Car Finance Out of Control?

 

Warnings over excessive and risky borrowing in the car finance market are evoking memories of the financial crisis. Regulators on both sides of the Atlantic are becoming increasingly concerned about the car finance market, amid mounting fears that the same practices which created the financial crisis of 2007 / 2008 may be happening all over again.

 

In the UK, British households borrowed a record £31.6 billion in 2016 to buy cars (up 12% on 2015) according to the Finance and Leasing Association. A similar phenomenon is apparent in the US, where the value of outstanding car loans rose to $1.1 trillion (£880 billion).

 

However, it’s not so much the growth in car finance that is worrying regulators, but the nature of the debt and how financiers are managing it.

 

In the UK, around 9 in 10 loans are personal contract plans (PCPs), where buyers pay a small upfront deposit and then commit to making a monthly payment for the next three years with the option to buy or hand back the car at the end of this term. Very often (analysts suggest) these plans are being offered to borrowers with poor credit scores.

 

Similarly, economists in the US warn that there has been a sharp increase in loans to poor credit scorers over the past 5 years……no surprise that the arrears are rising at an alarming rate.

 

Another thing the US and UK car finance sectors have in common is securitisation, with the finance arms of leading motor manufacturers working with investment banks to package up their loans into tradable asset-backed securities, offering an income stream financed by borrowers’ repayments. Such securities are attractive to investors looking for yield in an environment where ultra-low interest rates make income hard to come by.

 

Déjà Vu?

 

All this sounds worryingly familiar. In the subprime mortgage crisis of a decade ago, borrowers began to default on loans en masse, with the effects then bouncing around the financial system because these loans had been securitised and sold on to banks, pension funds and other investors.

 

Regulators are understandably worried by such echoes. The Federal Reserve Bank of New York has warned that while car finance arrears have been increasing, lender appetites to offer such borrowing shows no sign of diminishing, with lending volumes continuing to rise. The Bank of England’s Financial Policy Committee, meanwhile, has said it is determined to monitor underwriting standards closely amid fears that consumer borrowing has the potential to leave lenders vulnerable to financial shocks. The Bank’s economists have also warned that the growth of PCPs has added to the potential for car finance defaults to damage financial resilience.

 

The biggest issues that regulators fear is that some sort of macroeconomic shock (an economic slowdown driving unemployment higher or a sharp rise in inflation that increases the cost of living) could trigger much higher default rates. Given that the value of most cars depreciates rapidly compared to other assets, lenders seeking to repossess vehicles in order to mitigate their losses would be likely to fall short – just as repossessions of properties bought with subprime mortgages did not prevent the last crisis.

 

All very worrying……we are not at tipping point but it is definitely a watching brief. The warning signs are there……but will they be respected this time around?

 

Cautious times.