Over the past two years the government has been working on a proposed rule to change credit risk retention requirements. A part of that overhaul includes sweeping changes to automotive loans, changes that are leaving many commenters asking: do regulators have any idea how people actually buy cars today?

On April 29, 2011 the Comptroller of the Currency (OCC) posted a proposed rule to implement Section 941 (Regulation of Credit Risk Retention) of the Dodd-Frank Wall Street Reform Act.

Before we venture down this complex road of financial securities I have one confession to make; my understanding of finance consists of my wife sending me my monthly car part allowance.

The goal of this rule is to establish new risk standards to prevent asset backed securities from being built on poorly written loans. In other words – prevent the financial calamity that broke America.

What does this have to do with vehicles?

Like houses, cars are often purchased on credit which means they're ripe for securitization. The business of auto loans is a very lucrative one and there was a time when many automakers relied on profits from financing to support manufacturing. This is why you see manufacture incentives that say "Rebate applies if financed by ENTER CAPTIVE LENDER."

To issue the most loans possible financial institutions look to securitization as way to 'sell' loans to free up new credit to issue more loans. This rule really only impacts lenders who depend on asset backed securities. Unfortunately I wasn't able to find out which auto lenders rely on securitization. The comments tend to indicate the impact is rather large so we'll assume most originators of commercial automotive loans rely on securities.

I don't want to get into the details of how securities work, ratings, expected spreads, etc., nor do I want this to evolve into an auto vs. mortgage risk debate. For one I would be way out of my league trying to sound intelligent on this complicated subject. Secondly, that isn't the point of this post.

A large portion of this rule is focused on mortgages, but auto loans are also included under the section titled, "D. Qualifying Automobile Loans (QAL)."

Here are the main points from the first go around of this rule:

1. The Borrower's monthly debt-to-income (DTI) ratio must be no more than 36 percent.

2. The Originators has to verify and document the borrower's income and all outstanding debts to include; rent/mortgage, property taxes, insurance, debt payments (credit cards), debts not in repayment (deferred student loans, interest-only loans); and any required monthly alimony, child support, or court-ordered payments.

3. Auto loans can only have a fixed interest rate and cannot exceed 5 years, with the first payment due within 45 days of the closing date. For a used vehicle, the loan agreement must provide that the term of the loan, plus the difference between the current model year and the vehicle's model year, cannot exceed 5 years.

4. At the time of the closing of the automobile loan, the borrower tendered a minimum down payment from the borrower's personal funds + trade-in allowance that is sufficient to pay the full cost of vehicle title, tax, and registration fees, as well as any dealer-imposed fees, and 20 percent of the purchase price of the automobile.

In summary, most of America would be unable to qualify for an auto loan.

Not too worry – this rulemaking garnered a whopping 406 comments. Posted below are excerpts from some of the comments on the automotive loan provisions. This isn't a comprehensive list, but it gives you some idea of the concerns.

Hertz:

"We respectfully request that the Regulators exempt rental car from the risk retention rules to be promulgated under Section 150 of the Exchange Act."

American Securitization Forum:

"We believe that in preparing the qualifying auto loan definition, the Joint Regulators made a fundamental error in attempting to analogize to the residential mortgage asset class. This inappropriate paralleling is evident in the focus on debt and income verifications at origination, which have traditionally not been required for even the highest quality motor vehicle originations, a required 20% down payment (comprised of cash and/or vehicle trade-in value) in a market where advance rates above 100% are commonplace"

National Automobile Dealers Association:

"NADA supports the view of the motor vehicle sponsors that the proposed risk retention options would unnecessarily impose additional layers of risk retention that could have "a number of significant, negative impacts," including an increase in dealers' floorplanning costs and in consumers' costs to purchase and lease vehicles from motor vehicle dealers."

Comments are in! Now what?

Based on the comments provided, the Agencies huddled and issued a revised rule on September 20, 2013 (OCC-2013-0010-0001).

205 comments were received before the (second) rule closed on October 30, 2013.

In summary the Agency responded by saying:

1. Money-in (income) vs. money-out (bills) is the best crystal ball into default (risk). "The agencies do not believe that a credit score alone is sufficient underwriting for a conservative automobile loan with a low risk of default."

2. Vehicle leases will not be included as they fall into a different category of securitization.

3. 20% down requirement was changed to 10% while the 60 month term expanded to 72.

Noteworthy comments on re-issued rule:

CarMax:

"CarMax like other auto lenders, relies on statements made on a customer's credit application and on credit bureau reports in conducting our underwriting process. If we were required to demand independent income verification of our customers, we would disrupt our existing sales processes, put substantial burdens on our customers, and find ourselves at a competitive disadvantage behind lenders who do not rely on the securitization markets for funding and would not need to perform any income verification."

"..minimum down payment is not necessary if the other criteria related to creditworthiness are required. We do not require a down payment for many of our customers with excellent credit, as these customers have displayed behaviors and history that show their willingness and ability to repay their obligations. Many of these customers, those who should be the very focus of the definition, would be disqualified solely because of the down payment requirement."

SIFMA, FSR, ABA & ABASA:

"The criteria proposed for the definition of "qualifying automobile loan" are impractical and inconsistent with industry practice. This exemption would be useless, as virtually no loans made today would qualify. The proposed standards, which are more suited to unsecured installment loans, rely on information not available to prime and super prime automobile lenders. The cash down payment requirement is particularly out of step with the market, as is the lack of permitted reliance on credit scoring. The criteria should be expanded to include leases on the structural side, and motorcycles on the asset side.

Conclusion:

While much of this rule pertains to the quality and risk as it relates to the creation of asset-backed commercial paper, these rules could have a rather large impact on the how consumer's finance their new and used vehicles.

If CarMax is correct in stating "many" of their customers wouldn't be able to afford a 10% down payment and these rules were to be implemented as they currently stand, it could have a devastating impact on an industry that relies so heavily on ZERO DOWN credit offers.

Associated Links:

Original Rule (April 29, 2011): http://www.regulations.gov/#!documentDeta...

New Rule (September 20, 2013): http://www.regulations.gov/#!documentDeta...