Is the motor finance market in 2017 heading in the same direction as the US Sub-prime mortgage market in 2007? The size of the markets are very different, but there are certainly a number of similarities, which should prompt firms to review the adequacy of their risk controls, and assess their exposure.
- The rise in consumer lending – In the UK, lending is increasing at the fastest rate in more than 11 years, hitting £192.2bn in November 2016 (only a little below the September 2008 peak of £208bn). In the US, motor finance loans are at the highest level for 18 years, and show no signs of slowing down.
- The increase in bad debt – Also in the US, the Federal Reserve estimated that roughly six million individuals are at least ninety days late on their motor finance loan payments. Fitch reported that US auto ABS subprime delinquencies grew 11.6% year on year, to a high of 5.16% (the highest rate since October 1996).
- The softening of residual values – In the US, the volume of lease vehicles coming onto the resale market in 2017 will be about 1 million greater than in 2015. Increased supply, and flattening demand, could impact the viability of the Personal Contract Plan (PCP)/leasing model, which manufactures have relied on to generate sales, over the past few years.
- Increased regulatory focus – In the UK, the FCA conducted a ‘mini thematic’ into the sector in 2016, finding a number of issues with the treatment of customers. US regulators are issuing subpoenas and investigating firms in relation to customer outcomes and market integrity.
This article considers the current health of the motor finance sector, in the structurally similar markets of the US and UK – as what happens in the US today, will often follow in Britain tomorrow.
Warning lights are certainly flashing, as motor finance sales show signs of overheating in the UK, the US and other key regions throughout the world. In Beijing, in 1985 only 60 people owned private cars; now China has the world’s largest motor market, selling 28m new cars in 2016. China also issued $88bn of auto ABS (Asset Back Securities) last year, almost exceeding the $90bn market in the US – all this in a country which is deemed to have a rather underdeveloped body of case-law when it comes to establishing title over assets.
In the US, there were $142bn in motor finance loan originations in the 4th quarter of 2016, making it the highest figure in the 18-year history of the Fed’s Household Debt and Credit reporting. Overall balances have pushed past $1.1 trillion, and the growth rate is accelerating; with securitisation providing the ‘grease to the wheels’ – as with the mortgage market in the 2000s, in both the US and UK, an increasing portion of motor finance lending is packaged up and sold on to investors. For many lenders, particularly new entrants, securitization is an essential part of their business model. In the first two months of 2016, US lenders issued $17.69 billion in new auto ABS, compared with just $1 billion in credit card debt-backed ABS and $600 million in student loan-backed ABS. Standard & Poor’s estimate that retail auto loan ABS issuance in the US in 2016 was about US$67 billion, with roughly 58% being prime, and the remainder sub-prime.
The UK motor market is considerably smaller, but figures are moving just as fast. Motor finance loans reached an all-time high of £31.6bn in 2016, up 12% on the year before. A record 2.7m cars were sold in Britain last year, the fifth consecutive year in a row of rising sales. Per-capita, the British buy more new cars than any other large country in Europe. Much of this growth is due to the rise of PCPs, which now account for nine out of ten private car sales. PCPs, and the expanding motor finance sector, is driving the growth of unsecured credit. The overall unsecured credit market is increasing at the fastest rate in more than 11 years, rising by 11% in the year to November 2016, to £192.2bn. To put that figure in context – in September 2008, at the time of the Lehman Brothers collapse, UK consumer credit debt peaked at £208bn.
As consumers use leasing deals to trade-up to brands that were formerly out of reach, finance firms are extending loan terms to keep the headline monthly repayments attractive. In the US, the average loan term is now 67 months, with 30% of new motor finance loans having terms longer than 70 months. But combine long lease terms with an asset class that has inherently depreciating values, and it means an increasing proportion of consumers are reaching the trade-in point, with vehicles in negative equity – JD Powers reported figures of 32% for early 2017.
Strong consumer demand has led to a range of new lenders entering the market; with an inevitable widening of underwriting acceptance criteria, as firms take on riskier business to secure market share. According to data from the Federal Reserve Bank of New York, the proportion of motor finance loans taken by sub-prime borrowers grew from 17.1% in Q3 2010 to 22.9% in Q3 2015.
With looser lending criteria has come an increase in bad debt. In the US, motor repossession levels reached 1.7m, in 2016, the third highest figure for 20 years. In their Liberty Street Economics blog, the New York Fed noted that loans issued by finance companies (as opposed to banks), and in particular loans issued to sub-prime borrowers have shown a significant uptick in delinquency rates, over the past few years. The Fed estimated that the issue could be affecting a large number of households, with roughly six million individuals at least ninety days late on their motor finance loan payments.
Bad debt has flowed quickly into the ABS market. In February, Fitch reported that US auto ABS subprime delinquencies grew 11.6% year on year, to a high of 5.16% (the highest rate since October 1996). Subprime annualised net losses reached 9.7% in February 2017, which is an 11.6% increase over January’s figure and a 34.1% increase compared to February 2016. Further analysis by JPMorgan Chase & Co showed that, beneath these headline figures, there are significant differences between the performance of books sourced from new entrants, and those from existing sub-prime players – for example, the 60-day delinquency rate on business sourced from a new lender was running at 10%, in comparison to 2.3% for an established lender.
These red lights on the dashboard have prompted some hedge funds to start shopping around for short positions, and for a number of commentators in the media to tip motor finance as being the catalyst for the next big financial crash. In particular, the rise of sub-prime auto ABS has raised the spectre of the ‘Big Short’ era excesses of the mid-2000’s. Whilst these fears may be overstating the systemic risks – motor finance is still a fraction of the size of the mortgage market – there are sufficient similarities to the 2008 situation to warrant concern in the industry, and also to attract Regulatory interest.
The motor finance sector is seeing increased regulator attention
In the US, the Regulators have approached motor finance from two points of focus – market integrity, and customer detriment. Department of Justice (DoJ) officials have said they are using lessons learned from probes into mortgage ABS during the financial crisis to examine new areas of potential risk, like subprime motor finance. Over the past few years, the DoJ has issued a number of subpoenas in connection with an investigation into “subprime automotive finance and related securitization activities”. Bloomberg has also reported that there is an ongoing Securities and Exchange Commission investigation into the same issue.
On the consumer protection side, the Federal Trade Commission (FTC) is currently conducting an investigation into subprime motor finance lenders’ collection practices, with a particular focus on ‘kill switches’, which are used as a remote controlled repo-man to disable vehicles if a customer falls behind with loan payments. The technology gives lenders greater confidence to take on increased risks – the assumption being that an immobilised vehicle is a compelling incentive for a sub-prime customer to pick up the phone, when the debt collector calls. It is estimated that approximately 50% of cars financed with subprime loans currently have a GPS or kill switch device installed.
This regulatory attention, and a rise in adverse press coverage, is seeing the appetite for kill switches cooling. If kill switches do fall out of favour, it will be interesting to see how that affects the delinquency rates of sub-prime loan books (and auto ABSs). Risks that were underwritten on the assumption of an easy repossession using a kill switch, may not perform as well, when the tool is potentially no longer available. The increasing length of loan terms may compound this issue – with long pipelines of business having already been written.
In the UK, the Regulators have also taken a two-pronged approach. On the conduct side, motor finance is an area of interest for the FCA, as they continue to review the consumer credit sector they inherited in 2014. Last year, the FCA undertook a ‘mini-thematic’ with motor finance intermediaries and underwriters. It identified issues in the areas of governance, affordability, and collections. As well as raising concerns that firms did not have adequate controls in place to monitor and mitigate conduct risk, and senior management lacked the skills and aptitude to drive good customer outcomes. At the front end, the FCA noted that credit could be granted to customers without sufficient evidence that there had been adequate consideration of their ability to repay. At the back end, firms were not always demonstrating sufficient efforts to respond to the needs of customers in financial difficulties, and apply forbearance appropriately. Whilst kill switches are not as prevalent in the UK market, they are on the FCA’s radar, and some firms have been required to offer redress, where the FCA felt that the use of the devices had resulted in customer detriment.
On the prudential side, the Bank of England put out a blog post, in August 2016, raising concerns that the continued growth in the UK car industry may not be sustainable. They considered that the rapid rise in PCPs represents a significant concentration risk, in an industry sector historically susceptible to macro-economic downturns. According to the Bank, in the case of deteriorating economic conditions, motor manufacturers could be exposed not only to losses from falling sales of new cars, but also from the impaired value of PCP vehicles returned at the end of their contracts if the balloon payments exceed the vehicles’ market values.
Residual values on the slide?
The economic stability of the motor industry is built on resale value. High wholesale prices raise trade-in values, which help people to buy ever more expensive new and used vehicles. High wholesale values are also crucial when a loan defaults, and lenders have to repossess the vehicle and sell it in the wholesale market – a high wholesale value lowers the loss. And high resale values are the foundation of the leasing business model.
Any factors which effect residual values can have a significant impact on the industry. Macro-economic shifts are a key driver of decreasing values, but there are a number of other factors that add to future uncertainty in the sector. For example, over many years, diesel vehicles have been heavily promoted (and indulgently taxed), as a ‘green’ alternative to petrol cars – leading to high demand, and very high resale values. New evidence of environmental concerns, and moves for older vehicles to be banned from city centres suggests there is potential for a sharp decline in the demand (and resale value) for diesel vehicles. Concerns about diesel cars was brought to the fore during the recent scandals around the fixing of emission tests; if these allegations spread to other manufacturers (and recent indications suggest they might), further marques may see their brand values impacted. Using fossil fuels at all may become an outmoded concept, as technological innovation promotes the rise of electric cars.
There is also an, often overlooked, distortion in the motor market. The UK’s car scrappage scheme (and the more alliteratively named ‘cash for clunkers’ program in the US) took a significant volume of 2nd hand vehicles out of the market, after the financial crash. This concentration of demand distorted and inflated used wholesale prices, in an effect that is still being seen today. In the US, The Manheim Used Vehicle Value Index, which tracks wholesale prices of used vehicles, shot up in 2010, and hit a peak of 128 in 2011, but recent figures suggest the market may be starting to weaken.
In addition to these macro factors, some of the potential instability in the market is self-inflicted. By heavily promoting leasing options to consumers, the industry has force-fed the golden goose. The volume of lease vehicles coming into the US market in 2017 will be about 1 million greater than 2015. This significant uplift in supply will inevitably depress resale prices. A similar situation is anticipated in the UK, as PCP sales have been accelerating in recent years.
What can firms do?
As noted above, the motor finance market in 2017 is not the mortgage market in 2008, but there are a number of developing risks firm should be looking to mitigate.
- Overall business model – firms should consider to what extent their overall business model is driven by motor finance. In the US, figures show approximately 39% of dealer revenue comes from financial services. And motor manufactures have built their sales targets on the leasing model.
- Resale value – whilst leasing has been very beneficial to motor manufacturers they have stored up high levels of potential liability, if resale values soften. Firms should consider what their level of potential exposure is.
- Governance – firms should ensure they have an adequate control framework in place, to satisfy regulatory requirements, and for their own peace of mind. Having senior managers who understand risk, and a comprehensive monitoring programme in place to inform them of issues, will enable firms to spot problems, before they crystallise.
- Regulatory focus on sales – as noted, competition in the market has led to a relaxation in underwriting criteria and an increase in credit acceptance. Firms should ensure they are comfortable that their lending practices meet the letter, and spirit of regulatory requirements. Enforcement action could constrain future sales, or require firms to undertake very costly past business reviews of historic lending.
- Regulatory focus on collections – lending firms should ensure that bad debt assumptions reflect their current (and future) ability to collect. On both sides of the Atlantic, regulators are cracking down on debt collection practices that they consider detrimental to customers. The potential reduction in the use of kill switches, and the requirement to adequately explore forbearance options could make collections harder.
- Liquidity – if bad debt continues to increase, it will make auto ABS less attractive to investors. The drying up of liquidity was a particular feature of the 2008 crash, and the current motor finance market has similar risks. Many lenders have built their business models on the assumption that they can package up loans and sell them on, to eager buyers. Any slowdown in the demand for auto ABS will significantly constrain firms on the loan origination side. Any adverse findings from the US Regulators’ investigations into securitisation business in the sector will also be likely to cool off the appetite for auto ABS amongst institutional investors. Lenders should consider what the impact would be on cash flow, and pipeline business, if there was a drop in demand for securitisation.
For debt purchasers:
- Bad debt performance – for buyers, caveat emptor remains, as always, the watchword. The concept of an ABS implies some security in the asset. Car loans are empirically not ‘as safe as houses’, and some tranches of auto ABS could hold significant potential risk. Prospective purchasers should be mindful of the variation in performance, between ABS’s from different lenders.
- Overall due diligence – another characteristic of the 2008 crash was that the individual assets (and borrowers), packaged up into securities were often not as they seemed. There was an appreciable amount of fraud and misrepresentation, which only came to light as the loans defaulted. To ensure similar issues are not occurring, potential purchasers should certainly employ the due diligence equivalent of ‘mirror, signal, manoeuvre’ when they are considering investing in auto ABS.
In 2007, Citigroup‘s chief executive, Charles O. Prince, when asked about the bank’s continued funding of buy-out deals, was quoted as saying “As long as the music is playing, you’ve got to get up and dance”. That statement reflects the commercial conflicts between risk and reward, that have been at the heart of many financial crashes – the S&L crisis of the 1980s, the 90s dot com bubble, the 2008 crash, and the PPI miss-selling scandal. It is very hard to walk away, when there’s still money on the table.
However, it is evident that the current situation in the motor finance market does have similarities with the mortgage market, in the run up to the last crash. This should give participants cause for concern. A cautious firm would be ensuring that they have a clear view of the risks they face, and the effectiveness of the controls they have put in place to mitigate them. Again, a significant contributor to the impact of the 2008 crash was the fact that firms had failed to have honest conversations internally about their potential exposure.
Frank Brown is a Consultant at Bovill