It was free!” announces Bob the Dinosaur, an adorable moron from the Dilbert cartoon. Bob is driving a bright red convertible. “They just make you sign papers!”, he elaborates. That cartoon is a quarter of a century old, but some things never change. The suspicion lingers that too many people are buying cars using financial products they do not fully understand.
In the UK, the finger of suspicion is pointing at personal contract purchase agreements, or PCPs, which account for 80 per cent of new cars sold. The Prudential Regulation Authority and the Financial Conduct Authority are looking into the car finance sector (the FCA is supposed to prevent us being ripped off; the PRA is supposed to prevent banks accidentally ripping themselves off — thankless tasks).
It is difficult to explain quite how PCPs work, but easy to see the problem. Graham Hill, of the National Association of Commercial Finance Brokers, told the FT recently that using a PCP, drivers could pay less for a new BMW or Mercedes than for a second-hand Ford Focus. Or, as Bob the Dinosaur might put it, “they just make you sign papers!”
This miraculous effect is achieved by endlessly rolling over one quasi hire-purchase into another one, never quite buying a car. They are flattered by a buoyant used car market that is likely to sag before long. Yet manufacturers like them because they encourage people to buy new cars more often; car dealers like them because they generate more commission; and customers like them because the monthly payments are low. If you’re not worried yet, I have a car to sell you.
Some PCPs may be good value. The problem is that it is hard to tell. The closest analogy to a PCP — and it is not particularly close — is buying and selling a series of homes using interest-only mortgages. PCPs are a hybrid of several different financial products, part lease, part hire-purchase, and part option to choose between the two. Variables include contract length, the guaranteed value of the returned car, the deposit, purchase price of the car itself, maintenance contract tie-ins, mileage allowances, and (of course) the interest rate.
There is no reason to think customers can navigate these complexities. Suzanne Shu, an economist at UCLA, has shown that picking the cheapest mortgage deals is a problem that will fox even MBA students. PCPs are harder. We’ve seen this story play out before. There seems to be something about consumer finance that turns us all into Bob the Dinosaur.
George Akerlof and Robert Shiller, Nobel laureate economists and co-authors of Phishing for Phools (UK) (US), argue that the fallibility of consumers creates a profit opportunity. Consumer finance features heavily in their book, alongside junk food, cigarettes and slot machines — unflattering company. Given that a loan or insurance could be a life-saving product, why do financial services so often disappoint?
One reason is that finance shifts purchasing power over time and across different risky outcomes. We exhibit well-known biases when evaluating these different prospects, paying exorbitant prices to postpone a cost or eliminate a small risk. Payday loans, credit cards and extended warranties are real-world examples of that fallibility.
Second, financial contracts can create complexity out of simplicity. Even if we were thinking coolly about what was on offer, we might not be able to understand the small print — Suzanne Shu’s students couldn’t.
Third, many financial contracts are bundled up with other purchases — the PCP, plus mobile phone contracts and overpriced insurance for short-term car hire. Payment protection insurance is the infamous rip-off endgame.
Costly add-ons are not always a disaster. Everyone knows that popcorn is expensive at the cinema, and no regulatory intervention is needed. But all too often we’re seeing the primary product serving as bait for a consumer finance trap.
The best defence of laissez-faire in such cases is not that the market works well, but that regulators would make it worse. Is that true? Do regulators have a sensible response to the toxic tangle of slick salesmanship, financial wizardry, and consumer incompetence?
We could ban complex contracts: tempting, but heavy-handed. Most financial contracts have a rationale and a value to some customers. Richard Thaler and Cass Sunstein, authors of Nudge (UK) (US), have proposed an alternative system they call RECAP — for “Record, Evaluate, Compare Alternative Prices”. A RECAP rule would require finance companies to provide the entire pricing schedule in a computer-readable format, which would allow customers to go to third-party websites and compare different deals in a sophisticated way.
What auto finance needs — what most consumer finance needs — is for key information to be made simple and salient. Competition cannot work if consumers struggle to understand what they’re being sold and what it will cost. The car market’s heady mix of prestige products and bewildering finance will resist efforts at reform. Yet we must try. Bob the Dinosaur needs help.
Written for and first published in the Financial Times on 5th May.
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