The global auto industry is facing a set of new and unique challenges. Automobile sales are weakening and consumer preferences for vehicle use are changing. More stringent emission standards are being rolled out in major markets. And the market and regulatory push for greener technology is strengthening.
S&P Global Ratings believes that auto financiers' response to these global mobility trends may have profound implications for the performance of financing products in Asia-Pacific, particularly in China, Japan, and Australia. Responses could include increased support to brand sales and new business strategies to capture the new demand. New types of financing and securitization will also emerge. The nature and extent of the effects however may vary across countries for now, due to the different stages and directions of market development.
Declining Vehicle Sales Increase Financing Competition
Auto sales declined in almost all major markets in the first eight months of 2019 for a variety of reasons (see chart 1). In China, manufacturers sold 11% fewer cars than in the same period last year, which was already disappointing. Australia recorded a sales decline for a consecutive 17 months to August 2019. Japan, however, bucked the trend with mild sales growth.
Chart 1
Financiers have had to sweeten their terms to compete in a market with reduced opportunity, and to support the sales of their auto-manufacturing parents. This has, for instance, contributed to generally lengthened loan tenors in the U.S. We have not observed similar trends in this region, though (see chart 2).
Chart 2
The sales slowdown triggered more active lending among the captive finance companies in China, primarily through expanding the manufacturers' subsidy on loans. This helped reduce loan interest for the borrowers and therefore supported vehicle sales. As more borrowers took loans, the finance penetration rate rose quickly--it has reached 30% to 50% in AFCs. After factoring in finance from non-captive financiers, particularly banks and leasing companies, China's aggregate finance penetration is catching up with the levels in more developed markets such as the U.S., Germany, and Australia.
Because penetration has increased sharply from a low base, market participants began to worry about the resilience of auto loan performance in China, which previously was supported by low finance penetration and limited competition. We think differently--the rising amount of interest-subsidized loans is the main reason for the increasing loan origination and penetration. The higher portion of subsidized loans resulted in a transition in the borrower profile, because people with better credit quality or no need for financing took loans to benefit from low or even zero interest rates. The transition is positive for loan performance, explaining the decline in loan defaults rates over the past few years.
Slowing auto sales in major cities in China is encouraging the penetration of both vehicles and auto financing to the lower-tier cities, especially for the economy brands focusing on the mass market. We believe this geographic expansion could press on loan performance in the future, given the untested nature of these markets and lower employment flexibility in these lower-tier cities especially during an economic stress scenario.
Balloon And Schedule-Adjustable Loans Are Becoming More Common
Balloon loans that have a big portion of the repayment due at maturity are becoming a standard offering in most markets in Asia-Pacific. Although the application of product terms and market share may be different due to the varying levels of market development and tax schemes.
In China, the share of balloon loans is rising but remains at a single-digit percentage for most financiers. Australia sees consistent offerings of balloon loans. We have observed between close to zero, to up to 40% of loans having balloon features in securitization transactions there, with commercial customers tending to use this product more due to the associated tax savings. In Japan, some financiers even provide flexible loans for which borrowers can change the payment schedule whenever they want. We are yet to see such practices in Australia or China, though.
Balloon loans attract more vehicle buyers to use finance. Given the apparent higher tail risk in these loans, financiers are generally careful in choosing their customers and may adopt more conservative underwriting or down-payment requirements for these loans. Partly due to this additional layer of risk control, we have not seen a major difference in credit performance of these loans globally, when compared to the fixed-schedule fully amortized ones. However, we believe borrowers of these loans face much higher repayment stress when macroeconomic conditions deteriorate sharply and the liquidity in the second-hand car market dries up. We generally apply a higher default rate assumption for these products in our securitization analyses.
Auto Leases Gain Popularity As The Demand For Car Use Rather Than Ownership Increases
Globally, the demand for car use--but not ownership--is increasing. Leasing might be one of the answers to meet this trend. Leasing products are growing popular also due to the more flexible finance arrangements that provide lessees options of owning the cars or giving them back after the lease. In markets such as Australia, tax benefits for vehicle leasing payments further underscore demand.
Due to the different market development stages, the vehicle ownership ratio remains low in China and the appetite to own vehicles remains strong for most families. This is reflected in the strong vehicle sales to individuals, and the proliferation of consumer auto loan and long-term finance lease products. That said, generations born after 1990s are embracing the idea of paying for using vehicles and trading-in for newer models later, and the traditional preference for ownership may gradually change. More and more vehicle manufacturers in China now have affiliated lease companies to address these demands, in addition to the traditional auto loan businesses.
This mobility trend may give rise to operating auto leases and associated securitization funding, similar to what happened in Europe. In these transactions, the vehicles' residual value decisions and the evaluation on the new customer segment (lessees, rather than the traditional borrowers) become critical for risk analyses. Brand differentiation typically plays an even more important role in these transactions, due to the differences in the value of second-hand cars of different manufacturers. Many market surveys and second-hand car trading platforms in China indicate that a vehicle may be sold at as high as 75% of the original price after three years of use, or as low as 40%. Given the varying used car valuations, we believe performance of the operating lease sector may be more divergent than that in the typical auto loan asset-backed securitization (ABS) transactions.
Demand For Auto Finance From Companies Could Grow
The proliferation of subscription-style services for vehicles is increasing across the major markets in Asia-Pacific. Many major car companies in Japan now provide car lease/share for individuals, amid a shrinking population and reduced interest from younger customers, such as those in their twenties, to have their own cars. Millennials are walking away from car ownership and embracing subscription services in Australia, due to the higher costs of ownership and the availability of alternatives for convenient transportation. China also saw a quick development of driver-to-customer and company-run short-term transportation service businesses in many cities.
The shift to car subscription will fuel the growth of related services providers, and drive up needs for financing to support the capital investment. New business models could call for alternative financing options. For traditional lease models that focus on long-term direct lease or sale-and-lease-back arrangements, the primary subjects of financing remain with the lessees, and financiers can use these consumer receivables for funding. This may change if short-term use of vehicles becomes more prevalent and the financing shifts to business borrowers.
Experience in the more developed short-term lease/subscription services markets shows service providers typically need to first take commercial loans to acquire the fleets, and recapture their investments and repay the loans through operating the fleets. Financing therefore is assessed considering vehicle mortgage on a commercial scale, and the operational capability of the companies.
As this trend continues, the importance of auto finance relating to fleet acquisition and operations may increase. Securitization for these short-term-use fleets is limited at the moment, but could evolve into an important sector over time.
Regulation May Affect The Sale Of Older Models, And Their Second-Hand Value
More stringent environment-protection regulations across the globe are driving out vehicles with low fuel efficiency or those failing to meet new emission standards. This has resulted in a sharp drop in the sales of some older models and their secondary-market prices, due to the heavy discount in new car prices. Take the example of China--vehicle sales dropped 12.4% in the first half of 2019 from a year ago, partly due to the implementation of new emission standards in select major cities in July 2019.
On the other hand, global sales of electronic cars are rising, despite the recent drop (see chart 3). In China, vehicles that feature plug-in hybrid (PHV), electronic (EV), and fuel-cell power plants, are fast catching on primarily due to government subsidies and favorable plate issuance policies in some major cities. The Japanese government also has a plan to revise fuel regulation, which will require auto manufactures to develop EV and PHV to meet the regulatory targets by 2030. It is also planning to lower taxes on the purchase of new-energy cars. These regulatory trends fuel new-energy car sales, and could very soon increase the portion of such cars in securitization pools.
Chart 3
Increasing Popularity Of New Energy Cars Brings New Opportunities And Risks
It could be argued that due to the different segmentation of new-energy car users, loans supporting new-energy cars typically possess higher credit quality. This view is supported by the typical phenomena in green finance, where financially sounder borrowers are those that are willing to spend more for a better environment in the future. And therefore the credit performance of the related borrowing is better than the market average. However, for auto finance we do not yet have sufficient empirical evidence to support or reject this view, and believe that this potentially positive factor needs to be assessed with some caution relating to financing new-energy cars.
New-energy vehicles haven't been on the road long enough to generate sufficient data to assess their long-term secondary market values. However, the statistics on many second-hand-car markets indicate the valuations of many new-energy vehicles are significantly lower than vehicles with petrol or diesel engines. We believe this reflects various factors, such as these vehicles' generally shorter useable life due to quicker performance deterioration with age and the technology advancements that quickly make previous models obsolete. These vehicles also need strong after-sales maintenance and support networks.
The weak secondary-market price may affect the performance of auto leases, which face residual value risk when leases end and lessees decide to walk away. It's also an important consideration for recovery after a loan borrower or lessee defaults. However, for auto loans, especially the prime sector ones, the impact on loan default frequency is less clear. This is because in most markets, the repayment of auto loans will fully capture the capital value of the financed vehicles, and these loans are generally full-recourse obligations. With the full-recourse nature of car loans, borrowers' incentive to default purely because of the decreasing vehicle value should not be strong. Auto financiers in this region however have had little experience of negative equity in loans they offer. Typically the assessed vehicle values are always higher than the loan amounts outstanding at any time of the loan life, due to higher down-payments and shorter loan tenor than those in the U.S. The potential negative equity phenomena in new-energy car financing is an untested area here.
Another important feature in these new-energy car markets, especially EV, is the high market segmentation and the many manufacturers with differing scales. The competitive advantage of these cars is on car design and battery technology, rather than on traditional factors such as engines, transmission, or brand recognition. This reduces the entry barriers for new manufacturers. On the other hand, proprietary technology drives stronger linkages in maintenance and post-sale service with the manufacturers, creating post-sale dependence. We believe this may facilitate more industry consolidation. The bigger and more powerful brands may capture more market share, and threaten the sustainability of some smaller manufacturers. Therefore, loan performance may vary depending on the vehicle brand.
New Technology May Redefine The Processes In Auto Finance And Securitization
Implementation of information digitization, big data analyses, machine learning, cloud computing, automation, and blockchain technology in the traditional finance business is expanding worldwide. Throughout China, Japan, and Australia, many banks and finance companies have put significant resources into these technologies to enhance their risk underwriting, exploit new markets, find new ways of doing business, or protect their market position. Auto finance is no exception.
China has seen some securitization transactions with blockchain technology where "blockchain" is used in the name. Also, some leading intermediaries are setting up cloud-based operating platforms for the execution of securitization transactions and performance follow-up. Auto finance is the focus of these initiatives, due to the ease of introducing the smart contracts concept in loan origination, underwriting, repayment, and performance reporting. Efficient identity verification and credit information enquiry platforms and the very high share of bank account/e-payments auto-debit repayment arrangements facilitate the quick development of this technology in auto loans. This in turn may enhance the transparency of how the assets are formed, their performance trend, and the operation of the securitization transactions. It may also speed up the whole securitization process from asset origination to transaction offerings.
The Strong Performance Of Auto Finance ABS May Not Remain Within A Small Range
Auto finance ABS issuance has been stably increasing in Asia-Pacific since 2015 (see chart 4). Performance of loans and leases supporting auto finance ABS has been strong across the region. The favorable economic environment, low unemployment rate, enhanced risk-underwriting skills, and conservative customer targeting support debt serviceability in this sector in China, Japan, and Australia. Auto loan products in these markets are also characterized by vanilla repayment structures such as fixed amortization schedules (with or without balloon arrangements). Together they result in low finance delinquency, and differentiation of loan performance across different financiers is low.
Chart 4
Most China auto loan ABS have reported life-long cumulative default rates in the range of 0.1% and 1.0% in the past four years. The same rates are about 1.0% for the Japan transactions we rate. For the term auto loan ABS transactions we rate in Australia, cumulative net loss (prior to the transactions' being redeemed at their call option dates), are typically around 0.5%.
The limited differentiation in loan performance could change. Emerging mobility trends may affect loan performance directly, and the effectiveness of risk management at different financiers will be tested. Moreover, the mobility trends may affect financiers' business strategies and therefore result in differing business models and market targeting, as well as finance origination and servicing. All of these will eventually differentiate performance of the financing products that different issuers securitize.
This report does not constitute a rating action.
Primary Credit Analysts: | Aaron Lei, Hong Kong (852) 2533-3567; aaron.lei@spglobal.com |
Erin Kitson, Melbourne (61) 3-9631-2166; erin.kitson@spglobal.com | |
Toshiaki Shimizu, Tokyo (81) 3-4550-8302; toshiaki.shimizu@spglobal.com |
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