Bubbles all round?

Every silver lining has a cloud

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Whilst the economy is, slowly, lurching back into growth, there was still some grim reading in the consumer credit reports at the end of last year. Among the warnings about the growth in household debt there have been repeated concerns about the level of car finance credit. This country is issuing car finance credit at levels not seen since before the financial crash of 2007.

In some ways this is not surprising. Car purchases being largely facilitated through personal contract hire products (over 80% of new car registrations in 2017 were via PCPs). But with £30 billion car finance credit in issued by auto finance dealers in 2016, the question has been asked whether this is a new form of debt bubble which may precipitate a financial crash.

On the one hand reports show that generally the loans are being made to people with good credit ratings. The previous crash was caused by a proliferation of ‘subprime’ lending - lending to people less likely to repay the loans and precipitated by a high rate of defaults.

On the other, the new forms of car financing have created a different market with the potential for different unforeseen consequences.

Previously financing via banks meant that it was the banks exposed to bad debt – painfully so in 2007. In this new model, much of the funding for PCPs is provided by car manufacturers – exposing the automotive industry to the risks of default. Over the past five years this form of auto-finance funded by car makers has more than doubled from £14.6bn in 2011 (adjusted) to £31.7bn in new credit issued in 2016*. 

But it’s not just direct exposure to debt that could be the issue, there is also more exposure to both new and second hand values. In the old days, car manufacturers sold new cars. End of story and off the balance sheet.

These days, cars stay on the balance sheet for much longer one way or another – usually through automotive finance companies that are wholly or partly owned by automotive manufacturers. In addition, the value on that balance sheet is complicated.

Depreciation has become the metric on which PCPs are based. Essentially the monthly charge covers the depreciation between the start and end of the PCP period (plus some interest and presumably a sales margin). So the calculation of the ‘real’ value of vehicles is quite important. Value, as any auctioneer will tell you, is whatever people actually pay for something. In the world where car sales are dominated by PCPs, the market is held together by accurately predicting what people will be prepared to pay for second hand vehicles. If the economy or other factors reduce that, it could knock holes in the model.

In some ways the PCPs could be their own enemy here – early adopters are now trading in their three-year-old cars for new ones rather than hanging on to them, increasing the supply of second hand vehicles. Whilst this stimulates growth in new car sales (something the industry is keen on!) it also increases the supply of second hand vehicles which tends to depress their price.

A dramatic decline in second hand prices has the potential to affect car manufacturers quite directly. If the cars which are returned to them don’t hold their value as predicted, it could significantly reduce the value of their balance sheets.

What’s more, it’s not just a case of ‘what goes on in the car industry stays in the car industry’. Several of the large German manufacturers offer individual savers better rates than banks if people loan them their savings. For instance, Daimler group, which owns Mercedes-Benz bank, had €101bn of financing liabilities in 2015, the latest year for which full figures have been published. Roughly a tenth of this, €10.5bn, came from ordinary depositors whose savings are pooled with the other forms of financing.**

Echoes of the financial crash of 2007 cannot be ignored. The German penchant for sensible saving and steady returns meant that provincial German banks were avid buyers of the securitized US loan products. These products started out promising steady yields and then precipitated huge losses in the financial markets.

The crash of 2007 was a live action lesson in unforeseen consequences. It is concerning that there’s not more systematic review of large scale changes in consumer behavior and the finance that accompanies it.

Obviously, closer to home for DirectGap there are impacts for the insurance industry.

Motor insurers calculate risk, premiums and arbitrate replacement car values based on agreed values. Motor insurance looks at guide prices for the car at the age it is at the point of any incident (firstly to deem whether repair is economic and secondly to value it in the event of total loss).

GAP insurers use the list price when new to determine the amount insured over and above the depreciation. But with every manufacturer offering deals to consumers, the list price often bears little relation to the price people pay.

So, if cars change hands a prices that widely diverge from the list or guide price, the insurance industry may need to adjust its models.

On the other hand, the unforeseen consequences for the insurance industry could be positive. If cars actually become cheaper the industry carries less financial risk and is more secure as a result.

It’s time to talk about these things and to see what risk is being modelled and what isn’t. New finance has been a great boon for the car industry but the implications need to be more widely understood.

Car Finance PCP Changes Gap Insurance

*Guardian: Finance and Leasing Association figures adjusted for real terms

** Financial Times, 25 June 2017

by Beate Kubitz at 17 Mar 2018, 00:00 AM