Borrowers, lenders enter crisis in better position than past

Lenders and households are in a better position going into this period of economic stress than the previous recession, analysts said. But, credit patterns will be influenced by how long the crisis endures and the level of unemployment.

In a recent consumer finance report, equity analysts John Hecht, Kyle Joseph, Trevor Williams and equity associates Ryan Carr and Lance Jessurun, all of Jefferies, looked at the financial metrics of the consumer finance industry and compared them to peers and other sub-sectors. The report compared this period to the Great Recession to give context to how consumer lending companies performed in times of uncertainty and economic stress. It also included company-specific information for lenders, including Bentonville-based America’s Car-Mart Inc. Other companies in the report included Aaron’s, American Express, Credit Acceptance and Discover Financial Services and Rent-A-Center.

It’s too early to forecast peak losses, the report showed, as this will depend on how long the crisis lasts, how effective government programs are in offsetting the crisis and the related levels of unemployment. However, lenders have started to implement risk containment strategies, including tightening of underwriting requirements and proactive servicing strategies.

Lenders have a better position in their balance sheets compared to the previous recession, the report shows. And compared to previous recessions and analysis, the initial impact is expected to be harder on higher-risk borrowers or those with subprime credit scores, and losses are expected to rise in line with changes in unemployment trends. Once employment becomes stable, lenders in this group should recover the quickest and might benefit from a rise in higher-quality customers as prime lenders tighten underwriting standards.

Equity values of companies in the report were lower when compared to the previous recession. This suggests the market has already priced in the higher loss rates than compared to the past recession. Stock prices of these companies should rise once confidence starts to build that the COVID-19 (coronavirus) pandemic will be contained in the short term. The report included other concepts to consider when looking to invest in a period of uncertainty and placed priority on healthy risk-adjusted margins, excess capital and strong liquidity, and experienced management teams and models that have survived the test of time.

FINANCIAL FOCUS
The financial metrics the analysts focused on in the report include capital levels, loss sensitivities, breakeven analysis, debt maturity requirements and other factors related to balance sheet and operational strength. And while the Great Recession provided a comparison to the present crisis, it was a unique downturn. Analysts considered revenue and earnings recovery rates by sub-sector and evaluated how equity values performed in the period. Some of the trends and industry patterns should provide perspective for investment decisions.

It’s too early to determine how this financial crisis will impact loss rates and earnings, according to Hecht, Joseph, Williams, Carr and Jessurun. The primary driver to the change in loss rates is expected to be the unemployment level and the duration of higher unemployment rates. Compared to the past recession, lenders have more capital, tiered debt maturities and have established backup bank lines.

Car-Mart will borrow an additional $30 million from its lender group amid uncertainty in global markets because of the COVID-19 pandemic, according to a filing with the U.S. Securities and Exchange Commission. The buy here, pay here used car dealer is borrowing the additional money “as a precautionary measure to increase its cash position and preserve financial flexibility in light of the current uncertainty in the global markets due to the global pandemic,” the filing shows. The company plans to use the money for working capital, ongoing operations and general corporate purposes.

“We have also analyzed various lending markets, and while we have seen areas of over-extension, we believe these are contained and marginal when compared to the overall lending market,” said Hecht, Joseph, Williams, Carr and Jessurun. “Similarly, household leverage is lower now than the prior recession while interest rates and fuel prices are low, which will help offset other financial burdens to some extent.”

LENDER ACTIONS
Lenders have prepared in the event of disruptions, including the testing of call center transitions and remote capabilities to ensure collections are not affected. If a call center were to be impacted by quarantine or other event, lenders can move collections to other call centers or allow collections employees to work from home. Lenders also have conducted portfolio credit oversight and management.

They are more focused on the balance sheet and liquidity management, selective risk mitigation likely leading to tighter underwriting standards with more significant risk, and loan and customer treatment options that include payment deferment or extensions, waivers and restructuring.

Changes in credit conditions aren’t expected for at least several weeks after any employment disruptions because “sector disruptions only recently began, the consumer has been in a relatively resilient position, it takes time such as 30 days to score in a delinquency bucket and trust data is nearly one month lagged,” said Hecht, Joseph, Williams, Carr and Jessurun, adding they don’t expect market feedback for changes soon. More details should be available when companies report first-quarter financial results.

RECESSION COMPARISON
During the Great Recession, unemployment rose to a peak of about 10% and under-employment rates were in the mid-to-high teens. Traditional credit products saw a rise in losses. Auto losses rose to a peak of 9.2%, up from an average of about 3.5%. Overall, credit products had losses of between 10% and 12% at the peak. The analysts noted the loss levels were for average loss rates, which include a combination of non-prime and prime borrowers and should provide context concerning potential losses in the existing crisis. If unemployment rises to similar levels, a similar peak in net charge offs can be expected.

For Car-Mart, net charge offs are factored when a vehicle is repossessed and sold at auction. The net charge off accounts for the difference in a customer’s outstanding balance for the repossessed vehicle and the price for which it sold at auction. The company’s losses hit a peak of 31.6% in 2008.

Though it’s too early to predict peak losses in the existing crisis, Hecht, Joseph, Williams, Carr and Jessurun expect a linear relationship between the losses and unemployment levels.

CREDIT PERFORMANCE
In the auto finance sector, all of the companies in the report, except for Ally Financial Inc., have a majority of borrowers with non-prime credit scores. Ally has about 60% of borrowers with prime credit or those with scores above 650. All of Car-Mart’s customers have non-prime credit scores.

Ally had the lowest net charge off rate at 0.8% in the past 12 months, while Car-Mart’s rate was 24%, the report showed. Ally also had the lowest allowance for loan losses at 1%. Car-Mart’s allowance for loan losses was nearly 25%.

Non-prime lenders performed positively throughout the past recession because “the peer group’s customer is constantly in a ‘state of recession,’ while more resilient, the ‘waterfall’ of consumer credit, where tightening lending standards within prime lenders provides increased volumes to non-prime lenders and higher risk-adjusted returns/(annual percentage rates) within non-prime lenders,” said Hecht, Joseph, Williams, Carr and Jessurun. Sub-prime auto lenders, including Car-Mart, performed the best throughout the Great Recession as stock prices, earnings per share and operating income rose quickly.

In a previous consumer finance report, Jefferies analysts said lenders that serve customers with lower credit scores have outperformed banks and credit card companies in economic downturns. Between 2007 and 2009, the stock price of non-prime lenders initially fell 35%, while the S&P 500 fell 50%, credit cards declined 76% and banks were down 29%. However, the non-prime lenders recovered quickly, with stock prices up 50% within one year of 2009 and 225% in five years. While banks outperformed non-prime lenders initially, they recovered more quickly as banks continued to fall. One exception, however, was Car-Mart, with its stock rising 18% between 2007 and 2009.

In a 2019 earnings call, Car-Mart CEO Jeff Williams explained the company’s performance in the past recession: “The company’s credit results were actually at all-time lows at the tail end of the last recession. So by putting a good product out there for a fair price and supporting these customers, if credit was to constrict in the market significantly, that would certainly be a positive for us. And as somebody that’s providing good basic affordable transportation with the service to support these customers and things that happen in their lives, the last recession was actually very good for Car-Mart.”

Jefferies analysts gave a hold rating to Car-Mart stock, and a 12-month target price of $60, down from $130.