Brazil's economic risk from accentuated growth in auto loans

In a time of euphoria and confidence in the prospects for Brazilian economic growth, it is prudent to compare the American real estate subprime market and the Brazilian automotive credit market. A.T. Kearney’s analysis suggests that Brazil, especially automotive lenders, can learn from what went wrong in the subprime market to avoid similar consequences.

The subprime real estate crisis
At first glance, the concept of subprime lending looks absolutely sensible from a credit analysis point of view. Based on the regularity and value of their rental payments, clients with a subprime credit history could demonstrate the ability to pay real estate loan installments. Any residual risk would be offset by the property value provided by the underlying collateral.

This perceived securitization of loans neutralized the risks for the credit originators — transforming the pursuit of new loans into a bona fide gold fever. Therefore, the roots of the crisis, as often occurs, were already present in the mechanisms that ensured the explosive growth of this new market.

To maintain the flow of new loan originations, the market resorted more and more to loans with variable rates. Moreover, these loans generally contained promotional rates and low installments for the first two years of the contract. Concerns of payment ability in subsequent years, in which rates would be adjusted, were mitigated by the perception — or hope — that constant real estate appreciation would allow borrowers to renegotiate their contracts with more favorable conditions.

Auto loans in Brazil
Perhaps the greatest similarity between the American subprime market and the Brazilian automotive credit market is the high dependence on collateral value for the soundness of the market. The American market is suffering from the consequences that result from such fragile guarantees. With similar fragile guarantees, is Brazil also at risk?

The automotive credit market in Brazil is intensely competitive. Large dealerships work with various financial companies at the same time, and the dealers exercise their monopolistic power. They charge the financial companies increasingly larger referral commissions, and require extended loan term options and higher approval rates for credit applications.

Despite apparently unfavorable characteristics, automotive credit has grown at consistent rates over the past years. Outstanding volumes have risen from R$30 Billion in 2003 to R$100 Billion in 2007. Average loan terms, which ranged from 24 to 36 months in the past, today are set, as a standard, at 60 months. More aggressive financial companies risk contracts of 72 or even up to 99 months. In their service agreements with dealerships, especially for contracts for new vehicles, these financial institutions commit to application approval rates that exceed 80%.

With apparently inhospitable conditions — diminishing spreads, high referral commissions, long term contracts, and commitment to high approval rates – the ability to generate profits is connected to the existence of real collateral. If everything else goes wrong, the bank can repossess the vehicle and avoid, at least partly, large credit losses. The problem — and consequent similarity with the American subprime situation — is the questionable value that this collateral represents.

When an automobile is financed with very long contracts, there are different curves in the amortization of debt and the auto depreciation. Twelve months after the purchase, a vehicle retains, on average, 78% of its original value. A 60-month installment loan, on the other hand, will still have 89% of its original value outstanding after twelve months. Add to this analysis the costs of repossession and resale, fines, and past due taxes. A major part of an automotive loan is unsecured debt.

The resulting crisis, however, can probably be avoided as long as the Brazilian economy continues to grow at rates of around 5%, with the expected beneficial consequences on salaries and the unemployment rate. However, similar to the subprime market, the health of the auto market depends on the realization of a single economic scenario. For the subprime, the constant appreciation of real estate values — for the auto, the constant growth of the economy.

Safeguards through risk modeling
If risk stems from the fragility of the real collateral value and the possible misuse of incentives by loan originators, how can it be mitigated? On a country level, as Brazil adopts Basel 2 practices, it will have a process with constant calculations and updates on the value at risk. These processes can also carry over to analysis of the automotive portfolios in stress scenarios provoked by a deceleration of the economy and a spiral of the default/depreciation of real guarantees. The accurate measurement of these values could quickly lead to revision in practices.

More specifically and immediately, automotive credit managers in financial institutions can take steps to mitigate this risk. The better they are in risk modeling, information and control mechanisms, the greater the chances of a successful navigation in this market. Managers need answers to critical questions, such as:

• What is the collateral value of each individual operation?
• What will be the variation of this value in a stress scenario?
• How aggressive can one be in competing, based on lower interest rates and spreads?
• What signs must be observed to know when to change from an aggressive strategy that aims to increase market share to one that seeks to protect results?

In sum, it is important for the automotive credit market to remain healthy and growing, given its beneficial affect on the economy as a whole. Financial institutions will need to remain attentive to prevent potential misalignments of incentives and shortsightedness in relation to risks.

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Silvana Machado is a partner in A.T. Kearney's São Paulo office.
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Clecio Dias is a consultant in A.T. Kearney's São Paulo office.
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Rodrigo Motta Mendes is a partner in A.T. Kearney's São Paulo office.
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