There was an error in this gadget

Monday, October 27, 2014

The New Target: Auto Finance

By Nigel Aplin | Oct 27, 2014

After several years of being the focus of consumers over-extending themselves, the Canadian mortgage industry can rest a little easier as rating agencies and policy makers may now have a new target: auto finance. Both the Bank of Canada in its recent commentary and Moody’s Investor Services, in a report last week on Canadian banks, singled out auto loans as a possible area of vulnerability.

Auto loans at Canadian banks have been growing at an annual compound rate of 20% or more over the past seven years. Prior to 2007, auto leasing was a very popular vehicle acquisition option for consumers which offered low monthly payments but left auto makers with large inventories of used vehicles coming off leases which averaged between two and four years in duration. Pricing for leases increased significantly and many consumers began opting to purchase their vehicles and finance those purchases with loans which extended beyond the traditional car loan term lengths of three to five years. Auto finance loans which now extend over 72, 84, 96 or even 108 months offer consumers low monthly payments but create risk for lenders.

The Bank of Canada commented last week that “auto sales have reached record highs” as it suggested that the risks associated with household imbalances are edging higher. The Moody’s report looked at the potential exposure of banks which have loaded up their balance sheets with auto loans which have grown from $16.2 billion in 2007 to about $64 billion today. An economic shock like a sharp rise in the unemployment rate could trigger defaults on these loans and the risk to lenders comes from the rapid depreciation of new vehicles, particularly in the period shortly after purchase. Loan balances could exceed vehicle values during these periods and long amortizations of up to eight or nine years mean that loan balances are slow to reduce. Unlike real estate, the value of autos never increases over time.

Canadian consumers who can finance their car loans over long terms and enjoy relatively low monthly payments have also shown a preference for more expensive new vehicles and this only adds to the household imbalances to which the Bank of Canada refers. Canadian banks admit that auto finance is a rapid growth area for their balance sheets but they insist that they are maintaining prudent underwriting standards and that they stress test their portfolios regularly.