Will sub-prime car loans spark the next financial crisis?
Reputable banks, credit rating agencies, such as Fitch and Moody’s as well as newspapers on both sides of the Atlantic have signalled that the boom in new car sales in Europe and the USA since 2013 is being fuelled by riskier loans to borrowers, often using leasing or leasing type contracts called Personal Contract Purchase (PCP’s).
However, some newspapers and e-magazines go so far as to suggest that the securities based on car loans, leases and PCP plans – auto loan Asset Back Securities (Auto ABS) – could become the trigger for the next asset bubble collapse leading to yet another financial crisis. If they’re right some owners of the bonds would be facing significant defaults and losses in the next few years which, in theory, could undermine much of the supply side of the car finance market.
All this is hard to believe at face value when auto finance related debt is less than 10% of all household debt in both the USA and Europe.
But, this class of debt is expanding fast and, according to central banks, like the Bank of England, it represents increasing risk. Bankers point out that the credit risk is not only default by sub-prime borrowers on payments. Sub-prime borrowers only represent between 2% – 20% of the total contracts, depending on the country concerned. Although, in the US, while the overall sub-prime content is low on average, it has risen appreciably in the last three years. So, it’s realistic to forecast that an increasing number of borrowers could face difficulties in managing future repayments. The banks also point to a second risk, a sustained fall in residual values, which is potentially much more significant. If the residual value is less than the contract value, bondholders pay the shortfall. That could be billions of dollars in the UK and Europe.
A crash in used car debt has happened before. During the global financial crash there were multiple asset bubble collapses. US Sub-prime mortgages were the trigger but Asset Backed Securities based on commercial real estate mortgages and loans, credit card debt, new and used car loans, and student loans all collapsed in value. So, what would it take for that to happen again because of the financial drivers behind the recent boom in new car sales?
Financial crises do not happen easily and, to spark a global financial crisis, four conditions have to converge: 1. excessive borrowing; 2. an intertwined global economy; 3. globally traded and misunderstood financial instruments and 4. the crisis must start in the USA. Anywhere else except the US and the global financial system can protect itself. But, to trigger a regional crisis, you only require the first three.
This post examines how and if any of these conditions might be fulfilled by the combination of innovations in the financing of new and used cars introduced in recent years in Europe mixed into auto finance securitization dominant in the US for years. It concludes that, while there are risks, they aren’t significant enough in size or geographically and institutionally concentrated enough to cause a global or regional financial catastrophe.
New Car Sales
Globally, new car sales have been growing by just under 4% a year since 2005, according to the Organisation Internationale des Constructeurs
d’Automobiles” (OICA). By 2016 the ‘mature’ new car markets were more or less back at their 2005 levels: the EU27 (-0.14%), the UK (+0.9%) and the USA (Light Vehicle Registrations -0.98%). In fact, they had all either recovered the losses in sales caused by the financial crisis or were accelerating quickly towards their pre-crisis level . Taking only the last four years in each of these markets, the registration statistics tell an even more positive story. The EU27 new car market grew just over 7% each year from 2013 to 2016. The UK market grew by almost 6% pa and the USA market by almost 4% pa over the same period. Against a background of nominal wage growth lower than the growth in the new car market this apparently unstoppable rise in these major new car sales markets triggered the concern of financial regulators. Nominal US and EU wage rate rises were averaging 3% over this period and the UK 2%. After inflation, real average wage growth rates in all markets was nearer 1%.
Three factors seem to have driven the expansion: An extended period of low interest rates, coupled with the increasing appetite for PCP‘s or, in the US, leasing, linked with excess production capacity within car makers motivating them to seek additional profit streams.
Low Interest Rates: Throughout the last decade many central banks have based their action on two policies: near zero nominal interest rates (real interest rates were actually negative – see chart) and ‘quantitative easing’ (QE). One result has been to fuel consumer spending. Another has been to provide plentiful supplies of money seeking attractive returns. Almost $7TN was spent by EU, UK and US central banks on QE between 2008 and
2017. A by-product of the central bank’s ‘zero’ interest rate policies was to make it impossible for savers and investors to achieve a reasonable yield – unless they took on ever high risk. As the decade rolled on fixed income investors, be they pension funds, banks or individuals, invested in high-risk bonds that they may have shunned in former times. The investor’s dilemma was what to invest in and who to invest with when options were limited. Housing loans were highly regulated. Government bond yields barely exceeded inflation and corporate bond yields were little better. Some experts think that car finance loans – in the form of Asset Backed Securities – became the home for a lot of the funds looking for a return. There is some evidence for that. US Auto Debt levels expanded from around $750BN in 2010 to $950BN in 2014 and then to $1,200BN in Q4 2016. In Europe Auto ABS issuance grew from circa €15.5BN in 2015 to €18.1BN in 2016. In the UK in 2016 car loans issued were a record £31.6BN and Auto ABS issuance was around £8.0BN.
PCP’s and Leasing: What leasing did for the Fleet market, PCP’s deliver for the Retail market. They allow buyers with modest incomes to afford the car of their choice at a lower monthly payment. In 2016 the UK Finance and Leasing Association reported that PCP’s accounted for over 80% of all new car retail registrations. The PCP works by offering cars for a variable deposit at a monthly fee. At the end of the (usually) three-year period, customers either hand the car back, make a “balloon payment” and own the car outright, or put any equity they have in the car towards a new model. Every car sold through a PCP has a guaranteed minimum future value (GMFV). This is a forecast of the car’s value after depreciation. In practical terms it allows a borrower on a modest income to ‘own’ a car that is of a higher price or ‘own’ a new car on a lower monthly payment than he or she would be able to purchase outright.
According to Pendragon’s CEO, Trevor Finn, PCP plans have changed the way many consumers think about cars. A consumer, who might never own the car, is likely to view it in the same way they view a mobile phone contract, i.e. just another monthly payment. PCP plans have made it cheaper to run a car, especially one with a high residual value, and it removes the risk of falls in the car’s resale value from the borrower to the lender. Under PCP, the customer only has to finance the anticipated depreciation of the vehicle (plus the interest-only element levied on the GMFV) during the length of the contract, and not its capital value — unless of course the customer subsequently purchases the car by making the balloon payment. Premium brands, with their higher resale value, are thus more affordable, explaining much of the ‘badge inflation’ in recent years which has led to the expansion of UK-based dealer groups such as Sytner and Marshall Group .
Excess production capacity: Global installed capacity in 2015 for light vehicles was estimated at 125.6MN units. Global sales were approximately half of that – 66.3MN units – so, while break-even points for some have fallen significantly since 2010, a number of car makers are still thought to be producing at marginal cost or a little above in specific markets. One consequence was a search for new income steams which, in turn, fostered two income producing innovations in auto finance. First, a growing proportion of finance is now provided by the car manufacturers themselves, often through their own finance houses. Experian report that these so-called “captive” finance providers have a market share of about 70% of all private new car finance. Not only are captive finance companies profitable, they have the added benefit of being used to deliver consumer offers which help the car maker to increase demand and reduce over-capacity.
Second, car maker’s ‘captive’ finance houses promote PCP plans to potential buyers as their contract of choice. Their popularity with car manufacturers and their dealers is that PCP plans provide the opportunity to “lock in” customers to repeat purchases either at, or prior to, the end of the contract. Research suggests that around half of UK households renew their PCP plan with the same manufacturer. Indeed, once a buyer has positive equity in their vehicle — which in recent years, when used-car prices have been robust, has been after about 2-2½ years of the PCP contract — dealers will usually offer the buyer a PCP on a new car (a process known as “flipping”). The popularity of PCP plans has been associated with a shortening of the replacement cycle for private buyers, thereby boosting the aggregate level of consumer demand for new cars. A side benefit for dealers is that PCP plans focus the borrower on advance and monthly payments rather than the sticker price thus reducing pressure to discount prices.
However, captive finance companies and PCP plans would not have expanded without securitization. This process eliminates the captive finance company’s liabilities on the car maker’s balance sheet and allows it to re-cycle its funds to make new loan contracts.
Securitization is a financial process by which the owner of an asset, such as a portfolio of loans, receives cash upfront in exchange for the future cash flows from the asset – monthly loan repayments and the final value of the asset – without selling the asset in a normal contractual sales agreement. This process entails pooling the cash flows and selling them to investors via a special purpose vehicle (SPV), effectively turning ‘illiquid’ assets that cannot be sold easily into a ‘liquid’ asset that is tradable. If the income is ‘backed’ by underlying assets, such as vehicles or property, the securities are called‘asset-backed securities’ (ABS).
There are two benefits of securitization for a finance company. First, it gets cash now instead of in the future and can loan it out again. Second, it gets the credit risk liability off its balance sheet. In the case of ‘captive’ finance companies, owned ultimately by a car manufacturer, the finance company has passed the risk (e.g. default by the borrower or a drop in residual values) away to another entity, the SPV, and the SPV in turn transfers it away still further to a Trust, while the finance company who originated the loan continues to get a return on the initial transaction. In European securitizations, both the risk of default and residual value risk is increasingly passed on to bondholders. In US securitizations, residual value risk is not usually passed on.
How Does Auto Securitization Work?
Similar to other businesses a finance company has several funding sources available to obtain the necessary capital to finance loans and run its business. These sources include cash deposits, bank loans, issuing shares or bonds. But it has another source as well. It can issue asset-backed securities (securitizations). In fact, for many car finance providers, whether ‘captive’ finance companies or not, their primary source of funding is securitization. The securitization market allows the finance provider to sell the loans it has made and return large amounts of capital back to the business while still making a return – the “net interest margin” – for the lifetime of the loans. The net interest margin is the difference between the interest paid to the buyer of the Auto ABS and the repayments made by the borrowers. In effect, the originating loan company continues to make a return on loans that have already been repaid to it.
Although few car dealers, and even fewer borrowers, take an interest in a car loan, finance lease or PCP after it is ‘cashed’ – the funds have been provided for the transaction – it’s this phase of the loan where returns and risks are important to the auto finance industry as a whole.
Stage One of the loan’s life will be bundling it up with other loans made into what is called a reference portfolio by the loan issuer – the finance company. Stage Two is to transfer this portfolio of loans to a bankruptcy-remote SPV already set up by the issuer for the specific purpose of accepting the loans and realising their off-balance-sheet treatment for legal and accounting purposes. ‘Bankruptcy remote’ means that the SPV is structured to ensure that, even if the loan issuing finance company were to file for bankruptcy, the assets of the SPV could not be used to pay the finance company’s creditors. SPV’s are essentially robot firms that have no employees, make no substantive economic decisions, have no physical location, and cannot go bankrupt. Stage Three is where the SPV transfers the portfolio to another bankruptcy-remote entity, an Asset Backed Securities (ABS) trust. The trust becomes the permanent home for the portfolio of loan contracts.
Tranches and Risk
Auto ABS Risk
Between 2000 and 2017 the US issued $1.2TN of Auto ABS into the Global Securities market. Growth has accelerated in recent years. In 2015 new Auto ABS issuance in the US was $68BN and exceeded expectations to reach $90BN in 2016. The next largest market was China, with Auto ABS issues valued at $88BN in 2016. Then comes the UK and Europe (together circa $35BN), of which half is issued by Germany, mostly car makers. While the global total annual new Auto ABS issuance is around $250BN, the outstanding balances on Auto ABS from prior years is around twice that figure.
Taken as a whole, Auto ABS is arguably a safe haven for investors. Over 77% of Europe Auto ABS were rated AAA – Triple A is the highest level of creditworthiness – and, since 2000, the average as been 82% rated as AAA. In the US, average ratings are even higher at 86%+ of all issuance. However, within that comforting average value there are differences. First, issues by captives generally achieve a higher rate than issues by independent finance companies. Second, there are differences in the risk profiles from different issuing countries. Issues based on loans and collateral in Spain, Portugal and Italy have lower average credit ratings than issues from the UK, France and Germany. The highest quality issues are based on loans originating in the Netherlands – hard to believe when it’s citizens have the second highest personal debt level in Europe
Over 60% of all Europe’s Auto ABS is issued by captives. This contrasts to the US where independent finance companies dominate. So, who issues these securities? Volkswagen, Renault and BMW are significant issuers in Europe. However, Daimler is a also significant but selling the majority of its issues on the US market.
Credit Risk – Customer Default and Issuer Default
Auto ABS bonds are based on the cash flow of customer payments from the portfolio of auto loans or leases. The portfolio of bonds is rated and split into ‘tranches’ based on the borrower credit quality. Tranches are classified according to the borrower’s credit scores as being prime, non-prime, or sub-prime. Credit scores greater than 680 are classified as prime, non-prime scores are between 600 and 680, while sub-prime is less than 600. Deep sub-prime is less than 550.
The first class of risk – and most common – is that the sub-prime and deep sub-prime borrowers may default on their monthly payments. The second class of risk, primarily of interest in the US, is that the expanding sub-prime Auto ABS issuers fail and pull down the rest of the US Auto ABS market.
Issuers point out that the borrower default risk is primarily limited to specific loan tranches and, in any event, new and used car loans are not a large part of household debt in the USA or Europe, so the risk should be manageable. Outstanding US Auto loans at Q3 2017 stood at $1.213TN, according to Y-Charts, about 8% of Total US Household Debt. Of that 8%, the sub-prime and deep-prime component is rising fast and is recently up to 25%. It’s the behaviour of this element of the market that has triggered the recent warnings. However, it still only represents 2- 3% of Total Household Debt. Hardly enough to create a financial storm.
The UK and EU have even smaller sub-prime segments. In 2016 UK Household Debt totalled around £198Bn of which Consumer Debt (Credit Card debts & Loans – mainly car loans) reached £73BN by February 2017. According to the Bank of England this is up almost 70% on its level in December 2011. Figures from the UK’s Finance & Leasing Association (FLA) suggest that, by 2016, Total Car Finance was around £55BN – about 30% of the Household Debt total – of which regulated banks issued £24BN and non-banks (mainly car manufacturer owned ‘captives’) issued $34BN. However, the UK FLA report that only 2% of the debt is sub-prime. EU Household Debt was $6586.3BN in September 2017 of which an estimated 10%, $650BN was car finance. The EU Auto ABS market is thought to have a sub-prime segment of between 2% and 6%. Taking all these factors together, in the absence of a major economic shock, the economies in the US, UK and EU should all be able to stand significant levels of sub-prime payment default.
Issuer default is more serious and assumed to be much less likely. But, Fitch, the US-based ratings agency, are less optimistic concerning the Auto ABS issuers in the USA at present. They point out that sub-prime securities have more volatile losses, that there are
fewer lenders and that the lenders are smaller and less able to cope with a shock – at least in the US. As a result, they suggest that, a shock affecting one, could possibly transmit to the others – a ‘domino effect’. In the event of a collapse of one or two of these firms, the downside impact on all Auto ABS values could be considerable. Keep in mind that just such an event did occur in 2008 and the market reduced to a trickle thereafter and took six years to regain it’s pre-crisis size. However, as mentioned above, the US market is split roughly 50% Captive and 50% Non-Captive while Europe issuance is roughly 70% Captive. In the US and in the EU, it is the non-captive issuers that sold the largest share of low rated securities. If there is a credit risk, it lies mainly with non-captives in both markets.
RV Risk – Guaranteed Future Value (GMFV) and Voluntary Termination (UK-only)
The third class of risk is that the vehicle value may be less than the outstanding loan value. It’s a direct risk to bondholders where the cash flow of the bond includes a residual value component. In the UK, there is a specific additional risk concerned with Voluntary Termination, explained below, which does not apply to the US and EU markets. According to UniCredit SpA., “In 2016, the number of deals exposed to RV reached a record-high at roughly EUR 5.7bn from 14 transactions, thus accounting for almost a third of primary market Auto ABS supply. We project new issuance of RV deals to be of similar magnitude in 2017 fuelled by automakers’ incentives to originate lease contracts.”
GMFV: Under a PCP, the car buyer does not initially take ownership of the vehicle, but instead rents it for a period – typically three or four years. At the end of the contract, the renter has the option either to return the vehicle to the finance house, or purchase it at a price specified in the initial contract. This price, or “balloon payment”, is based on the finance house’s estimate of the vehicle’s residual value at the end of the contract, or “Guaranteed Minimum Future Value (GMFV)”. Like every forecast, calculating residual values is not an exact science. The balloon payment could turn out to be higher than the value of the car in the used market, in which case the renter is better off just returning the vehicle to the finance house. The finance company might then make a loss on the transaction. Thus, finance houses are typically conservative when making assumptions about the car’s residual value, such that the “balloon payment” is typically less than the market price. The renter then has “equity” left in the car at the end of the contract, leaving him or her three further options: making the balloon payment to take ownership, selling the car privately to release the equity, or using the residual equity to part-finance another new vehicle.
However, as the Bank of England pointed out in 2016, residual values are subject to external shocks. The EU had around 256MN cars ‘in use’ in 2016 of which almost 40% were diesel engines. Higher environmental taxes and vehicle use penalties may sharply reduce the future values of diesel engine vehicles. In terms of Auto ABS this would have a substantial impact on some bondholders who have residual value cash flows built into their bonds and have the lowest tranches. That group would be liable for the shortfall and their bonds would fall in value. That does not imply that all bondholders would share equally in the losses. Losses would be concentrated into the smaller, lower rated ‘junior’ and ‘mezzanine’ tranches. More importantly, in the US market the issuer is required to retain 5% of the bond. This retained tranche takes the most severe share of any losses before the ‘junior’ tranche. Further, there are ‘credit enhancements built into the issue to reduce its risk. Often there’s a reserve account equal to 1% or more of the total issuance to pay for defaults. The issue is overcollateralized – bonds are valued less than the assets behind them. There is an excess spread – income exceeds payments to the bondholders. The issue is ‘wrapped’ – supported by an insurance policy against default. In many cases, three or four methods of credit enhancement are used to reduce risk and underpin the initial the credit rating.
Although extremely unlikely, theoretically car makers might find themselves in difficulty if losses were so severe that their originating SPV or ABS Trust could not make payments to the bondholders, after all enhancements had been exhausted. An SPV and a Trust is ‘bankruptcy remote’ – not ‘bankruptcy proof’. To begin with, investors have an implicit understanding that sponsors intend to back their SPVs even though this is not explicitly guaranteed. So, if the residual value losses were high enough, issuers may find themselves mired in litigation for years let alone facing the reputational risk they would suffer with catastrophic residual value losses. Secondly, US Bankruptcy courts might be minded to consolidate an SPV with its ‘sponsor’ – the originator of the loan but that would require the originator to go bust, which is again an extremely remote possibility.
To put risk into context, a recent stress test by UniCredit showed that, even at 80% RV loss severity, European RV based Auto ABS demonstrate the strongest break-even levels, ranging from 26-45%. This compares with 18-30% for UK seniors. At 30% RV loss levels, Euro Auto ABS senior tranche is almost unaffected. The Schwacke Daily RV Price index shows that the premium paid for diesel compared with petrol variants is closing, not that the RV of diesel cars is collapsing.
Voluntary Termination: In the UK a borrower can end a hire purchase or a PCP plan and return the vehicle to the finance company as long as they have repaid 50% of the Total Amount Payable and complied with the conditions concerning reasonable care of the goods. This will include interest and fees in the case of a HP Agreement and also the GMFV, in the case of a PCP Plan. This means that you usually don’t reach the voluntary termination point until very late in a PCP agreement but for a regular HP agreement, you will usually reach the 50% repayment point about halfway through the agreement.
For Auto ABS issued in the UK this poses a significant late stage risk for the issuer in a period of volatile residual values. If the borrower has no further interest in the vehicle they can terminate early without charges – perhaps at the 30 month point in a 36 month contract. In a period of falling residual values, the issuer could face a drop in receipts plus the possibility of crystallising a loss on the sale of the returned vehicle while still being liable for payments on the Auto ABS until maturity.
There is little evidence to suggest that the growth rates in car sales seen in the US and the UK since 2013 are sustainable. It appears that their ‘pent up’ demand from 2008 – 2011 has been satisfied. But, that is not true of Europe as a whole. While the UK economy is temporarily overshadowed by ‘Brexit’, the EU economies and car markets continue to grow. It is true that vehicle over-supply will remain a feature and there is concern that profits and cash from China may slow, as the PRC government supports a switch from conventional engine imports to electric and hybrid domestically produced cars. So, a softening in volumes is ahead in the US and UK and car makers operating margins will remain depressed, but does that imply a global crisis or regional financial crisis is imminent?
There certainly is evidence that, at the consumer level, central banks are already concerned about excessive borrowing, so contract delinquencies along with interest rates are both likely to rise. Within the loans that have already been made there are some causes for concern:
- Increased sub-prime loans coupled with rising interest rates are increasing delinquency rates and reducing cash flow to repay existing Auto ABS
- Over-supply in the US new car market is leading to greater discounting or more incentives thus eroding carmakers margins
- While the UK used car market is holding up well, in the US there is evidence that leasing and rental returns are over-supplying the used market and will depress residual values. Reuters suggest that up to 12 MN vehicles will be moved off lease between 2017 – 2019.
- As for the major EU markets, convincing trend data is difficult to find but one is emerging, according to experteye : the residual value premium paid for diesel versus petrol engine has narrowed sharply. They warn that leasing companies across the EU are likely to be increasingly cautious about diesel engine residual values from 2020. this caution will be reflected in the bonds issued at that time.
But none of these factors suggest that cash flows to pay bondholders will fall so low that the Auto ABS market will collapse. As mentioned earlier, firstly, the lower rated loans and securities are concentrated in non-captives and, in Europe, in collateral from specific countries. Secondly, the size of the overall issuance and outstandings are comparatively modest on a global scale. Third, securities have a series of risk mitigation bulwarks in place to ensure that the largest tranches are unaffected. Finally, the RV risk that commentators draw attention to is confined to recent EU and UK issuance. It is not a risk factor in US ABS bonds which form the largest share of the market.
Is the global economy intertwined and are there misunderstood complex financial products? Undoubtedly there will be retail bondholders who have not researched the details of the bonds they own well enough. This has been recognized by the EU by planning new legislation. In the summer of 2017, after a process spanning several years, regulations for simple, transparent, and standardized securitizations (so-called STS securitizations) were published, with which the EU aims to provide securitization markets with a more solid foundation and to revitalize securitization as an effective financing mechanism for investors such as banks. In June 2017 a new securitization directive, was published, as well as a directive to amend regulation 575/2013 on capital requirements for banks.