True Yields of Indirect Loans

Emily Hollis, ALM First Financial Advisors
March 16, 2005

Before we begin analyzing the current true value of indirect loans, remember that two-year Treasury rates have risen 250 basis points (b.p.) from their lows of 1% in June of 2003. Investment yields correlate to this rate movement; however, car loans in the credit union industry correlate to a much lesser degree.

True yields on indirect loans are dependent upon numerous factors. Generally speaking, given the recent rise of interest rates, credit unions can make incremental income with comparable security purchases rather than issuing indirect loans. Having said that, market conditions will change and that will make indirect loans more attractive. Experts in indirect lending advocate that if you enter the market, you must be committed; most dealers will not tolerate institutions that are in the market one month and out the next.

True yields of indirect loans are greatly dependent upon prepayments and charge-offs. We’ll assume that the average book yield (using a combination of all grades of paper) is 6.00%. Assuming that a four-year loan prepays in month 24, a typical $450 dealer contract or “flat” fee on a $20,000 loan reduces the yield by 150 b.p. Assume 70 b.p. for charge-offs and 30 b.p. for servicing costs, and the true yield is now 3.50%. Currently, a two-year, high-quality amortizing investment can be purchased around 4.00%--that’s 50 b.p. higher than the loan.

What about A-rated loans at 4.%? Even with zero defaults, the credit union’s true yield assuming a two-year prepayment is 2.70% (4.50% – 1.50% – 0.30% = 2.70%). Is this program worth the effort? Not in today’s rate environment. However, are condensed margins required to continue relationships with dealers? Each credit union will need to analyze their particular situation to answer these questions.

To help determine true yields of indirect loans, your credit union can set up an easy Excel spreadsheet using the “IRR” function. An example follows:

Additionally, this table shows the effect of a $450 flat fee on a $20,000 car loan.

Thus, prepayments, flat fees, servicing costs, and charge-offs are critical elements in determining true yields of indirect car loans. In addition, the portfolio mix of different grades of paper and respective yields could be critical.

Emily Hollis is a CFA and president of ALM First Financial Advisors, LLC in Dallas, Texas. Contact her at 800-752-4628 or ehollis@almfirst.com.