Tuesday 12 December 2017

Driving down car prices through cheap credit could put lenders on a road to ruin

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Richard Curran

Richard Curran

'Attainable" is the new buzz word in motor advertising. "Driving away in the Audi of your dreams is even more attainable with enhanced flexible plans to suit your needs", is how the Audi literature puts it.

Over at Mercedes Benz, it is about dreaming of owning a Mercedes Benz one day, and "one day is now".

The sheer luxury of driving around in a new car is pretty appealing. Drive any road in Ireland and the number of new cars is quite staggering.

However, if your neighbours are pulling up in a brand new car, there is a very strong chance they have financed the purchase on a personal contract plan or PCP.

This is the financial instrument that is making so many of these new cars "attainable", and estimates suggest that 60pc to 70pc of new car sales in Ireland are being financed through PCPs. The reason is they involve making substantially lower monthly repayments than in a standard car loan or hire purchase agreement. They do require a deposit, usually of 10pc to 30pc of the purchase price. If after three years you don't want to keep the car you can hand it in and 'buy' a new one. The deposit needed for the new one, in theory should be derived from the difference between the guaranteed price the car dealer will pay for the car, and the amount you still owe.

If you want to, you can just hand in the keys after three years and walk away, assuming you have kept to the terms of the deal around the condition of the car and how many miles you have done per year.

The PCP is an ingenious financial product. "Your Audi journey begins with PCP finance" is now Audi puts it, while Mercedes says, "one day is now, with PCP across the range".

But there are potential problems which may well be coming down the track. What if so many new cars are sold on PCPs that the second-hand car market gets flooded with second-hand cars, as people keep opting for new ones?

The downside would be shared by both the lender of the money and the customer. The risk for the lender is that they have set a guaranteed minimum future value for the car, three years in advance.

A flooded second-hand market could reduce the market value which would hit the lender.

For the customer, these risks are a lot less. The lender will take the hit if the car isn't worth what they thought it would be worth, but the customer may find they don't have enough equity left the in car to use as a deposit to go again and get another one. The lower the deposit, the greater the monthly repayments will be on their next car.

This isn't so much a direct financial hit for the consumer as an adjustment they might have to make to the plan on their next car.

And second-hand car prices have begun to fall, largely prompted by an influx of tens of thousands of cars from the UK, aided by cheaper sterling after the Brexit vote.

PCPs have been a key driver in new car sales in Ireland. Banks are lending for them. So too are the car companies themselves through their financial arms.

Volkswagen Bank lent out €340m in the first seven months of 2016, which was equivalent to what it lent out in all of 2015. The average amount being lent also appears to have risen, with BMW saying its average PCP loan in 2015 was €27,000 but last year it was up to €30,000.

However, as growth in new car sales began to slow, some manufacturers are reducing their prices. Internationally, Volkswagen Bank has lent out €100bn to its customers.

In the UK some economists and some industry figures are getting concerned about the impact of PCPs on the lenders and the risks for them.

The real danger is that second-hand car values will fall dramatically. In the UK, a used car that is less than two-and-a-half years old is worth 57.6pc of its original value on average. This is down from 61.1pc in 2014. The scale of motor credit in the UK has garnered attention from the Bank of England.

In a recent in-house blog, staff wrote: "the UK car industry has seen very strong demand growth in recent years which most participants believe is not sustainable."

A Bank of England report found that falling used-car prices were pushing up monthly payments for consumers.

In the US used-car prices have fallen a lot in the last year. Shares in car rental company Hertz have crashed 70pc. Ford has issued a profit warning for its finance business.

One difference between the US and the UK is that in America, cars tend to be leased so all of the financial hit is borne by the lender.

In the UK, where PCPs have been wildly popular, some of the risk is shared between the lender and the consumer.

However, it is worth pointing out that the "risk" for the consumer is not as great as for the lender because it should only result in them having less equity or higher repayments when they go again for the next PCP car, as opposed to actually losing money on their first PCP deal.

Plus, they can simply walk away and hand back the car. The real risk is carried by the lender.

The UK has the highest proportion of cars purchased on credit. It even has lenders doing PCP deals on used cars, which in a sense sees them taking a punt, not only on the customer's ability to meet repayments but on the future state of the used car market.

Traditional lending, for anything, is about taking a risk on the person's ability to pay. In PCPs, where the monthly repayments are so modest, the risk is really on the future value of the car. Has this been fully factored in by motor lenders?

Billions of euro in motor loans internationally have been bundled up and sold on to investors. It all sounds a little ominous because of natural comparisons with sub-prime mortgages back in the boom years.

And funny enough, a chunk of the money being lent out for motor purchases is actually coming from German savers. Motor company finance arms are taking billions in deposits from German savers, in search of a good interest rate.

So, some of the credit splurge on cars is emanating from elderly Germans putting their savings in the bank.

But there are differences with the sub-prime mortgage situation.

The scale of borrowing isn't nearly as great. Secondly, in the housing market, the financial engineers who devised the products did not assume that house prices would fall. In fact they assumed they would keep on rising.

With new cars, everybody expects they will be worth less in a few years' time - it is built into the model.

But that doesn't mean the financial wizards can't get their assumptions wrong about how much a Qashqai, with one previous owner and 48,000km on the clock will be worth in three years from now.

It seems we are all about to find out.

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