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Car financing continues to speed down a dangerous road

As we hit the 10th anniversary of the first clear signs of the global financial crisis, further rises in sub-prime car financing loans illustrate how, in matters of money, the human memory can be very short indeed

21/09/2017

Andrew Evans

Andrew Evans

Fund Manager, Equity Value

Last week saw the 10th anniversary of the moment most people had their first inkling all was not completely well with the global financial system.

On 13 September 2007, word began to spread that Northern Rock had asked for emergency funding from the Bank of England in its capacity as ‘lender of last resort’, thus prompting the first run on a UK bank for more than a century.

Last week also saw the publication of the latest ‘State of the automotive car finance’ report from Experian, which showed 86% of all new cars and 54% of all used cars in the US have been bought using some form of car financing.

And if those numbers sound vaguely familiar, it may be because they are within a whisker of what they were when we highlighted the corresponding report this time last year in an article we wrote- Crash course.

 

The picture has gotten worse

 

Other figures in the report, however, suggest the picture has only deteriorated – for example, the percentage of car loans and leases that are at least 60 days in arrears is up on 12 months ago.

Furthermore, the proportions of car financing described by Experian as ‘sub-prime’ or, more ominous still, ‘deep sub-prime’ are respectively up by 8% and 16% on last year.

Nor is this uneasy state of affairs confined to the US.

As you can see from the following graph, which is taken from the Bank of England’s annual Prudential Regulation Authority statement on consumer credit, the value of annual dealership car finance for new car purchases in this country has grown every year since the financial crisis and indeed 90% of all new car sales in the UK are now funded this way.

 

Value of annual dealership car finance for new car purchases, and proportion of private new car purchases funded with dealership car finance.

 

Sources: Finance & Leasing Association, Society of Motor Manufacturers and Traders (SMMT) and Bank calculations.
(a) Annual sterling gross lending to individuals on dealership car finance for new car purchases provided by Finance & Leasing Association members, attributed to personal contract purchase (PCP).
(b) Annual transactions on dealership car finance for new car purchases provided by Finance & Leasing Association members, as a proportion of SMMT new car registrations.

 

The situation is certainly worrying the powers that be.

In April, the UK’s financial services watchdog, the Financial Conduct Authority, began an investigation into possible mis-selling to consumers by the car finance sector while, last month, this Bank of England blog noted the industry “continues to accumulate credit risk, predicated on the belief that used car values will remain robust”.

 

Ballooning concerns

 

A particular issue concerns the final, so-called ‘balloon payment’ borrowers can make to secure ownership of the car.

The blog’s authors describe setting the value of this payment as “a difficult balancing act”, explaining: “If it is set too low – perhaps because the lender anticipates high depreciation of the vehicle – then car finance costs increase for the consumer, perhaps making the deal unaffordable.

“But if set too high so the market value of the car at the end of the contract is lower than the balloon payment, the lender risks losing money if the vehicle is returned.”

The bigger issue, of course, is that lending money to people who cannot afford to pay it back rarely ends well – a lesson we were supposed to have learned after the crash that began a decade ago, though clearly not everybody has.

Nobody is seriously suggesting sub-prime car finance is sowing the seeds of another global financial crisis – to offer a little perspective, earlier this year the Bank of England estimated there was £58bn of outstanding car loans in the UK, compared with £67bn of credit card debt and £1.3 trillion of mortgage debt.

Nevertheless, when it comes to matters of money, it is always remarkable how short the human memory can be.

Author

Andrew Evans

Andrew Evans

Fund Manager, Equity Value

I joined Schroders in 2015 as a member of the Value Investment team. Prior to joining Schroders I was responsible for the UK research process at Threadneedle. I began my investment career in 2001 at Dresdner Kleinwort as a Pan-European transport analyst. 

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