LONDON — Four out of five new cars in Britain today are bought using a credit product that has “exactly the same problems … that happened with the mortgage market” 10 years ago, Morgan Stanley automotive analyst Harald Hendrikse tells Business Insider.
He believes the current state of car credit in the UK — £41 billion ($US54 billion) in loans last year — is unsustainable.
The reason: car finance companies are allowing drivers to buy vehicles using a consumer debt product which requires car dealerships to take cars back if their owners decide they don’t want them anymore. Almost all the risk in these transactions is carried by the car finance company, not the consumer. There is virtually no other consumer credit product which allows borrowers to simply walk away from an asset unpenalized if they don’t want to pay for it anymore.
The scenario — of cash-strapped consumers handing back their keys with almost no downside — might bring back memories of the 2008 housing crash in the US, and a concept called “jingle-mail.”
In the depths of that recession, mortgage bankers experienced an avalanche of envelopes from former customers that jingled when they were delivered. American homeowners who couldn’t afford their mortgage payments and couldn’t sell their houses simply mailed their house keys back to the bank and walked away. The houses then became the bank’s problem.
Morgan Stanley’s Hendrikse isn’t alone in worrying about the condition of the UK car market. The Financial Conduct Authority said this week it would examine “whether consumers are at risk of harm” and whether “firms managing the risk that asset valuations could fall [are] ensuring that they are adequately pricing risk.”
If the UK car market were to crash, dragging the car credit market down with it, the situation will be less systemically serious than the mortgage business in the run-up to the 2007-2008 financial crisis, Hendrikse says, because the value of the car market is only about 10% the size of the housing market.
But it would still be a big problem: The personal contract purchase, or PCP, market is creating a supply of high-quality used vehicles which is greater than the entire aggregate demand for new cars in Britain, in some years.
82% of new cars in Britain are bought with contracts that pay less than the value of the car
The problem stems from the way new cars are bought in Britain. A decade or more ago, drivers had three simple choices: pay cash for a new car; lease the car (but not own it outright); or take out a traditional loan with fixed “straight-line” payments over time.
Very few buyers take those options today. Eighty-two per cent of new cars in Britain are currently bought under PCP agreements, according to the Finance & Leasing Association, which tracks car credit data.
Typically, a PCP requires a cash deposit on a new car and then three years’ of cash payments plus interest, similar to a lease. The difference is what happens at the end of the three-year period. Drivers a have a choice: They can either pay a lump sum “balloon” payment to buy the remaining value of the car, or they can hand the car back and walk away.
Either way, at the end of the three-year period, the car finance company has received a stream payments which is worth less than the total price of the car at the beginning. The finance company makes its money because most people do not simply give the car back to the dealer. Rather, they use whatever “equity” they have in the vehicle as a downpayment on a new car, which is then rolled over into a new PCP agreement. The dealer can recoup the “lost” equity by selling the car as a used vehicle.
Auto finance companies typically set the estimated “guaranteed future minimum value” (GFMV) of the car at the end of the three-year period at about 85% of its estimated future market value. After three years, this gives the driver a good chance of owning a car that might be worth more than its GFMV. For example, if the three-year-old car was worth £5,000 on the second-hand market, a PCP driver might only owe £4,250 to the dealer for the balloon payment.
The advantage for the driver is that they can either pay the £4,250 and then sell or keep a car worth £5,000, or — more commonly — use the £750 “equity” as a downpayment on a new car with a new PCP. The advantage for the dealer is that if the driver walks away it receives a car it can now sell for £5,000, even though it is owed only £4,250.
This has never been tested in a recessionary market
There is an obvious problem with all of this: It only works as long as the dealer/finance company has correctly estimated the second-hand value of the car three years from now. If the market heads south — due to a recession, an unexpected glut of used vehicles, or Brexit — and the market values are less than the GFMV, then everyone is in trouble. Drivers are left owing more than their cars are worth; dealers are likely to get stuck with cars whose value is less than the price they need to make a profit.
We are repeating exactly the same problems in the US and the UK specifically that happened with the mortgage market in 2007.
“The mechanics of the situation are exactly the same” as the mortgage crisis, Hendrikse says. “We are repeating exactly the same problems in the US and the UK specifically that happened with the mortgage market in 2007 – well, 2005, ’06, ’07.”
“The dangerous part of it is that the residuals on those vehicles would fall very sharply. And so that’s dangerous in the sense that the consumers and owners of those cars would lose a lot of money and would clearly be in negative equity on those cars.
“And obviously, if you’re a lease company or, a finance company, you would potentially have to take very large losses to try and get rid of those cars from your balance sheet.”
The UK market has never been through a period in which it has taken significant losses on PCP cars. But it may be about to do so for the first time, for three reasons:
- A huge wave of new PCP cars, the most in British history, will come back onto the market in the next few years, creating a glut of good-quality second-hand cars and depressing prices for both new and used vehicles.
- Consumers are suddenly abandoning diesel cars in favour of electric, petrol, and hybrid cars due to the Volkswagen emissions-testing scandal, which has spread to multiple models of diesel cars. The UK government has promised to make diesel cars illegal by 2040, and London will begin imposing a “T-charge” on diesel vehicles driving through the city starting in October. About 44% of UK cars are currently diesel-fuelled. Those cars will not be wanted in the years to come.
- Brexit is likely to administer a negative shock to the UK economy. The UK has not been through a recession since 2008/2009. Back then only about 50% of new cars were on PCPs.
The unanswered question is, what happens to the PCP car market when people are losing their jobs, and can’t afford — or don’t need — their cars?
“It’s going to create enormous pressure on the whole system.”
The challenge is compounded, Hendrikse believes, because of one other unique factor about the UK market: Its cars are all right-hand drive. Brits drive on the left. In Europe and the US, cars are left-hand drive because everyone else drives on the right. British cars cannot be sold anywhere else. That removes a crucial market safeguard that exists on other continents. If a dealer can’t get the price they need in Florida or France, companies can transport those vehicles to a different state or country where the market is more robust.
There were “2.7 million cars sold in the UK last year,” Hendrikse says. The vast majority of those are on PCP contracts. “That means that in each of the next three years we will have 2 million units of these very good quality, low mileage, nearly new cars as an alternative to people buying new cars, right? And obviously that relative — 2 million versus 2.7 million — by definition is absolutely huge.”
Two million vehicles is potentially bigger than the entire market for new cars bought in Britain in some recent years. Over the last 10 years, Brits have bought between 1.7 million and 2.7 million new cars every year, depending on the health of the economy.
Obviously, the new car market is not the same as the used car market. But the prices in one do affect demand in the other.
You’ve got more used, nearly new cars coming into the market than you have of total car demand for new cars.
“It’s going to create enormous pressure on the whole system,” Hendrikse says. “And that gets even worse when you get a downturn in demand altogether. From 2007-2009, the UK market dropped from about 2.6 million units to about 1.8 million, 1.9 million. So at that stage, you’ve got more used, nearly new cars coming into the market than you have of total car demand for new cars.”
Not everyone is so pessimistic. Adrian Dally is the head of motor finance at the Finance & Leasing Association. “The UK car market is very transparent,” he tells Business Insider, noting that there might be one or two thousand PCP agreements on every single different make of new car in the UK. All dealers and finance companies have access to the same pricing information through services like CAP and Glass’s. They use actuaries to predict values into the future. There aren’t many surprises, he says. Used cars lose between 8% and 16% of their value in most years.
“UK auto securitization is rated very highly by ratings agencies,” Dally says, referring to ratings on bundles of PCP loans that are sold on by finance companies into the asset-backed securities (ABS) market.
Ford Credit Europe, for instance, offered £542 million ($US711 million) of financing contracts onto the ABS markets in late June. A majority of them were PCPs, according to the Financial Times. In May, Volkswagen priced a €1 billion ($US1 billion) bundle.
That sounds like a lot. But systemic UK bank exposure to PCP contracts is “pretty negligible,” Dally says.
The Bank of England agrees with him. UK banks are exposed to about £20 billion in PCP assets, according to BOE. That is equivalent to 9% of “Common Equity Tier 1” capital, one of the measures of capital banks are required to hold to absorb losses.
“The cycle ends itself, right?”
Rather than the banks, the risk this time round is concentrated inside the captive finance arms of the car companies themselves, according to Alex Brazier, the BOE’s Financial Director for Financial Stability Strategy and Risk.
“The main risks are with the finance companies offering these contracts — typically arms of car manufacturers. Unlike credit cards or personal loans, the lenders here are predominantly the finance arms of car companies. Their losses — however painful to them — pale in significance for the wider economy next to situations in which it’s the banking system making the losses,” he said in a recent speech. (Ford Credit Europe did not respond to messages requesting comment.)
Both the FCA and the Bank of England are conducting research into the extent of PCP financing and UK banks’ exposure to it.
In the meantime, Hendrikse expects the system to come to a self-fulfilling end, with car finance companies being the losers: “When leasing as a proportion of sales is growing very sharply, it automatically creates a very fast growth in the supply of used vehicles in a three- to four-year time frame, which then causes the residuals to weaken, which then means that leasing becomes that much more difficult. And the cycle ends itself, right?”