Are we facing a car loan credit crunch? Here are the facts

Most new cars are now bought on credit. Shutterstock

Sales of new cars in the UK fell for the fifth month in row during August, with demand for diesel cars falling more than a fifth, according to data from the Society of Motor Manufacturers and Traders (SMMT).

But looking at longer term trends, sales are still near record levels and on a par with pre-credit crunch levels. Last year, some 1.2m of the 2.7m new cars sold in the UK went to private individuals, a 47% increase on 2011 figures.

These private sales are overwhelmingly fuelled by credit: 86% of them were financed by members of the Finance & Leasing Association who lent over £18 billion to private individuals buying new cars. This is a 164% increase on 2011. Finance provision on secondhand cars is roughly the same amount again.

No wonder the Bank of England is looking at this closely – and others are warning it could lead to another credit crunch.

How it works

Personal Contract Purchase (PCP) financing deals now account for over 80% of new car credit sales. To many, PCPs are essentially a form of rental agreement; after paying a deposit, the consumer pays a fixed monthly payment to use the car for an agreed time period and number of miles.

But the mechanics and options of a PCP deal are a little different to a traditional lease (or Personal Contract Hire). In many PCPs, the deposit is fairly small, and often comes with a contribution from the manufacture or dealer, albeit in lieu of a discount.

So once registered, the value of the finance will be close to the asset’s value. A guaranteed minimum future value (GMFV) is set for the end of the term – usually 24 or 36 months – with this GMFV based on a forecast of the vehicle’s value at that stage, allowing for depreciation.

The consumer’s monthly payment is based on paying back the difference between the amount financed and the GMFV, with interest often calculated and payable during this term based on the total amount financed.

At the end of the agreed term, the consumer hands back the car, or can purchase it for the pre-agreed GMFV, also known as a “balloon payment”, or use any positive equity (that’s excess value over the GMFV) as a deposit towards a new car – assuming there is any.

Don’t celebrate the ‘boom’ just yet. Shutterstock

It all sounds simple, and has kept the champagne corks popping in dealerships. What could possibly go wrong?

The catch

First, think of consumer expectations. Fees are payable if the car is handed back with more than the agreed miles on the clock, or if the car is deemed to have more than reasonable wear and tear. This often catches consumers out.

Early termination is also usually penalised, although dealers target mid-term upgrades, and consumers often have an expectation of some equity being available at end of the term. Being sold a new car upgrade at the end or during the contract will likely require a further injection of cash – or the rollover of any deficit.

Second, let’s think how the finance industry works. To hit high volumes, many lenders have made credit acceptance easier, thus making PCPs more readily available to those with less than prefect credit records – think of the subprime housing market in the US and how it led to the last credit crunch.

But this credit “boom” relies on a number of elements.

First, low default rates. But the Bank of England reported an increase in “voluntary terminations” of late which usually means losses for finance houses, perhaps linked to the fact that prices are rising faster than wages. And any rise in interest rates will put further pressure on household budgets, whether that’s owners or renters.

A stable boom also relies on stable underlying assets. But PCPs use as security a car, a fast depreciating asset.

As an asset, cars depreciate … fast. Shutterstock

If a large percentage of consumers upgrade at the end of their term, whether to avoid the balloon payment or just to keep up with the Joneses, this could also mean a tidal wave of end-of-contract cars hitting the secondhand market.

The risk here is of values falling and a spiralling effect setting in, as those seeing the actual value of their car falling below the GMFV also decide to return it to the dealership.

Secondhand values of diesels have already fallen sharply according to auction specialist Autorola thanks to environmental pressures and consumers becoming spooked by bad news about diesels and concerns over future residuals.

This could also cause material losses to lenders through their GMFV risk. Here, the entwined relationship between auto makers and lenders means it is not actually that clear who is ultimately underwriting these risks; indeed, around half of the finance comes from lenders which are actually owned by the manufacturers. For example, Volkswagen’s financing division had over €150 billion of loans to customers on its books in March this year.

What next?

The Bank of England is now concerned about the financial stability of these products as banks have a £20 billion exposure, and manufactures as much again. It is concerned that the industry’s growing reliance on PCPs has made it more vulnerable to macroeconomic downturns.

The Bank reckons that a 20% fall in used car values could lead to losses as high as £1.2 billion, in turn denting what’s termed “Common Equity Tier 1 Ratios”, a key measure of banks’ financial stability.

This is possible as average prices for used fleet cars fetched at auction fell 19% during the global financial crisis, according to BCA figures.

A likely outcome of the Bank of England review could well be tougher affordability criteria, to improve the quality of the loan book, and this reduction could in theory lead to a credit crunch.

Some of the car loans in the UK and US have been sliced up and packaged into asset-backed securities (ABSs) and sold on to investors (like pension funds). These ABSs played a big part in the last global financial crisis of course. Last year, €4.8 billion of auto loan ABSs were sold in the UK alone, with around €18 billion of auto bonds placed in Europe.

Auto loan ABSs involve numerous banks; HSBC, Lloyds, Wells Fargo and BNP Paribas were all involved in a £1.3 billion ABS issued by PSA Finance, for example.

At the same time, the Financial Conduct Authority, which is responsible for regulating consumer credit, has concerns about the sales practices involved in PCPs, and is studying whether there is a lack of transparency, potential conflicts of interest, and irresponsible lending in the motor finance industry. Others have joined the clamour.

Most dealerships are only authorised in a non-advisory capacity for finance, and cannot recommend specific finance deals. But it is suggested that the full implications to the consumer are not always clearly disclosed. Other options (like leasing which could work out cheaper) may be ignored in favour of “drive away” PCP packages which are a great tool to help dealers meet car and finance targets, and make commission in the process.

Are we likely to see a crash? That’s unlikely in the UK, as the market is smaller than in the US, and the Bank of England is relatively vigilant, and likely to impose controls that will gradually adjust the situation without causing a snowball effect. It may well be a far bigger problem in the US, however.

Nevertheless, greater public exposure may be welcome news for one sector: the potential PCP mis-selling scandal may soon become the ambulance chasers’ next meal ticket. Think PPI all over again.