Over the last 10 years, UK car dealers have ramped up a new form of car loan, called “personal contract purchases” (PCP), that could shake British banks exposed to them, according to the Bank of England.
In 2016, the total amount of car loans being carried by consumers was £58 billion ($US75 billion), more than double what it was in 2012 (£28 billion, or $US36 billion). The Bank of England estimates “major UK banks’ total exposures to UK car finance to be around £20 billion,” the bank said recently.
That is equivalent to 9% of “tier 1 capital,” the bedrock equity that banks must maintain in order to be considered sound by regulators. To put that in perspective, the recent Italian bank bailout cost £15 billion (€17 billion, about the same value in US dollars).
The problem is that the quality of UK car finance loans has changed over time. Previously, car finance was simply a matter of a driver paying a deposit and then making monthly payments, with interest, until the loan was paid off. In 2008, a majority of car loans from dealers in the UK were financed this way.
Today, however, the vast majority of dealer loans are in the form of PCPs. In a PCP, there is no deposit, and the driver makes much lower monthly payments until the end of a fixed term. At that time, the driver must either make a large “balloon” payment or return the car. The dealer either gets all the cash and interest generated by the loan or, in the case of someone who can’t afford the balloon payment, the dealer can sell the car again.
Obviously, the value of the underlying asset in a PCP deal — the car — can change dramatically depending on how well the driver treated the car, or on how the market for second-hand cars is performing.
In a downturn, drivers who fall on hard times can simply return the car and walk away from the rest of the loan. The dealer is stuck trying to sell a car in a recession, when prices are likely to be plummeting. That leaves dealerships and the banks funding them exposed to a highly volatile market.
Today, 85% of auto financing in the UK consists of deals done via car dealerships, and of those, the vast majority are PCP deals:
In total, car finance is 30% of all consumer debt, the BOE says:
Total consumer debt of all kinds: £198 billion
… of which car finance: 30%
Total car finance debt: £58 billion
… issued by banks: £24 billion
… issued by non-banks: £34 billion
At first glance, this sounds like a problem that might solve itself: If car dealerships are issuing low-quality loans, then they will be the victims of their own bad judgments and no one else need worry, surely?
Unfortunately, about half the financing for dealer loans comes from banks or other lenders outside the car company universe, the BOE says: “Around half of the debt funding for these subsidiaries comes from their parent companies, around a quarter from securitisation, with the remainder from bank lending.”
That word “securitisation” ought to ring alarm bells. It was securitised mortgages — mortgages bundled into bond-like investments that could be traded or used as leveraged assets in credit derivatives — that led to the 2008 property crash.
Just like in the run up to 2008, the market for new car loans is non-transparent. MPs are currently urging the government to require the Finance & Leasing Association to publish a breakdown of the quality of loans issued by its members.
The fear is that car dealerships aren’t as careful as banks — or simply don’t care — in assessing whether drivers earn enough to pay back their PCPs. The Mail, for instance, sent reporters pretending to be unemployed or otherwise on low incomes to 22 Scottish car dealerships. They were offered PCP deals at half the dealerships.
The BoE is concerned about what might happen if prices for used cars went down. If car values at the end of PCP contracts came in at 30% lower than expected, “market-wide losses would rise to 7% — 10% of the outstanding stock” of loans held as assets at UK banks, the BoE says.
Steve Baker MP, a member of the Treasury Select Committee, told the Telegraph that his panel will want to see the F&LA breakdown in order to figure out just how bad the PCP problem is.