Quantitative Easing and its Potential Effect on Pre-Owned Auto Sales

15 May

Introduction

Quantitative easing should positively affect the pre-owned automobile business for many different reasons.  Lower interest rates should incentivize consumers to enter the automobile market because they will be able to borrow money less expensively to finance their purchase.  Furthermore, lower long-term rates should eventually drive home prices upward, improving homeowners’ personal balance sheets and helping to restore confidence in the American economy.

Hypothesis

The following pages will seek to prove the following: Assuming quantitative easing stimulates growth in the used automobile business, customers will be less likely to pay cash for their vehicles than they have been in the past.  They will probably begin accepting dealer financing more often, as the interest rates will be more attractive.  Further, high savings rates indicate customers are more likely to hold their cash than they have been in over a decade.  This increase in finance penetration willl make dealers richer as they always make higher profits on finance deals than on cash deals.

Why Dealers Care About Finance Penetration

Increased finance penetration will be positive for dealers because profits generally increase when customers finance their transactions instead of paying cash.  One reason dealers make less on “cash deals” than on “finance deals” is that cash customers tend to focus their energy on negotiating price, which causes dealers to lose profit.  Contrarily, finance customers are more likely to negotiate their monthly payment.  A common remark made by automobile customers is, “If you get my payment to $250 per month, I’ll take the car.”  Dealers do not necessarily lose profit by allowing customers to negotiate lower payments, as many variables affect monthly payments.  These variables include loan term and interest rates, and can be manipulated by dealers who wish to reduce customers’ monthly payments without sacrificing profit.  For instance, a customer who wishes to be at $250 per month might qualify for finance terms that naturally result in his payment being at, or below, the desired level.  Although this customer feels he has made an offer that will force the dealer to give him a “better deal,” the dealer can likely extend the customer’s loan term and approve him for a low interest rate to reach the agreed-upon monthly payment.

Another reason dealers make large profits on finance transactions is that finance customers qualify for many aftermarket insurances, or “back-end” products.  These products include GAP insurance and Life, Accident and Health insurance.  These are products that protect customers from financial devastation throughout their loan terms, and are significant profit opportunities for dealers.  “Cash” customers cannot buy these products.  Furthermore, “cash” customers are far less likely to purchase even the aftermarket products for which they do qualify, such as extended warranties.  While many people can easily justify paying $35 per month for an extended warranty, far fewer people are willing to pay $2000 in cash outlay to have this protection.

In addition to the finance customer’s propensity to negotiate payment and buy aftermarket products, the finance customer will also pay “reserve spread” to the selling dealer without knowing he is doing so.  This represents an easy way for many dealers to make an additional $500 to $2000 by financing a vehicle for a customer instead of selling the car for cash.  Reserve spread is paid to a dealer if he “buys” money from a bank at a lower rate than that at which he “sells” the money to his customer.  For instance, if a customer’s credit qualifies him for an interest rate of 2.99% through Chase Bank, Chase will allow the selling dealer to offer this loan to the customer at 5.49%.  Chase will pay the dealer a percentage of the increased finance charge.

 

 

Why Quantitative Easing Will Increase Finance Penetration

For all the reasons stated above, dealers should welcome quantitative easing with open arms.  Not only will quantitative easing entice buyers to enter the pre-owned vehicle market, but it will also give them reason to keep their cash and use dealer financing to make their purchases.  This is because interest rates will be low enough that many buyers will find it makes sense to finance their transactions and keep their cash in investments that yield higher returns, such as individual stocks or mutual funds.  Indeed, with auto loans below 5%, customers should easily be able to find investment vehicles that provide them with a high enough returns to make the auto loans financially beneficial.  Furthermore, customers will jump at the opportunity to hold more cash in their bank accounts without being penalized for this luxury.  With savings rates at decade-long highs, it is reasonable to assume that people will be comfortable keeping their cash in their bank accounts, CD’s, IRA’s, or stock brokerage accounts.  Holding cash is an attractive option for the average American consumer who has been beaten down by a poor economy for the past 3 years.   (Exhibit A)

The best way to predict the effect quantitative easing will have on the future finance penetration is to analyze the relationships between the target Fed Funds rate, average auto loan rate, and the finance penetration Portsmouth Used Car Superstore has experienced since 2007.  From 2007 to 2010, the target Fed Funds rate has been reduced from 5.25% down to 0%.  This has brought the average 60 month auto loan interest rate down from 7.17% to less that 5%.

The data analysis from Portsmouth Used Car Superstore’s records from February 2007 to November 2010 reveals that there has been a moderately positive correlation between the target Fed Funds rate and the percentage of customers who finance their auto loan purchases.  In 2007, the average Fed Funds rate was approximately 5.07%, and the average number of customers who financed their vehicle purchase was 78.58%.  The vehicle finance penetration remained at 78% throughout 2008, and dropped to 76% in 2009.  This happened even while the Federal Reserve was aggressively reducing the target rate down to .25%.  It was not until 2010 that the The Superstore began to benefit from the aggressive rate reductions in the form of increased finance penetration.  This year, finance penetration is up to 82.27% as the target Fed Funds rate is down to 0%.

Is the Fed Funds Rate an Adequate Predictor of Finance Penetration?

Based on the information above, it is clear that a reduction in the Fed Funds rate causes a subsequent reduction in auto loan rates.  This reduction in auto loan rates has a positive impact on the finance penetration.  However, the Fed Funds reduction seems to have a reverse multiplier effect when put in terms of the other two factors.  Indeed, a reduction from 5.07% down to approximately 0% only caused a reduction in the average 60 month auto loan rate of approximately 220 basis points from 7.17%.  This is a 507% decrease in Fed Funds and only a 30% decrease in average 60 month auto loan rates.  Furthermore, this 220 basis point reduction only increased the finance penetration to 82.27%, representing only a 3.69% increase.  Therefore, the Fed’s actions become less significant as they filter through the banking system down to the consumer.

One reason that low rates haven’t changed the finance penetration very much is that the low interest rates make the prospect of saving money very unattractive.  (Exhibit D)  Consumers who might like to keep their money in an interest-bearing savings or checking account will not do so because the rate they will earn on this account does not exceed the rate of inflation.  This causes consumers to pay cash for their vehicle to avoid paying any finance charges, as little as those charges might be.  Furthermore, increased savings rates confirm that consumers have money set aside for this expenditure.  This could be considered a “crowding out effect” specific to the automobile business, as low rates are implemented in order to stimulate borrowing and economic activity but consequently cause customers to pay cash for their purchases.

In addition to the financial benefit to paying cash for a vehicle, it also provides consumers with peace of mind that is very difficult to quantify, as they do not have to worry about making a consistent monthly payment.  Many consumers have expressed concern about monthly payments because they’re not convinced the payment will be credited to their loan due to human error.  This could be human error on the consumer’s part, as they might forget to make the payment.  It could also be human error on the bank’s part.  The prospect of taking a hit to one’s credit score due to human error is enough to entice many people to pay cash instead of finance.

Fed Funds Vs. Loan Rates

There are many reasons the average 60 month loan rate has been reduced at a much lower pace than the Fed Funds rate.  Significantly, the 60 month loan rate includes a default risk premium.  For example, TD Bank might charge a rate of 3.49% to a customer with excellent credit history.  This rate includes a very small risk premium as the customer’s credit score puts him in a category with people who rarely default on their auto loans.  Since this customer represents very little risk, TD Bank requires a very low rate of return on his loan. Contrarily, a customer with a credit score in the 600 range will have to pay TD Bank a greater rate of return if he wants to borrow money to buy a vehicle, as he is in a category that represents more risk.

To understand the modified impact of reduced Fed Funds rates, one must consider why rates are being lowered in the first place.  The poor economic environment has caused companies to release workers, stop growing, and stop investing.  The Fed floods the banking system with cash to lend so that companies will see the value in borrowing, and reduces rates in order to stimulate demand among consumers. However, profit-seeking (and loss-preventing) banks might respond cautiously to the Fed’s aggressive actions by tightening their lending standards and reducing their loan portfolios.  After all, if the future is bleak enough for the Fed to implement such impressive rate reductions, perhaps the banks should just sit on their money and ride out the storm.  Furthermore, when banks receive large injections of risk-free dollars they are sometimes less likely to lend them.  This was a major argument against 2008’s TARP program.  By some estimates, TARP did very little to stimulate lending activity.  (Patalon)  Some argue that these large injections actually reduce the incentive for banks to seek profits by lending to customers because the injections allow banks to sustain operations without risk of consumer default.

Another reason banks are unlikely to reduce their lending rates as fast as the Fed reduces its target rate is that banks must plan for inflation.  Exhibit B underscores a major dilemma faced by lending institutions: As the consumer price index rises, purchasing power falls for consumers and lending institutions.  A CPI increase generally reduces ROI on receivables for lending institutions.  As interest rates fall and the consumer price index rises, banks experience an enhanced reduction in ROI as a result of this decrease in purchasing power.  If the Fed is reducing its target rate to 0%, banks are able to calculate the expected effect this reduction will have on the overall price level over the following 60 months.  TD Bank, for example, knows that if it lends money at 3.49% to a prime customer for a 60 month term, then the return on this loan will be lower than the nominal return of 3.49% because the payments will be worth less in terms of what the money can actually buy.  This is especially true if the Fed has implemented an expansionary money policy that is likely to enhance inflation and increase the price level.  Therefore, TD Bank must take caution in what rate it offers its customers.

Although it seems likely that this would incentivize TD Bank to make short term loans (as opposed to long term loans) so that it has more flexibility in the future, the data on 60 month and 36 month loans suggests something different.  Some research suggests that banks are willing to offer lower rates on 60 month auto loans than on 36 month loans as an incentive to get borrowers to borrow money for a longer term.  This suggests banks expect rates to go lower and are trying to lock in a high return for the longest term possible.  (Exhibit C)

Findings

The data in this report indicates that the Fed’s aggressive rate changes since 2007 have not made much of an impact on PUCS’ finance penetration.  One reason is that banks have not moved their lending rates as aggressively as the Fed has moved its target funds rate.  While customers are more likely to take a loan than they were in 2007, this increase in likelihood has muted because of the other consequences of low interest rates.  Reduced interest rates make the prospect of saving money less attractive for customers.  This is not to say that customers are less likely to buy cars.  It simply means that when they are ready to buy cars, they have more money in the bank to pay cash for their cars and are just as likely to do so as in 2007 because the rate they currently receive on their savings is poor.

PUCS’ experience since 2007 renders the original hypothesis inconclusive, at best.  Quantitative easing will make dollars readily available for businesses and consumers, but does not necessarily mean people will be much more likely to borrow instead of pay cash for their automobiles.  A further reduction in interest rates simply means that customers, who have cash in the bank, have as much incentive to use cash to purchase a car as they have to finance the car.  Furthermore, lenders will reach a point where it is simply not profitable to make loans given the discount they are required to offer in order to stay competitive with one another.  At this point, it will make more financial sense for lenders to hoard cash rather than risking it on consumer loans.

How Dealers Can Use Low Rates To Their Advantage

As previously stated, dealers make higher profits on finance customers than on cash customers.  This is because a customer is more likely to purchase an aftermarket service contract when it is presented as a monthly investment, as opposed to a “one-time $2000” charge.  Since quantitative easing will not definitely increase finance penetration, dealers should begin planning strategies to maximize profits on the 18% of customers who prefer to pay cash for their vehicle.  One idea of how to do this is to include extended warranties in the prices of all pre-owned vehicles.  For example, a 2007 Camry that would normally be priced at $14,995 should be priced at $16,995 to include the aftermarket warranty.  This way, customers are not faced with the choice of whether or not to pay cash for an “extra.”  It is simply included in the price.  The downside to this idea is that the dealer might price itself out of the market if all the other 2007 Camrys are priced at $14,995 or below.  Customers who do not see enough value in the extended warranty to justify the $2000 premium will choose a competitor’s vehicle that is priced more competitively.

A second idea as to how a dealer can use low interest rates to his advantage is by offering refinance programs to previous customers.  For instance, a customer who purchased a vehicle at 9.99% in 2007 probably qualifies for a much lower rate in today’s lending environment.  Furthermore, since pre-owned vehicles have generally increased in value, that customer probably holds an equity position in the vehicle he purchased.  If given the opportunity, he would agree to refinance the remainder of his loan at a 5.49% rate, reducing his payment or the number of payments he has left on his loan.  This gives the dealer an opportunity to refinance the customer and keep the reserve (or rate mark-up).  Furthermore, it gives the dealer an opportunity to offer this customer an extended warranty if he does not already have one.  Finally, it puts the customer back in the dealer’s showroom, which is always a golden opportunity to generate another sale.

“Cash conversions” occur when a customer is planning to pay cash for his purchase and is shown the benefit of financing with the dealer.  Dealers need to begin focusing on cash conversions, because they sometimes work.  For example, there is a small part of the automobile customer base that has poor credit history but has a large stash of cash on hand.  This often is a result of insurance settlement or inheritance.  These customers can often be persuaded to finance their auto loan purchase in order to build their credit histories, even though they have the ability to pay cash for their vehicle.  In this situation, the prospect of building a strong credit score justifies the finance charge the customer will have to pay on his loan and justifies the inconvenience of making a monthly payment.

One final way dealers can use low interest rates to their advantage is to negotiate its interest rates with its creditor.  For instance, most dealers “floor-plan” their inventories.  This means they purchase cars on credit and pay these cars off as they sell.  A reduction in interest rates is a great opportunity for dealers to reduce floor-plan costs.  Unfortunately, if all dealers do this then they will be more likely to hold higher levels of inventory.  This will reduce the supply of inventory available for dealers to purchase and should cause a further increase in prices across the industry.  Dealers should operate under the assumption that this will eventually happen and should take advantage of low prices while they still exist.

 

Bibliography

 

1. Patalon, William III.  Seekingalpha.com. December 5, 2008.

http://seekingalpha.com/article/109435-tarp-funds-fueling-global-buyouts-not-lending

2. Smith, Lisa. Quantitative Easing, What’s in a Name? Investopedia.com. http://www.investopedia.com/articles/economics/10/quantitative-easing.asp

3. Bankrate.com

4. Fed Funds Target Rate. Moneycafe.com. http://www.moneycafe.com/library/fedfundsrate.htm

5. Changes to the Fed Funds Rate and Discount Rates. The-privateer.com.

6. FRED Graph. Economic Research – Federal Reserve Bank of St. Louis. http://research.stlouisfed.org/fred2/graph/?chart_type=bar&s[1][id]=PSAVERT

7. What Causes Bank Rates to Rise and Fall? Gobankingrates.com. http://www.gobankingrates.com/banking/factors-bank-rates-interest-federal-reserve/

8. Baden, Ben. Why More Quantitative Easing Could Be a Mistake. USNews.com. October 13, 2010. http://money.usnews.com/money/business-economy/articles/2010/10/13/why-more-quantitative-easing-could-be-a-mistake.html

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