(by Julia Jenson)

Lots of American consumers cannot resist the temptation to replace their old clunkers with brand-spanking wonders of modern technology at the time when auto financing rates have dropped to the average of 5.79% for a 48-month new car loan. The auto loan market that once consisted of simple paydown structures with short repayment terms available only to consumers with a good credit history now has a bewildering assortment of loan types and caters to the needs of different categories of car buyers.

In recent years the extension of loan terms enabled consumers to stretch payments over longer time periods lowering the amount of the monthly payment. Since this number is a key decision factor for many, its reduction spurs consumers to purchase more expensive cars. In July 2004, the average transaction price on a new vehicle was $25,855 which is 8% higher than three years ago according to the National Automobile Dealer Association. Most automakers report increase in sales in their luxury car departments.

The trap of the luxury car financing is the quick depreciation of the asset. Quality brands are known to lose 25-35% of their value in their first year compared to the average of 20% leaving the borrower with negative equity when the loan balance exceeds the market price of the vehicle. In this case, the owner cannot offset the loan by selling his or her car in the market, a situation that increases the likelihood of default. With a detective twist added to credit card business following a series of suicides on debt grounds in the UK and a call for tougher controlling procedures of lending practices, it appears that lenders had better take their clients’ solvency checks as seriously as possible.

Extending credit is even riskier with balloon and deferred loans. A balloon loan agreement allows the borrower to make relatively small payments for a certain period of time later covering the rest of the balance in a lump-sum payment. Deferred loans let one use the car for a certain amount of time without paying anything at all. That means that when payments start, the value of the depreciated vehicle is inevitably lower than the loan balance.

Anyway, lending is about managing risk, and finance companies are getting more sophisticated as they move into riskier markets. Subprime borrowing has proliferated, and finance professionals are honing their skills in assessing the borrower’s creditworthiness. Last quarter used-car dealer CarMax launched a nationwide financing program aimed at the subprime market pairing up with Drive Financial Services, an auto-loan provider that will use its expertise to screen potential buyers to minimize the risk of default. The ultimate goal of the venture is to grant loans to those customers who had been turned down by CarMax’s in-house providers while passing the risk of non-payment to experts.

For those who opt for a new American car, last quarter was a great season for savings. “Big Three” American manufacturers are heaping incentives on consumers in an effort to boost car sales and oust their Japanese rivals from the North American market. US top producers General Motors and Ford spent on average $4,300 and $3,800 respectively on sales incentives per vehicle at the end of September, offering rebates, discounts and zero-percent financing while Honda managed to keep these costs at $700 per vehicle. Zero-financing feast is not for everybody though: only a third of those who apply qualify for it. Strenuous marketing efforts bit heavily into the American companies’ bottom line leading both giants to post losses in their flagship car production businesses. Dismal condition of the core business was surprisingly offset by the strong performance in the financial services sectors of both firms. Financial services made up the bulk of GM’s $440 million third-quarter profit. At Ford, higher-than-expected profits in the finance arm helped the company beat Wall Street expectations raising earnings to 28 cents a share twice the average 14 cent estimate. Investors were left wondering whether car manufacturing business will boil down to an appendage to the booming finance divisions.

More automotive giants are stretching their finance divisions into the coveted Chinese market. Although car sales in China have shown signs of slowdown, the auto industry continues to see a huge potential in the Asian market. The state-owned banks pioneered an auto financing program in 1996, and in the first half of this year outstanding auto loans exceeded 180billion yuan. Auto financing remains a risky business in China, since the non-performing loan ratio is over 50 pct with bad loans amounting to 94.5billion yuan. Volkswagen promised to be careful launching its car loan program in China attempting to expand the sales of upmarket models. Absence of the central credit rating agency and laws to repossess cars from delinquent payers or ubiquity of fake documents used to defraud credit officers do not keep the auto makers from granting credit in the country where most consumers have little experience of dealing with debt. Volkswagen is treading in GM’s footsteps, and there’s still a long way to go. Currently only 15 to 20% of all the cars sold by GM in China are financed through loans as opposed to 85% in the US and 70-80% in Europe. Ford and Toyota already have initial approval to start car loans and will likely follow suit.

As emerging markets continue to attract manufacturers, their consumers are bound to see the growth and increasing sophistication of the auto finance sector comparable to the extended network of lenders in the developed countries. Subprime borrowers in all markets will probably see greater attention to their needs and a drop in the rates. It remains to be seen whether the lending institution will handle these developments with an adequate degree of caution in their risk management procedures.