According to an NCUA poll, approximately 84% of credit unions are involved in some sort of indirect lending. Another 8% are considering becoming involved. Indirect lending can expand your lending opportunities and give you a way to create member growth by reaching out to those individuals obtaining indirect loans who may reside in your credit union’s community. It can be a win-win situation for both you and the auto dealer or third party involved.
Indirect lending, however, is not without its risks. Net indirect loan charge offs as a percentage of indirect loans were 1.4%, 1.7% and 1.3% in 2008, 2009 and 2010, respectively. They were .85%, 1.21% and 1.1% respectively among all loans. Simply put, indirect loans are riskier than the average loan. So how do you mitigate that risk to make this a profitable endeavor?
Just like any other portfolio segment, you should limit your concentration risk both as an indirect lending segment and on a dealer-by-dealer basis. There have been instances of large scale fraud among dealers where they have manipulated credit reports to push loans through. Limit your indirect portfolio to a size where risk factors affecting indirect loans, both procedural and economic, do not have significant negative effects on your net worth.
You need to set credit quality standards for your dealers and monitor dealer underwriting performance to ensure loans are being made in compliance with credit union policies. Dealers have a financial interest in a loan going through, so you should maintain professional skepticism surrounding the procedures at the dealer. Trust but verify. To this point, you should also be obtaining third party data to support dealer’s collateral values (KBB/NADA). A dealer can maintain any LTV you require as long as they don’t have to support it.
Testing your results is key to the loan process. Analyze charge offs by dealer to determine which are performing the best. Use this analysis to modify future underwriting procedures and to implement procedures at your other dealers.
You should set short and long term goals for your indirect portfolio, both in terms of growth and risk. It’s easy to assess growth, but also periodically analyze profitability. Be sure to include all the costs surrounding your portfolio including cost of capital, loan charge offs and staffing costs. Compare your profitability to the benchmarks you had previously set to determine if you need to re-evaluate your pricing. Indirect lending can be a great way to improve your portfolio, but keep in mind that a small portfolio operating in the black is better than a huge portfolio operating in the red. You don’t want to wind up in the position of having your direct lending subsidize your indirect operations.
-Dan Price, CPA
Twenty Twenty Analytics Blogger