Saturday , October 23 2021
Home / Economy / Car finance – the next sub-prime crisis?

Car finance – the next sub-prime crisis?

Most people think of the 2008 crash as a subprime mortgage crisis.  This is only partially true – and misleadingly so.  The real crisis was in the unregulated “shadow banking” sector where “securitised investment vehicles” (SIVs) are traded.  A SIV is created by repackaging the income from loans (including mortgages) so that risk is standardised.  This allows the banks to recover the income from the loans they make by selling the SIVs on to third parties.

Prior to 2008, banks guaranteed the value of SIVs by insuring them and having a ratings agency value them as AAA-rated.  However, as the housing bubble inflated, banks began to add riskier loans and mortgages into the mix.  But because the price of houses kept going up, this did not seem to be a problem – even if a borrower defaulted, the bank could sell the house and recoup the cost of the loan from the sale.  As a last resort, they could also fall back on the insurance cover.

As we now know, it went wrong when the house price bubble burst.  Too many subprime mortgages had been issued and crucially included in what had been repackaged into supposedly AAA-rated derivatives.  Banks themselves had invested in these derivatives, which made up a large part of the – now worthless – assets on their balance sheets.  This was the real cause of the crash.  The subprime borrowers were merely the straw that broke the camel’s back.

Fortunately, governments around the world have acted decisively to regulate the banking industry to prevent a similar crisis in future, right?  Wrong!  While some changes were made to mortgage lending, and bank shareholders and large depositors were made liable for a share of the losses in the event of a bank failure, the shadow banking sector is if anything even bigger and more dangerous today than it was in 2008.

The practice of issuing dodgy loans on the back of assets that are temporarily rising in price has spread.  One area that it has spread to is car financing.  Even before 2008, car dealers had stopped encouraging cash payments because they could make more money on finance deals than on the vehicles themselves.  For buyers, the choice was between a loan from their own bank or a hire purchase agreement with the dealership. However, after 2008 too many people were averse to taking on more debt, so car sales slumped.  In the USA the state had to step in and provide direct bailouts to the car industry.  In the UK a more modest scrappage scheme was used to encourage people to trade old vehicles for new.  But while this prevented a collapse, it did little to grow the market.

The solution adopted by the car makers was to remove the risk of borrowing from their consumers.  This was done through an arrangement known as a Personal Contract Purchase (PCP) through which consumers could lease a new car with an option to buy or walk away at the end of the term.  Were the consumer to decide to buy the car at the end of the (usually 3 year) term, the total cost would be greater than if they had taken out a loan.  However, because the monthly payments included just the cost of depreciation and an interest payment, they were significantly cheaper than the monthly payments on a loan would have been.

The important point to note with PCPs is that the risk lies with the car manufacturer rather than the consumer.  This is because the car manufacturer has to price in (and fix) the depreciation at the start of the agreement – in effect guessing what price the used car will sell for in three years’ time.  There is no requirement that the consumer must sell the used car directly or finance a new PCP on a new car. At the end of the term, the consumer need only return the used car to the dealer and walk away.

This is where used cars and subprime mortgages start to look unnervingly similar.  PCPs work so long as used car prices keep rising.  So long as car manufacturers make accurate predictions of the resale price of the used cars, they stay in the black.  But what if used car prices fall?  Here’s where the shadow banking system comes back to haunt us.  To finance the PCP deals, car manufacturers issue bonds that are bought up by investors – this provides the cash to cover the PCPs.  These bonds are then securitised and derivatives are created so that the investors can cover the risks involved in buying the bonds.  These derivatives then become tradable commodities that other investors will buy, potentially creating piles of worthless paper similar to those the banks were holding in 2008.

In the UK, the Bank of England has expressed concern about the level of PCP deals.  In the US there is growing concern that an even bigger PCP bubble may be about to burst.  This is reflected in Ford’s recent announcement that it intends cutting 10 percent of its global workforce.

Remember, though, that the car manufacturers are merely the subprime borrowers in this story.  The bigger threat is from the derivatives that have been created on the back of their borrowing.  Nor is it only PCPs that have pumped up bubbles.  The housing market is back to 2008 highs.  Indeed, in Australia, Canada and China the housing bubble didn’t pop in 2008; it just kept on rising.  Borrowing against student debt, fine art and shares has also added to the mountain of derivatives in the shadow banking sector. There is growing concern that we are on the edge of another 2008-like event.  Private debt to GDP ratios around the world are back to 2008 levels.  Central banks are expressing concern about the level of indebtedness, and in the USA they have even raised interest rates to increase the cost of borrowing.  Sooner or later another crash is coming.  And while it is impossible to predict which event will be the straw that breaks the back of this particular camel, you could do a lot worst than betting on a collapse in the price of used cars.

Check Also

Wrong for a different reason

Alexandria Ocasio-Cortez – A well-meaning but not particularly bright left-leaning US politician – made a …