What a difference 6 months makes! I read a report earlier in the year that “debunked” the myth that securitised loans in the car industry would fail in the same way that the subprime mortgage defaults contributed to the Global Financial Crisis (GFC) back in 2008 across the world.
Car loans just like the mortgages before the GFC are split into “securities” and repackaged up into other “investments”. One of the contributing factors to the GFC was that as home owners lost their jobs, they defaulted on their mortgages. This affected the securities that formed other investments which also tanked, forcing banks to call in debt to cover their losses. This in turn meant that some companies went to the wall, forcing other workers out of a job and more mortgages were defaulted. Repeat the process until various Governments stepped in to stop the wheel spinning.
The mortgages were known as subprime because the borrowers were “sub prime”, in other words were a credit risk and probably shouldn’t have been given the opportunity to borrow as much as they did. The banks were very keen to lend to as many people as possible, the Governments allowed it and the whole concept collapsed spectacularly – but not after some organisations and individuals made a mint!
The report I read a while back suggested that car companies and dealers were ignoring history and providing loans to people so that they could buy a new car. Some of these people were “sub prime” and had a higher risk of default. Apparently loans for cars in the US make up $900B of the $12T (trillion!) of consumer debt. That’s still a huge amount in my view! Car loans typically have a much lower rate of default compared to credit cards, mortgages and student loans.
To hedge their bets, the auto lenders (including many manufacturers who have finance arms) create securities that they on-sell to investors. These securities are made up of portions of the subprime car loans. Typical buyers of these securities are mutual funds, insurance companies and even hedge funds.
The after-effect of subprime mortgages happening with car loans was dismissed earlier in the year – and that was before VW was caught rigging an already rigged emissions test. Now things are different. All manufacturers have debt – some for operational purposes and some that is basically a simple liability (loans to consumers). The cost of insuring against default has risen sharply since the current issues at VW surfaced which means it is more expensive to cover the risk.
VW and several other large European manufacturers have huge amounts of debt on their balance sheet that needs to be refinanced on a regular basis – the cost of doing so is increasing. More worrying is that a portion isn’t on the balance sheet – it has been “securitised” and sold off. Two issues have arisen from this:
1. To encourage new buyers (that VW desperately needs – as do all manufacturers) they need to offer competitive finance. This may become difficult if the original problem isn’t fixed. Reduced sales means reduced revenue to cover the operational loans.
2. If owners default on their loans because the value of their asset has dwindled leaving the liability higher (or because there are other economic factors at work), VW is at risk of helping to start a subprime auto loan based financial crisis.
If the emissions testing debacle spreads to other groups (we now know that many of the sub-brands within VW are affected) such as Daimler, BMW or PSA (Peugeot Citroen) then finance lenders may get wary about lending more and could start demanding repayments on existing loans. This could be disastrous for the manufacturers and we could see not only the State of Lower Saxony owning a portion of VW (20%), but the Federal Government too as they are bailed out. We will have to wait and see how future sales track and what the markets will do with subprime car loans.
In any case, financing will get more expensive for any type of loan document that a manufacturer needs.