Captives and Contagion

peugeot

The French automaker Peugeot is in trouble. Automobile sales in Europe saw a dramatic 8.6% slump in 2012. For Peugeot it was even worse: a 15% drop. Since the company relies overwhelmingly on sales in Europe, the company was burning through cash at a rate of €200 million per month, according to the Financial Times. Earlier today the company reported a loss of €5.01 billion in 2012. Already last March, Moody’s had downgraded the company’s credit rating to junk. To stabilize its finances, management last year initiated a program of asset sales, an issue of new equity, and the closure of one of its manufacturing plants near Paris.

Like many other manufacturers, Peugeot owns a captive finance arm, Banque PSA Finance (BPF). The bank has a special access to Peugeot-Citroen dealer networks and supports automobile sales by offering loans, leases and insurance to customers.

The bank gets its funds in the wholesale market, as shown in the figure below, taken from the bank’s 2012 annual report.

BPF

BPF’s captive relationship with Peugeot-Citroen exposes it to the risks of the car company. The sales volumes achieved on Peugeot and Citroën cars directly affect the bank’s own business opportunities. The ownership relationship, too, creates exposure. Accordingly, the credit rating agency Moody’s determined that its rating of the bank is constrained by its rating of the parent.

In 2012, the automaker’s financial problems infected the bank. As the parent was downgraded, Moody’s also reviewed the rating of the bank, and it was downgraded. In July, the parent was downgraded to junk, and Moody’s announced that the bank’s credit rating was in review for possible downgrade to junk status.

A possible junk rating for the bank threatened its viability. It’s cost of funding would escalate, threatening its ability to offer competitive terms for loans. And it created uncertainty about the bank’s continued ability to roll over the short-term funding with which it financed its loans. Already in 2012, the bank had started to offset the unavailability of short-term financing on the capital markets by increasing the use of securitization and accessing the European Central Bank repo facility. Here is the commentary from Moody’s:

BPF’s funding profile is entirely wholesale funded, making it vulnerable to sudden changes in investors’ confidence. Restricted market access could lead to a shortening of the bank’s maturity profile and higher funding costs, which would constrain loan origination. This would in turn affect the strength of BPF’s franchise and ultimately reduce its earnings generation, particularly if any funding constraints coincided with higher loan impairments.

To have an idea of the gravity of the situation here is an excerpt from BPF 2012 Annual Report (page 31):

After the rating agencies lowered BPF’s short term ratings to A3/P3, outstanding short-term debt, commercial paper issued …and deposit bonds issued by Banque PSA Finance dried up, falling from €3,754 million at December 31, 2011 to €147 million at December 31, 2012.

A drastic and quick fall that is not that much different from a typical bank run.

So the French government stepped in to provide support to the bank. In October, it announced that it would offer guarantees on €7 billion of future bond issues under its EMTN program. The guarantees helped put together a refinancing package that will enable BPF to continue operations while the parent company restructures, and while – hopefully – automobile sales recover. This past week the EU approved the first installment of the guarantees with conditions. The guarantees come on top of €700 million in support from the European Central Bank earlier last year.

Peugeot’s predicament has lessons for other manufacturers considering whether or not to operate their own captive finance units. While there are obvious potential synergies to be had, there are also unique risks involved. The distinctive feature of a bank is the critical role that liquidity and confidence play in assuring its funding model. Many manufacturing businesses can withstand the indignities of a junk rating. And, should the debt burden become too heavy, a restructuring and workout can sometimes be negotiated which allows the firm to continue in a new form. In the case of banks, that is not so: a fragile bank undermines the foundation of its very business, and then there is no alternative but a takeover or some form of government sponsored resolution. Putting a manufacturing operation and a bank together under one roof opens up the possibility that otherwise manageable problems at the manufacturing unit may infect the banking unit and produce unmanageable risks.

Of course, there are ways to structure a captive bank’s business model so that it is more resilient. Indeed, the European regulators had already taken steps to require captive finance units, including Peugeot’s, to alter their funding models. And, as a part of its latest restructuring announcements, Peugeot’s bank described plans to start taking deposits so as to reduce its reliance on wholesale funding markets.

Better late than never.

One Trackback

  1. [...] Last week we wrote about the financial contagion from Peugeot’s auto manufacturing business to its captive finance unit, Banque PSA Finance (PFA). The important question this raises for management is whether there are other ways to get the synergies associated with a captive finance unit without at the same time being susceptible to the contagion. [...]

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