Volkswagen Emissions Fallout Presents Claims Trading Opportunity for Fund Managers

News that Volkswagen AG sold millions of diesel cars with software designed to evade emission-standards testing continues to have enormous ramifications beyond the automobile industry — investment funds are among those keenly interested in the ongoing fallout as the German manufacturer could become the next target for widespread claims trading activity.

The long-term consequences for Volkswagen remain uncertain at this relatively early stage; however, significant regulatory penalties and class-action lawsuits are both strong possibilities, as is increased claims trading related to reduced used car values. Any of these outcomes are likely to become the target of substantial activity as investors, including hedge funds, seek to monetize the repayment process and capitalize on a short-term decline in securities. The company indicated in its Q3 2015 financial update it had set aside more than $7 billion to deal with the costs. However, investors, led by the litigation funding group Bentham, were quick to announce plans for a $45 billion lawsuit inGermany.

In the U.S., the Department of Justice, on behalf of the Environmental Protection Agency filed a civil action against Volkswagen in January that could seek up to $48 billion in damages. Although it seems unlikely they will seek the maximum penalty, U.S. officials previously indicated Volkswagen’s violation of the federal Clean Air Act could result in financial penalties of up to $37,500 per car, or more than $18 billion in total. By comparison, in November 2014 the Environmental Protection Agency imposed a record $100 million penalty on Hyundai Motor Co. and Kia Motors Corp. for exaggerating fuel-economy claims and revoked another $200 million worth of regulatory credits. General Motors, meanwhile, recently agreed to pay $900 million to settle criminal charges stemming from the poorly handled recall of vehicles with dangerous ignition defects. Ratings agency Moody’s confirmed the threat facing Volkswagen when it dropped its outlook for the company and its subsidiaries from stable to negative in September. It then downgraded the company’s credit ratings in November. In addition to the direct cost resulting from any vehicle recall, loss of future sales and reputational damage, Moody’s cited the potential for action from regulatory authorities — specifically those outside the U.S. — as justification for the diminished outlook and ratings.

Europe could become the epicenter of claims activity. Approximately 11 million vehicles globally are believed to be affected, the vast majority of which Moody’s expects to be in Europe, where diesel engines are significantly more common than in the U.S. In 2015, only about 6% of Volkswagen’s sales were in the U.S., meaning international regulators will be highly influential as the company attempts to work its way through the aftermath of these revelations. The agency noted that “further negative rating action is likely if Moody’s reaches a view that fines and legal costs are likely to be well in excess of Volkswagen’s EUR6.5-billion ($7.1-billion) provision, or that there will be significant damage to the company’s market share or pricing position, with sustained negative impact on revenues or EBITDA, and impact starting to extend to core markets outside the U.S.”

Meanwhile, Fitch Ratings lowered its rating of the company to BBB+, the third-lowest investment grade, as a result of the heightened risk of legal proceedings involving regulators and customers alike.

A drop in car values would also pose a risk to bonds tied to the company’s auto loans, leases and dealerships worldwide. In response to the initial revelations, the resale value of Volkswagen’s diesel cars decreased by an average of 13%, Volkswagen corporate debt bonds dropped while prices surged for the more liquid credit default swaps — which allow for the purchase of insurance against the risk of default, suggesting investors expect the company to face further volatility for some time to come as the compensation and regulatory processes unfold.