Could auto loans really be about to cause the next global financial crisis?

Everyone who works in the auto industry can vividly recall how horrible the last financial crisis was. The effect of the 2008 crash was devastating for auto sales as consumers postponed new car purchases and defaulted on existing loans. A few titans of the industry only survived thanks to massive state bailouts.

The root cause of the 2008 crash was, as we know, a collapse in the market for sub-prime mortgages, sold on to investors in the form of so-called Collateralised Debt Obligations (CDOs). Now economists think we could be due for another, similar shock – only this time the cause could be the auto industry itself.

The auto industry has been booming in recent years, with record sales and rising average spend per vehicle throughout most major global markets. But around the world, financial analysts are warning that the auto industry’s good times are built on unprecedented levels of credit, much of it sub-prime. And there are multiple reasons to think the bubble might be about to burst.

Take the UK for example. Interest rates have never been lower and ultra-cheap finance has fuelled most of the country’s growth over the past three years – nowhere more so than in the buoyant automotive sector. Indeed Britain saw a record £31.6bn in car loans last year.

In the UK, a new breed of ultra-low-cost loans known as Personal Contract Purchase (PCP) plans account for a staggering 82% of all new car registrations. PCPs have exploded in popularity because they seem so cheap. This is because PCPs only take into account the cost of the car’s depreciation (typically over the first 3 years), rather than spreading the loan and interest charge over the whole cost of the car. This has made the most expensive models (those which are expected to maintain their value best) affordable to those on lower incomes. Sales of up-market diesel SUVs, in particular, have been soaring.

Picture of man buying a new car

This, in turn, has created unprecedented levels of exposure for the auto finance companies and lending institutions. Last year, Bank of England economists writing in a blog post entitled Car finance – is the industry speeding? warned that “the industry’s growing reliance on PCP has made it more vulnerable to macroeconomic downturns”.

The banking industry, which provides most of the finance for PCPs, is vague when it comes to the details of how affordability and default metrics are applied and tracked across this vast market. Much as it used to be vague when probed about mortgage lending decisions. Analysts now worry that the absence of any standard way to calculate customer arrears and vehicle repossessions could mean that the 3% figure which the industry itself defines as “sub-prime” could, in reality, be far larger.

The Finance & Leasing Association (the trade body for car lenders) cannot provide figures to support its assertion that lenders are following conservative credit guidelines. It says PCPs are sold responsibly only to those people with a strong credit score. Yet lenders’ credit scoring policies, which are relatively transparent in the US – the original home of the PCP – are secret in the UK.

More troubling than the levels of irresponsible lending though is the sheer total volume of auto lending. Last year UK household borrowing to buy cars was up 12% on 2015 levels. This year, the total borrowed is expected to exceed £40bn. Cash purchases are almost unheard of. A record 2.7m new cars were sold in Britain last year – the fifth year in a row of increasing sales. Today the British “buy” more cars per capita than any other major European economy. Now with the economy slowing, there are real worries that this volume of lending will be highly vulnerable, even to small increases in interest rates or rises in unemployment.

Another cloud in the perfect storm might be diesel. Of the 2.7m new cars sold last year, 1.3m were diesels. Many experts foresee a collapse in the residual values of diesel cars, especially top-of-the range premium diesels, as the government considers a clampdown on the fuel as part of plans to improve air quality in cities.

And it’s not just the UK that looks risky. Cast an eye across the Atlantic and the indicators are every bit as troubling and on a much larger scale.

Today more than a million Americans are behind with payments on their car loans – a level not seen since the last financial crisis. Meanwhile Morgan Stanley is projecting that used car prices in the US “could crash by up to 50%” over the next four or five years.

As of April 2017, approximately $200bn had been loaned out by auto finance companies to consumers with sub-prime credit scores. This at a time when sub-prime auto loan losses have soared to their highest level since 2008, and the delinquency rate on those loans has risen to the highest level seen since the last financial crisis.

And, just like with sub-prime mortgages in the run up to the last crisis, sub-prime auto loans have been bundled together and sold on as – you guessed it - our old friend the Collateralised Debt Obligation!

There could well be pain ahead for the auto industry. It might not be as severe as the 2008 crash. But this time it will have been self-inflicted.