The real winner of the used car bubble is revealed

When Porsche tried in 2008 to take over (much larger) Volkswagen AG using opaque financial derivatives, analysts pejoratively dubbed it a "hedge fund" that also makes sports cars. The bid was unsuccessful.

Now Porsche is part of Volkswagen, and the parent could almost be described as a "credit giant" with some car brands attached. This structure, though, is doing wonders for the German manufacturer's bottom line.  

Operating profits at VW's auto finance unit doubled last year to 6 billion euros ($6.6 billion), according to figures published last week, outstripping even the bumper earnings of Porsche and Audi.

Rivals have also enjoyed windfalls from their financing units thanks to soaring used-car prices and exceptionally low loan-default rates. At BMW's financial services division, the pre-tax return on equity doubled to almost 23% last year. 

Such favorable market conditions won't continue, yet 2022 still looks pretty good for car-loan providers. That's fortunate because the business of actually manufacturing vehicles remains a headache. In addition to raw-material cost inflation and semiconductor supply issues, automakers now have to worry about component shortages stemming from the war in Ukraine, as well as the rapid spread of omicron in China and Europe.

These headwinds underscore the benefit of carmakers having finance units that can make decent money regardless, and whose dividends can be repurposed by the parent for electric-vehicle and software investments.

Customer and dealer financing typically account for between one-fifth and one-third of auto-group earnings, but at some underperforming carmakers the figure is currently much higher. At Renault SA, for example, car finance contributed more than 70% of  yearly operating earnings. No wonder Stellantis NV, owner of the Jeep and Ram brands, moved to create its own US finance unit last year.

One reason why financing has become so profitable stems directly from the cost and limited availability of new vehicles. Used-car prices have increased around 40% in the US in just the past year.  In some cases, pre-owned vehicles cost more than the equivalent new models, because the wait is shorter. 

The upshot is leased vehicles are worth far more at the end of the contract than the lender assumed when the customer signed on. Hence, lessors are enjoying book value gains and can sell the cars returned to them for big bucks. General Motors Co. enjoyed $2 billion of leasing gains last year, while at Ford the profit uplift from leasing was around $1.5 billion. This chart of Ford's leased vehicle resale values helps explain why.

Another factor juicing auto-finance earnings is that consumers are taking out larger loans to pay for more costly new or used vehicles. By the end of last year, the average size of a new US vehicle loan had jumped 12% to almost $40,000, according to Experian, while the average used car loan increased to more than $27,000. Meanwhile, government stimulus checks and furlough programs have helped customers keep paying off their car loans and pandemic restrictions meant they built up savings as there was little else to spend on.

Auto lenders were therefore able to unwind the precautionary provisions for credit and re-sale value losses booked at the start pandemic, further padding profit. At some lenders, credit losses turned negative last year because defaults were astonishingly low and the value of any repossessed collateral rose.

Factor in low interest rates, which reduce auto lenders' funding costs and help customers afford more expensive cars, and you can see why auto lending has been going gangbusters.

Yet in such a comfortable environment, there's a danger of companies letting down their guard. "We think that heavily inflated asset prices give rise to the risk of similarly inflated guaranteed future market values in auto loan contracts," Fitch Ratings warned in December.

Fortunately, few automakers appear to be counting on conditions remaining so favorable. Most expect their finance-unit profits to decline in 2022, albeit to levels that are still pretty high. VW's financial-services arm predicts about 4.5 billion euros of operating earnings for this year. 

One new issue is more consumers are exercising their right to buy their leased vehicles, rather than return them, so the lessees can sell it and book the profit themselves. At GM, very few US customers were returning leased vehicles by the end of last year.

The bubble in used car prices is also bound to deflate at some point. Auto-lending giant Ally Financial is assuming used car values will drop as much as 20% by the end of 2023, but that may yet prove overly conservative owing to the slow improvement in available inventory.

With the Federal Reserve now hiking interest rates, lenders' funding costs are poised to rise, potentially depressing the spread they make on customer loans fixed at low rates. Meanwhile, customer defaults may increase as pandemic support payments are reduced and inflation erodes household budgets.

But at least for now the labor market remains strong and consumers will, in any case, tend to prioritize paying car loans so get they can get around.

The more daunting challenges are longer-term. Auto lessors must carefully gauge how the shift to autonomous and electric vehicles will affect the value of the combustion engines they replace. Last week, Germany threw its weight behind a European Union plan to ban new combustion engine sales by 2035.

I doubt the transition will be smooth, but auto lenders at least start that journey from an extremely comfortable position.

Disclaimer: This article first appeared on Bloomberg, and is published by special syndication arrangement.