Fears of UK economy slowdown as car loan sustainability weakens
26 June 2017
26 June 2017
Concerns are rising in the UK financial world that rapidly rising levels of car loan debt, hit by used car residual values (RVs) continuing to fall, are reaching crisis levels.
In signs which bear resemblance to the sub-prime mortgage crisis in the US that led to the world financial crisis, the mounting UK consumer car loan debt levels are now seen as one of only a handful of pivotal factors under intense scrutiny by the corridors of power in Europe’s financial centre, the City of London.
The Bank of England has announced it is bolstering its probes into the state of the market, amid high risks of strong implications for consumer spending – which form the central pillar of the entire UK economy.
The Bank of England wrote in startling clarity in a blog last August that UK car loan debt is simply ′not sustainable,’ in the face of ′very strong [UK car industry] demand growth in recent years.’ The SMMT continues to announce record UK car industry sales month on month – now nearly a year after the Bank of England warned of these incoming dangers.
Understanding why it is the RVs of used cars that is the key factor risking the creation of an ominous finance bubble – which sends shocks through the country’s financial system, with trade in the asset (here, loans) strongly exceeding the asset’s intrinsic value – requires knowledge of how the UK car market works.
The UK market is highly valuable for OEMs, despite its size accounting for 30% of European auto profits. This is down to the development of a highly successful range of attractive financing deals, which are largely administered by the finance divisions of OEMs – effectively their in-house banks.
The vast majority of these UK finance deals – which allow a consumer to pay for a car monthly rather than have to pay for a car completely upfront (allowing them to spend more on a car) – are in a form known as Personal Contract Purchases (PCPs).
PCPs work as follows. Customers pay a deposit, and then monthly payments for a fixed period. The key part is what happens at the end of their contract: then, they can buy the car from the manufacturer – crucially, at a price that is guaranteed at the start of the contract.
Now this is where the problem occurs, because in the UK, due to market forces, newer used cars are currently losing more of their residual value – and this rate of fall is speeding up in a sinister fashion.
Due to the way PCPs work, a downturn in the used car market raises the prices of new cars in the UK, because OEMs will offer less generous PCP deals (since the car is worth less at the end of the fixed period), or because a used car owner selling their car will leave them will less down payment to spend on a new one.
Autovista Group UK division Glass’s head of vehicle valuations Rupert Pontin said: ′However, the detail is the key.’
According to our internal data, while the average UK used car less than two-and-a-half years old was worth 61.1% in 2014, it is now worth only 57.6%. That is a considerable industry-wide drop.
Worse still, there is no sign of this portentous trend abating. Pontin added: ′This is likely to continue to be the case for the rest of 2017 and into 2018 as well.’ This is because PCPs tend to last three years, and so the picture will continue to ever worsen as more and more cars flood the market coming off these fixed-term deals.
The number of PCP deals in the UK market has skyrocketed 394% over only the last five years, according to credit agency Experian – and so with the three-year lag factor from the length of the deals, the current market trends will only grow through 2017 and 2018.
Moreover, the value of UK car loans has almost trebled to £31.6 billion (€35.9 billion) between 2009 and 2016. Financial analysts have long reached the consensus this is not sustainable. A source from a leading OEM told Autovista Group in March that ′personal contract purchases were expected to have a destabilising effect on the used car market but this has not happened,’ despite high Brexit-related uncertainty, which has only been fuelled further by the now″”weakened minority government, and that it will take ′something seismic’ for values to plummet during 2017-18.
However, with Brexit the probabilities of this ′something seismic’ are heightened, and with high UK government debt, the UK’s ability to deal with any shocks is weakened.
Autovista Group also warned OEMs last year of the need for them to review their PCP finance businesses, stating: ′There may be a requirement to encourage extensions of PCP and lease terms, to ensure continued ability of consumers to afford repayments and to avoid large numbers of early terminations. This will also postpone vehicle returns until markets improve and help support residual values.’ However, these extensions have not occurred at meaningful levels.
Industry groups expect UK new car demand to fall this year. The SMMT has previously forecast that new car registrations will decline by 5% in 2017 but Autovista Group division Glass’s has been less bearish, predicting a decline of 3.5%.
Figure collator the Finance and Leasing Association reveals up to an enormous £18.6 billion (€21.1 billion) of borrowing is associated with the UK’s buying of new cars on credit (accounting for 86.5% of the market). Another heavy £14 billion (€15.9 billion) borrowing sum is spent on used cars.
The second critical pillar that means these surging loans got right to the heart of the UK economy is that many of these car loans are securitised, which means that in the City they are packaged together and sold on to investors as bonds. This is exactly the same way the mortgages were in the run-up to the financial crisis.
This intrinsically links the health of the car loan market to the health of the overall UK economy.
There is one perspective of consolation. The dramatic growth in UK car finance (totalling £32.6 billion (€37 billion), as per figures above) is still tiny compared to the monstrous size of the UK mortgage market, where stratospheric house prices led to £238 billion (€270 billion) in loans lent against property last year, according to the Bank of England.
Evercore ISI research analyst George Galliers, who previously worked in Ford’s finance division, said: ′Part of the reason you had big issues with [subprime mortgages], is people underwrite housing loans under the impression they will keep their value.’
However, in the car world, people expect cars to be worth less at the end of their contract than at the start, so the risks are less severe. Nevertheless, he noted: ′The risk is that it loses more value than was forecast.’