The Guardian gets worried because it doesn’t understand

Well, this is finance:

A huge increase in the amounts borrowed by already indebted households in Britain and the US to buy new vehicles is fuelling fears that “sub-prime cars” could ignite the next financial crash.

British households borrowed a record £31.6bn in 2016 to buy cars, up 12% on the year before, said the Finance and Leasing Association on Friday. Nine out of 10 private car buyers are now using personal contract plans (known as PCPs), which have boomed since interest rates fell to historic lows.

Terrors, terrors.

Some of the car-leasing loans in the US and the UK have been packaged into asset-backed securities, to be sold on to investors such as pension funds. This was an asset class that played a ruinous role in the credit crunch, except this time the collateral for these assets is cars, not houses. The ratings giants, Standard & Poor’s and Moody’s, have given most of these batches of loans a triple-A safety rating.

The 2008 problem was that those bonds were *not* sold on to end investors like pension funds. Instead they sat around on bank balance sheets, often leveraged up 25 to 30 times the capital base supporting them. That was the problem – value impairment mean the banks had to dump them before their entire capital base was exhausted setting off a spiral of downward valuations.

If these bonds are with unleveraged final investors then this will not and cannot happen. Thus there’s no problem. If values fall then pensions fall a tiny bit in value. Shrug.

24 thoughts on “The Guardian gets worried because it doesn’t understand”

  1. Bloke in North Dorset

    Most of those housevloans that went sour were based on the premise that house prices would keep rising. I can’t see anyone in their right mind believing that the value of a car will be be greater at the end of a 3 year contract.

  2. The Laughing Cavalier

    Given the experience of the past who will be dumb enough to buy a sub-prime package based on a depreciating and,eventually, valueless asset?

  3. A pcp normally allows you to purchase the car at the end of the term by making a substantial balloon payment. So the finance only covers a small proportion of the cost, thereby de-risking the loan substantially. Provided the loans are packaged well, it should be very good as a securitised income stream. Wasn’t one part of the problem with home loans that the risk grading went badly wrong?

  4. Wasn’t one part of the problem with home loans that the risk grading went badly wrong?

    Actually, the risk grading was okay-ish. But when the high risk tranches went bust, people panicked about the valuations of the medium and low risk tranches. And because they had done value-to-market so the wide boys could get their bonuses in early, and people had to sell their okay assets to cover the drop in the high-risk assets, then the market exploded in a lack of information and values (it’s only worth what somebody will pay for it) crashed. Positive feedback loop – as mark-to-market now applied to the (fundamentally solid) lower risk tranches and …

    Unfortunately, I didn’t have and don’t have the spare capital to invest but some lucky people managed to buy selections of the better tiers of these loans at under 10p to the £ and they are still paying out at par – or above it with the long-term interest rates continuing to be so low (which nobody had predicted either.)

  5. Diogenes

    A pcp normally allows you to purchase the car at the end of the term by making a substantial balloon payment. So the finance only covers a small proportion of the cost, thereby de-risking the loan substantially.

    Is that true? I would assume the finance pays for the full value of the car. If there is a substantial payment at the end then in effect the loan isn’t paid off unless the car is purchased at the end of the contract.

  6. These deals usually give the driver an option at the end of the three or four year term; buy the car for a pre-set amount, or hand it back and walk away.

    If that final value is set too high, so you’d be paying significantly more for the car than you could buy one for second-hand, lots of people will walk away, leaving someone with a lot of second-hand cars that they can’t sell for enough to cover the outstanding amount.

    Problem is there’s an incentive for the manufacturer to set the final value too high, because that makes the monthly payments lower and helps you sell cars (particularly when times were bad).

    That isn’t the borrower’s problem; they’ve handed the car back and don’t owe anything. But I don’t know where that risk lies – is it with whoever holds the loan at the end, or the finance company, or the manufacturer?

    As Tim says, it isn’t a systematic problem if the risk is on someone who can cope with the loss. But I suspect that final value risk remains with a finance subsidiary of the manufacturer, so some may start feeling the heat if they’ve systematically over-valued.

  7. SE thanks for the clarification.

    Djc, on reflection I should have said smaller rather than small. I would imagine the loan covers the VAT and 3 years’ depreciation. It is definitely not for the full value of the car. The balloon payment really needs to be in line with second – hand values, as Richard points out. In any case, securitising these loans should be less risky than many sub-prime mortgages.

  8. The point about the subprime scandal was that it fed on itself. In America, people involved in the construction trade were granted mortgages on the houses that they themselves were building. But when the music stopped, it was a double-whammy: no more construction jobs meant they couldn’t pay the mortgage on their rapidly-depreciating houses. To make things worse, low deposits and no-recourse laws (in some states) meant they could post the keys to the bank and just walk away with little to lose.

    Car factory workers and car salesmen aren’t making out like bandits and expanding rapidly in the PCP boom. It remains a tiny market compared to housing.

    PCP deals usually involve a sizeable up-front deposit, so that’s one cushion for the banks. Onerous contract terms mean you have to return the car without a scratch, otherwise you have additional charges to pay. In Britain, finance companies are fairly ruthless about chasing up unpaid debts. This isn’t going to break the banks again.

  9. Also the time scales / affordability are completely differemt. it’s all cleared within three years.

    And the buy price at the end is generally set (lower than expected market value) so that if the punter doesn’t take it, the lease company doesn’t lose.

  10. PCP is interesting, none of the cars available are base models, they charge you £200 for a £30 stereo and £1000 for an £80 satnav.
    The buyer is also charged list price for a premium car, a cash buyer would expect up to 15% off that price.
    The hefty upfront deposit plus the monthly payments pay for the interest, the car and the insurance for the residual payment at the end, the residual covers the margin.

    It is quite an expensive way overall of buying a car but the buyer is lured by the prospect of driving a brand new £25000 car for only 5 grand plus £250 per month, an ordinarily astute buyer would borrow the money from the bank (Santander will lend £25000 @3% over 5 years) and pay the discounted cash price.

    There are however much better deals if you are prepared to look and hustle. 10% off list, no deposit, 5 years @0%, £500 of free petrol and they will throw in a set of mats (everybody gets those) with nothing to pay at the end, the car is yours.

    What assets back all these loans ? The car, the owners house and belongings plus any attachments to earnings that can be had.

  11. Andrew M said:
    “PCP deals usually involve a sizeable up-front deposit, so that’s one cushion for the banks.”

    Yes, but new cars experience a sizeable up-front depreciation, which probably wipes out the deposit.

    PF said:
    “the buy price at the end is generally set lower than expected market value”

    Used to be. Not sure it has been recently, as the manufacturers were desperate to avoid a slump in sales.

    That’s the nub of the problem; if the buy price is indeed lower than the second-hand value then all is well, If it’s too high, there’s some big problems about to pop up and bite someone – question is, who?

  12. Richard,

    I’m not sure I buy that.

    Simply in that this is a decision that “every” customer will face at the end of the three years. Take ownership (and then either keep or make a small gain on PX), or walk away.

    If the buy-out price is typically below the estimated 3 year residual value, to support lower monthly payments as you suggest, then “every single” deal will make a loss at the end. This is not just about the tiny minority who might fail / bail out in the middle of the term?

    That’s not a working business model, unless it’s factored in from the start (and made up elsewhere in the margin), and in which case it will be transparent in any case when “packaged”?

  13. I took out three vehicle loans last year. One is at 0.9%, the other two at 1.7%. I could have paid cash, but that would have been foolish, as I can make way more than 1.7% on my money.

  14. My current car is on a lease rental through my company. I’m retiring when the three-year lease ends and I might (or might not) want to keep the car, so I asked if I could buy it from Lex at that point, but was told ‘no’ – which surprised me a bit.

    I assume they have an agreement with some third party to buy all their cars at the end of the lease and then sell them on through the trade and they’re not allowed to pick and choose which ones. Does anyone know if that’s how these things work?

  15. Chris Miller

    Depends on the type of agreement, there are different types.

    The PCP options have a purchase option. Your lease agreement clearly doesn’t.

    It’s usually obvious / spelt out when you take on the agreement.

  16. Chris, could well be a long term contract for disposal. A company specialising in leasing cars isn’t necessarily wanting the time and effort involved in disposing of those cars. So for a discount they pass them on to one company who does specialise in disposing of the cars and the leasing company can focus on its core business.

    You find similar all over the place, companies don’t want to do all the work involved in dealing with side issues so pass it on to specialists who do that kind of thing.
    Debt recovery, cleaning, security, recruitment etc.

  17. Yes, but new cars experience a sizeable up-front depreciation, which probably wipes out the deposit.

    Yes, in the UK. Not so much in North America, where your number plate doesn’t tell everyone how old the car is. I ended up buying a new car in Canada after driving old ones in the UK because there just wasn’t enough of a saving in buying one that was a couple of years old (and also because a breakdown over here can be life-threatening if it’s forty below zero outside).

    That is, unless you buy a car that’s likely to break down and be expensive to fix. Many high-end German cars, for example, still seem to have staggering depreciation here. Seems everyone wants to offload them when the warranty expires.

  18. @Martin – yes, that was my assessment, too. I just wondered if someone might know.

    @PF – thanks, I fully realised I’m only renting. IF I wanted to keep the car, I’d almost certainly be prepared to pay more than a third party, and more than it would fetch at auction – since I want a specific car, whereas any bidder is just looking for a generic specimen of a particular age, mileage and condition (they’d also save the cost of turning up with a trailer and hauling it away). But if Lex have a deal that prevents them from taking advantage of my better offer, that’s fair enough.

    Sorry for taking the thread off topic (a bit) 🙂

  19. My experience as well, EMG.

    I bought my son a new Toyota pickup. It made financial sense to buy new, rather than used.

  20. Always buy a car from a dealership near the end of the month (at a quiet time of year) when the sales team is often struggling to meet their targets. I recently picked up a Approved Used 3yo Audi Q3 with 25k on the clock for £17,000.

  21. SE has it right. “Okay-ish” – where the risk grading was wrong, was it assumed that defaults on mortgages were uncorrelated events, which meant it was highly unlikely they’d all default at once. Which they had been during previous observation periods. However if you massively relax your lending criteria, as sub-prime did, with the added bonus that in the US there is no negative equity post-default – you just hand in your keys and you’re done – suddenly in a downturn all your marginal loans are highly correlated, and your recovery rates start to drop through the floor. Oops. Groupthink strikes again.

  22. One more level to add (and a detail, some states are recourse, some aren’t) and that’s that there never had been a nation wide decline in house pries before. Regional varations, most assuredly, horrible busts (oil patch in 80s say). But never national.

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