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Crash course – Sub-prime lending is a dangerous road no matter what is used as security

23/09/2016

Andrew Evans

Andrew Evans

Fund Manager, Equity Value

Everybody in finance is likely to have learned a big lesson from the 2008/09 sub-prime crisis – just not the same big lesson. Most people, you would imagine, might say an important point to take away from that time was that lending money to those who cannot afford to pay you back is not a particularly sound business plan.

Some people have apparently reached a different conclusion, however – that while lending money to those who cannot afford to pay it back may not be a good idea in the context of the biggest asset in people’s lives – in other words, their house – everything  will work out just fine if it is only their second-biggest asset – their car.

According to a recent report from Experian, the total balance of outstanding car loans in the US now exceeds $1 trillion (£771bn) while 85% of all new cars and 56% of all used cars in the country have been purchased using some kind of financing. Nor is this a uniquely American issue – in China, for example, 30% of all cars have some form of finance and a similar picture occurs in Europe and Japan.

Returning to the US, more than 20% of car financing is now described by Experian as sub-prime or, worse, ‘deep’ sub-prime – thereby surpassing sub-prime mortgages’ own peak of 20%, which was recorded in both 2005 and 2006 [1]. Furthermore, adds Experian, more than 80% of sub-prime borrowers and more than 90% of deep sub-prime borrowers make use of loans when buying a car in the US.

Still, while some might take the latter two percentages as an indication such people really cannot afford to buy a car, it would not appear to have stopped lenders queuing up to offer them finance nor borrowers queuing up to take it – at rates that equate, despite the current ultra-low interest rate environment, to roughly 5% for new cars and 9% for used cars.

Delinquencies on the up

With such high interest rates being charged to people who in all likelihood would be unable to afford the loans even at a fraction of the cost, it is unsurprising that delinquencies are on the up. Finance providers – the lenders who have sprung up on the edges of the car industry – report a remarkable 5% of loans are more than 30 days overdue while, in total, 2.2% of loans are.

One obvious issue here is that not only are these finance providers seemingly happy to lend to people who cannot afford it, they are seemingly happy to do so using a depreciating asset as security. At least with a house, a lender could – on a long-term view – reasonably assume its price would rise. In the sub-prime crisis, of course, prices fell but it was still a better bet than with an asset that always depreciates.

A second issue is that, for the last few paragraphs, we have been talking very specifically about ‘finance providers’. Half of all new car-financing in the US is being carried out not by banks but by the auto industry itself – as you can see from the following charts, the financial services assets of leading manufacturers in both Europe and Japan have mushroomed over the last few years.

European OEM financial services assets (€m) have risen almost 100% since 2007

Source: Company data, Morgan Stanley Research

 

Japanese financial services assets have grown even more quickly

Source: Company data, Morgan Stanley Research

Historically, the car manufacturing industry is looking very cheap – a factor that is always going to attract our attention, here on The Value Perspective – and yet these sorts of statistics represent a serious concern and a real obstacle to our making an investment. It is not a new problem – indeed we wrote about it two and a half years ago in Offside indicator – but it is undoubtedly growing worse.

Not to such a degree we are looking at ‘Sub-Prime II – The Sequel’, we would hasten to add, but it is strange that so many people appear not have learned a lesson from the extreme events of what is still less than a decade ago. Or, if they have learned a lesson, it is a very specific one: that sub-prime is not helpful – but only when lending to people who cannot afford to buy a house. Cars though? Game on.

The wording remains the same – it is still ‘sub-prime’, albeit now of varying degrees of depth – while extrapolating from a person’s largest asset to their second largest is not much of a mental journey. Yet apparently there are plenty of people unable or unprepared to make it – just another reminder market memories are short and the same financial mistakes are repeated over and over again.

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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