#9 - Is Car Finance Subprime 2.0?

The race to the bottom we are currently witnessing in the world of automotive financing scares the crap out of me. Don’t get me wrong, I have used and will continue to use (where appropriate) leverage to buy cars but the carte blanche attitude that many lenders appear to have adopted these days is not only concerning, but has a taste not too dissimilar to the last time we hit a little road bump due to “over provision of liquidity”.

In its simplest form, the concept of car finance (particularly on new cars) is a bizarre one….especially from a lenders perspective. You will lend funds on a typically high LTV (80-90%) to a borrower looking to buy a depreciating asset over a 3-5 year period at a rate of anywhere between 4-25% (yes I know you could drive a bus through that). For the privilege, you will briefly assess the affordability of the borrower….a couple pay slips, an NI number and a vague overview of monthly outgoings will suffice and that it’s….good to go. A brand new £80k Range Rover Sport has just been purchased with £5k deposit, the rest borrowed and monthly repayments of £800 that “we can kind of afford”. The RR salesman is one notch closer to meeting his monthly targets and the guy lending the money is clipping a juicy pick up in yield over risk free rates on a secured asset……everyone’s happy. Only if you take the rose tinted specs off, the above is a self-fulling prophecy that is destined to go bang eventually. Allow me to expand……

The second that Range Rover Sport drives out of the showroom it will have lost 10-12% of its value, pretty much instantaneously, as residual values attributable to SUVs are scandalously poor. What’s more, it will continue to chart its depreciation course until it finds a temporary floor at around £40k or 50% of face some 24-36 months down the road. The lender remains relaxed as long as those monthly repayments keep coming in and the borrower is happy with their new car and isn’t too bothered about the mark to market on the vehicle. That however is where the real problem starts……especially if we continue to tread water in a borderline recession environment.

You see the horrific level of negative equity (market value of vehicle less debt outstanding on it) doesn’t really become an issue for the borrower until they have to try and realise that value…..and that can come into play for several reasons. The monthly repayments can be less sustainable than first thought or a change in personal/financial circumstances can be just a few reasons. But typically, an individual’s appetite for discretionary spending is heavily correlated with the rest of the population…..herd mentality. The fear of a tough or uncertain outlook can precipitate a reduction in consumer spending which ultimately magnifies the weak macro back drop in the first place.

So the borrower decides to get rid of their shiny 12 month old Range Rover and get something “more sensible”. They take the car back to the dealer where they are told the heavily discounted price the dealer will pay them for it, the nice early repayment fee that will be incurred and the additional monies due to settle the finance given the negative equity in the vehicle. If they can, the borrower will try and find the funds to close out the finance there and then but what more commonly happens is the borrower continues to hold onto the vehicle to “try and make it work”.

The problem I see is that your default risk (probability of default) for that borrower has gone up exponentially but no one has really paid any attention to it. What’s more, these are not isolated incidents because as I mentioned before, people’s appetite for discretionary spending is positively correlated. So the same Range Rover dealer probably receives 10 similar enquiries about selling cars and ending finance which pushes down the already discounted buy back prices on the vehicles even further, decreases second hand prices across the country, further increases negative equity outstanding in vehicles…..you get my point, self-fulfilling prophecy.

Now most people would argue that you can’t really compare this it to the previous subprime mortgage crisis as actual default rates haven’t started to rise yet and the absolute leverage that people are putting on when buying a car is substantially less than when they were buying second or third homes. My point however is that it definitely feels like the start of a perfect storm brewing and it is being exacerbated by the car manufactures. If new car sales are declining, manufactures will continue to offer more and more attractive financing terms to less than optimal borrowers. They will attempt to bolster sales figures by potentially jeopardising the credit quality of those counterparties they are lending to. This cannot end well….especially in a no growth or recession environment.

I mentioned at the start that there is a time and a place for car financing. If affordability has been appropriately assessed, it can be a great way of reducing the capital intense nature of buying a car as well as helping maintain cash flows for the borrower. It can even be an interesting carry trade on sports and supercars going up in value if you are able to borrow at a rate below the level of appreciation. However, while lenders continue to competitively chase lower quality counterparties, I see worrying times ahead for us.

Happy Motoring,

CC’s Investment Team