The Bank of England recently warned about the high level of outstanding consumer credit, or, to be blunt, “debt”. Consumer credit in the UK increased by £1.7 billion to £198.4 billion in May 2017 following a downward revision of a £1.48 billion rise in April. This was above market expectations of £1.4 billion and represented the biggest increase since November 2016.
On an annualised basis, consumer borrowing rose 10.3% (at the same pace as in the previous month), as credit card lending rose by 9.1% year-on-year to £68.2 billion (from 9.7% in April). Other loans and advances grew by 10.9% to £131.5 billion (from 10.7%).
British consumers in debt
Source: BOE and Eurostat
The chart clearly shows that the level of credit and the degree of debt relative to income declined between 2008 and 2010, as the financial crisis reached its height and consumers looked to pay off debt amid the growing uncertainty.
Credit did begin to advance after 2010. However, the weight of credit relative to income appears to have fallen. This is quite a puzzle as data from the Office for National Statistics (ONS) does not suggest disposable income in the UK began growing until 2014. What is clear, however, is that the level of total consumer debt in the UK now stands close to £200 billion and is growing at the fastest rate since 2005.
The quality of UK car finance loans has changed for the worse over time. Photo: Shutterstock
Consumer prices in the UK gained 2.6% in the year to June 2017, easing from a four-year high of 2.9% in May and missing market expectations of 2.9% again. Average weekly earnings including bonuses in the UK rose 1.8% year-on-year to £503 before tax and other deductions in the three months to May 2017, following a 2.1% increase in the previous period, and was in line with market expectations. That was the weakest gain since the three months to November of 2014.
As such, consumers have been turning to credit cards with low introductory rates and cheap loans to support their spending. One key area of cheap loans can be found in car finance.
New cars sales soar
Sales of new cars have risen to a 12-year high. While this superficially sounds like good news for car makers, the amount of new car deals on finance schemes has risen dramatically as well.
This affects the volume manufacturers more than the high-end producers for while 90% of all new car sales are financed, only 50% of luxury-brand sales, on average, 50% are arranged via finance.
Yield hungry investors fuel the market
In a financial world of monetary accommodation and skinny bond yields, investors have sought out financial products that can offer enhanced returns. In this respect, car loans have been attractive as the material with which to create asset backed securities (ABS).
This has driven a new form of car loan, called "personal contract purchases" (PCP). These account for 85% of the car finance market in the UK, and they are increasingly being bundled together to create ABS. The value of these is linked to the market for used cars as PCPs allow borrowers to return their vehicles at the end of the contract instead of paying the balance and keeping a three-year old car. This means investors typically rely on used car sales to recover their investments.
In the UK, investors say highly rated auto securitisation bonds are trading at around 20 basis points over one-month LIBOR, which currently stands at 0.254%. So, the car loan ABS yields 0.454%. In contrast, floating rate bank debt in sterling trades at 19 basis points over three-month sterling LIBOR (0.288%); the bank debt is paying 0.478%.
Ratings agencies Standard & Poor’s and Moody’s have given most of these batches of car loan-backed ABS a triple-A safety rating as the default rate on car loans is running at an 11-year low.
AAA? That's worrying
In 2016, the total amount of car loans being carried by consumers was £58 billion which is over double the figure in 2012, i.e. £28 billion. The BoE estimates major UK banks total exposure to UK car finance to be £20 billion. That equates to 9% of "tier-1 capital," which is the bedrock equity that banks need to maintain if they are to be considered sound by regulators.
The problem is that the quality of UK car finance loans has changed for the worse over time.
In the past, car finance meant a customer had to pass a stringent credit test, then pay a sizeable deposit and then make monthly payments, with interest, until the loan was paid off.
This has changed as with PCPs there is no deposit, and the customer makes much lower monthly payments until the end of a fixed term. At that time, one either makes a large "balloon" payment or returns the car.
The dealer either gets all the cash and interest generated by the loan or, in the case of someone who can't afford the balloon payment, the dealer can sell the car again. The value of the underlying asset in a PCP deal, the car, will change dramatically depending on how well the driver treated the car and how many miles have been clocked and, of course, on how the market for second-hand cars is at any given time.
In a downturn, drivers who fall on hard times can simply return the car and walk away from the rest of the loan. The dealer is stuck trying to sell a car in a recession when prices are likely to be plummeting. That leaves dealerships and the banks funding them exposed to a highly volatile market.
Another sub-prime mortgage market?
Like a home mortgage, a car loan is secured on an asset. However, even though property can dip in value, over a cycle the value can recover. That is not the case with a car, as we all know that if one buys a brand-new vehicle, as soon as one drives off the forecourt, up to 40% of the value can be lost.
So, for a car loan customer in difficulty, the car can be repossessed, but the customer is still liable for the difference between the original loan outstanding and the used resale value. Borrowing is a bad idea when it is done against a depreciating asset.
Even if there is no default, it is because lenders are increasingly reluctant to confirm there is a problem. Arrears have apparently risen sharply as the amount of loans that are running at 90 days or more in arrears is at the highest level in six years. That does not sound very AAA to me.
The risk is, of course, moderate compared to the housing crisis, and only 20% of UK car loans have been turned into ABS cf. 75% of sub-prime mortgages before the crash, but the quality of the ABS market can be seen once again to be at the very early stages of becoming a poisoned well.
If a car loan ABS were to collapse, the majority of the financial pain will be inflicted on the car manufacturers who stand behind their leasing agencies. BoE economists have stated that the car industry’s growing reliance on PCP has made it more vulnerable to macroeconomic downturns.
Nothing sub-prime about this one. Photo: www.jaguar.co.uk/
– Edited by Robert RyanStephen Pope is managing partner at Spotlight Ideas