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Is car finance out of control?

Article | 29 June 2017

Warnings over excessive and risky borrowing in the car finance market are evoking memories of the financial crisis.

Could we be about to see a repeat of the subprime mortgage 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 led to the mortgage collapse – and then the financial crisis of 2007 and 2008 – may be happening all over again.

In the UK, British households borrowed a record £31.6bn in 2016 to buy cars – up 12% on 2015, according to the Finance and Leasing Association.1 A similar phenomenon is apparent in the US, where the value of outstanding car loans rose to US$1.1 trillion (£880bn).2

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 nine 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 subprime borrowers over the past five years, and that ‘delinquencies’ – where borrowers fall behind on repayments – 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 delinquencies have been increasing, lenders’ appetite 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.

In particular, regulators fear that some sort of macroeconomic shock – an economic slowdown driving unemployment higher, for example, 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.

For their part, lenders insist they are behaving responsibly. The Finance and Leasing Association says car finance providers in the UK have been highly disciplined when assessing the affordability of loans for borrowers and points to analysis from credit reference agencies that shows securitised loan portfolios are robust. It’s also important to point out that despite the recent boom, car finance volumes are modest in comparison to mortgage lending. The US$1.1 trillion total reached in the US last year compares to around US$14 trillion of home loans.

For this reason, even a calamitous collapse in the car finance sector might be containable, rather than posing a systemic risk like mortgage debt. Car manufacturers would be in the firing line, exposed through their car finance arms, but their difficulties might not spread throughout the financial sector, or at least not with the same degree of seriousness.

Nevertheless, regulators declare themselves determined not to take the risk. The UK’s Prudential Regulation Authority has already begun an investigation into credit quality in the consumer sector while US policymakers are keeping a close eye on delinquency rates. For those for whom the last financial crisis is an all too recent memory, this vigilance is crucial – the last thing that Western economies, already plagued by a range of uncertainties, need is the car industry speeding them towards a high-impact crash.

1 fla.org.uk, as at 10 February 2017.
2 economyandmarkets.com, as at 26 January 2017.

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Where individuals or the business have expressed opinions, they are based on current market conditions, they may differ from those of other investment professionals and are subject to change without notice.

Tags: Equity, UK, US, Market