower delinquencies for less than 90 days, and especially for over 90 days.

Exhibit 2: Share of Auto Loans Delinquencies

Sources: ABS data, company filings, Capstone analysis

The data from Santander and other subprime lenders reflects the broader subprime auto lending market. According to data from Fitch Ratings, as shown in Exhibit 3, the 60+ day delinquency rate for subprime autos peaked at nearly 6% in August 2019 and was 5.1% in March 2020. Our review of other subprime lenders found consistent 60+ day delinquency rates of slightly over 5%, while 90+ day delinquencies were less than 3%.

Exhibit 3: Share of Auto Loans Delinquent for Over 60 Days

Source: Fitch Ratings

FICO Scores Demonstrate CACC’s Reliance on Subprime Borrowers

One major factor in CACC’s loan performance is its participation in a deeper subprime market, particularly compared to Santander and many other subprime lenders. At the end of 2019, CACC reported that 95.9% of its borrowers had FICO scores below 650 or no credit score. Santander reported 80.2% of its borrowers had a FICO score below 640 or no credit score. Santander also disclosed an average credit score of 598, with 10.0% of loans having no credit scores. Our review of other subprime lenders and subprime auto loan securitizations suggest several lenders address lower credit score borrowers, but a higher share of the borrowers is current on the loans. A recent CACC securitization had an average FICO score of slightly below 550, with around 20% having no FICO score. We believe borrowers with no credit score are generally viewed as performing on the level of a 550 credit score borrower, in line with CACC’s average.

We believe a higher standard of the borrower’s ability to repay would force the company to compete more directly with other subprime lenders and reduce its existing advantage servicing borrowers that have few alternatives. According to the Federal Reserve Bank of New York, for the trailing twelve months at the end of the second quarter of 2020, the subprime auto market, defined as credit scores below 620, was 19.0% of the total auto market (by loan value). The third quarter of 2015 represented the post-financial crisis peak, when the subprime market accounted for 23.0% of total auto market originations. As shown in Exhibit 4, the subprime auto market has been around $120 billion per year since 2015, while the total auto loan market growth has been driven by prime borrowers.

Exhibit 4: Market-Wide Auto Loan Originations by FICO Score

Source: Federal Reserve Bank of New York, Capstone analysis

CFPB Complaints about CACC Outpace the Industry

An analysis of consumer complaints is also helpful in comparing CACC to other subprime auto lenders. Regulators are highly responsive to consumer complaints, especially consumer complaint trends. As shown in Exhibit 5, total auto loan complaints to the US Consumer Financial Protection Bureau (CFPB) dipped in each of the last three years, and the run rate for 2020 is relatively flat y/y. Meanwhile, complaints to Santander increased slightly in 2018, before decreasing in 2019. The run rate for 2020 indicates complaints about Santander will likely increase in the mid-teen percentage. Complaints about CACC have increased each year (although we attribute much of the large increases for CACC and Santander in 2017 to a change in the CFPB complaint database). The company’s complaints as of September 15, 2020, were already 18.8% higher than all of 2019, indicating a run rate increase of roughly 50% y/y.

Exhibit 5: CFPB Consumer Complaints Regarding Auto Loans

Interest Rates Present Risk from State Caps

Given CACC’s typical loans, we believe it also lends to borrowers at a higher interest rate, which may draw the attention of consumer advocates and regulators, particularly in states that set an interest rate limit. In Massachusetts, the AG charged the “vast majority” of loans in the state were at 20.99%, just under the state’s usury limit of 21%. While we believe CACC’s interest rate is in line with several other deep subprime lenders, it is considerably higher than Santander, increasing the potential impact from the number of policies that may be invalidated if, for example, ancillary products are found to be a mandatory finance charge rather than an optional product. The AG found the company had an attach rate of 83.5% on vehicle service contracts (VSCs) from 2013 to 2019.

In a review of a recent securitization, CACC’s average weighted APR was slightly over 22%. For auto loans originated in 2019, Santander reports an average APR (which includes roughly 20% of its loans which are not subprime and have a FICO score above 640) of 16.3%, down from 17.3% in 2018. According to Cox Automotive, a market intelligence firm, the average subprime interest rates (for lenders with a FICO score below 620) is around 18.7%, compared to 11.8% for nonprime auto loans (FICO score between 620 and 659).