Sometimes, it's what you can't see that matters most. First, the bad news: after years of economic growth and generally good times, consumers' credit scores may be inflated. Like 50 is the new 40, a prime score today may be the equivalent of a sub-prime score pre-financial crisis. If you believe a leopard doesn't change its spots, a high credit score may be masking a borrower's likelihood to default in bad times, and the risk on subprime loans is bigger than believed at origination. Now, the good news: if existing loans are riskier than believed at origination, improving collection efforts behind-the-scenes can have the greatest impact on portfolio performance.
With this in mind, we spoke to David Albers, CEO of Revenue Connections. David has nearly three decades of executive experience in banking and financial services and formed Revenue Connections to help clients grow top-line revenue through improvements to business development and operational performance. We asked David to share his deep operational experience to advise on ways to positively impact collection efforts, specifically in an area of challenge – subprime auto.
Industry Professional's Advice to Improve Collections for Better Portfolio Performance
Just as form follows function, collection activities often flow from the characteristics of the asset class in question. How can new technology and system modernization be tailored to improve recovery rates in subprime auto?
Recovery rates in both lending and leasing can be improved to varying degrees. In lending, as opposed to leasing, any "retaking" is most often due to financial hardship. The vehicle is not maintained, is often hidden and the interaction is almost always adversarial creating additional layers of cost and longer time frames to find, retake and liquidate the collateral. These "pain points" represent areas where modernized systems can significantly improve lender's recovery rates, which can be controlled or at least influenced through enhanced IT.
Most companies define recovery rate as the sale price of the vehicle divided by the remaining principal balance on a loan (or adjusted capitalized costs on a lease) plus costs to retake, transport, prepare for sale (repair, recondition, clean, etc.) and sell the vehicle.
In this context, although the sale price is perhaps the least controllable factor, a creditor can get marginally higher sale prices in varying geographic regions where certain vehicles have greater appeal (i.e. trucks in the South or Texas) or if they are able to retail to the public versus selling wholesale at auction. Historically for larger portfolios, the additional time, cost and risk involved in transporting vehicles and/or making them showroom ready has seldom paid off, but this is an area where better data analytics and modernization of logistics systems is having a positive impact on recovery rates for both lessors and lenders. The remaining principal balance (or adjusted capitalized cost in leasing) is largely a function of the loan-to-value approved in the lending decision and the setting of the residual value in the leasing decision. Once a loan/lease is booked, from a back-end perspective there is nothing that can be done to impact the remaining principal balance or adjusted cap cost to improve recovery rates.
So, given there is little-to-nothing that can be done to positively impact the numerator or the largest part of the denominator in the equation for existing loans/leases, the key is to use new technology and systems modernization to control costs and shorten the cycle from retaking the vehicle to liquidation.
While the transport, preparation for sale and sales functions are materially the same for repossessed and off-lease vehicles, the creditor-customer dynamics and pre-possession processes are sufficiently different to warrant separate responses for loans versus leases.
In leasing, the creditor-customer relationship is typically not adversarial in an end-of-lease scenario and is a simpler, straightforward pre-possession process. It's key to have effective contact strategies to communicate with lease customers early and often to re-take the car as timely and efficiently as possible.
In the context of repossession in the lending scenario, where the creditor-customer relationship is often adversarial, tools available in this capacity revolve around customer scoring and segmentation, early detection of fraud and skips and pro-active measures to locate not only the borrower but, often more importantly, the car. In my experience, this is where most lenders, even large national shops, fail miserably in deploying new technology and modernizing systems and where recovery rates could be most positively impacted. For some reason, spreadsheets still rule the day.
What are the challenges of loss mitigation in the post-financial crisis era?
I think the challenges of loss mitigation are generally the same as prior to the financial crisis, but with the added element of moral hazard and borrowers reprioritizing what and who they pay in times of hardship. Moral hazard has always been a part of unsecured lending and most credit card and consumer finance companies do well managing that risk, but the proliferation of private loans made to individuals is new ground, so I am interested to see what happens there.
The reprioritization that has been surprising to me is that borrowers are often paying their credit cards and unsecured debt over their car loans. Mortgage and rent still typically get paid first, but because of the relative ease of being able to secure another car loan regardless of how many repossessions you've had and the lack of sophistication of most lenders in being able to locate and repossess their cars, many borrowers simply stop paying and drive for free as long as they can. I believe this is a fundamental cultural shift fed by an ever-growing group of sub-prime auto lenders making loans to a changing populace that represents risks they didn't account for, don't understand and don't know how to mitigate. There are troubled days ahead for sub-prime auto.
Looking Ahead
An age-old problem like collections doesn't have to be met with old, stale tools. Going forward, state of the art collection and recovery systems will be the foundation for solid top-line performance – the kind that drives bottom-line performance and makes investors take notice. For smaller and newer lenders, they will likely be necessary to survive a downturn. In all cases, if recoveries aren't where they should be, getting the right professional on board with experience in new technologies that can help modernize systems would be the best first step before turning to business development for top-line growth.
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