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Before the pandemic, vehicle finance lending in the UK had risen year-on-year from £24 billion in 2012 to £48 billion in 2019. This was mirrored by a steep rise in the number of PCP loans taken out, representing 75.2% of all new car finance loans in 2019.

Under PCP agreements, the borrower pays a fraction of the vehicle’s purchase price as a deposit and then a series of monthly instalments during the life of the agreement. Throughout the contract, the finance company retains ownership of the vehicle, and at the end of the contract the borrower can either take ownership of the vehicle by making a final balloon payment for the residual value, or return the vehicle to the lender.

In an attempt to offer aid to consumers, the FCA declared on April 24 that auto finance lenders should offer a three-month payment freeze to customers having temporary difficulties meeting payments due to the pandemic. This was already happening with many of the larger auto finance lenders on a case-by-case basis, but the new rules mean that a payment holiday must be offered as a minimum.

Despite the consumers’ payment freeze, the interest continues to build up, eventually needing to be repaid by either extending the term of the agreement or by increasing the remaining monthly payments.

While necessary for many consumers and a worthwhile attempt at minimising the incoming descent into arrears, these rules put mammoth pressure on lenders, especially when combined with the ruling that prevents them from ending an agreement or repossessing a vehicle if a borrower is struggling to meet their repayments as a result of the pandemic.

Residual values uncertainties

Ramping the pressure up another notch, the FCA also claimed that auto lenders would not be able to introduce unfair changes to contracts and would not be able to recalculate the residual value (RV) of a vehicle that is stipulated under the customer’s contract.

DBRS Morningstar argues that in an attempt to put out this particular fire, the manufacturer of the asset may subsidise RVs at captive lenders, setting them at a higher level resulting in more affordable monthly payment amounts. This is achieved through the reduction in the amortising element of the lease or loan, offset by an increased future RV.

However, a distinctly negative aspect of this decision is that it increases the risk at contract maturity that the sale or realisation of the asset may not cover the required contractual payment.

The expected downward pressure on vehicle valuations due to the various effects of the pandemic may result in borrowers facing a negative equity situation at the end of the contract as the RV surpasses the market value of the vehicle. This is forecast to make the customer hand the vehicle back to the originator rather than repaying the loan to finance a new vehicle, increasing the turn-in rate at maturity and place an increased RV risk on lenders.

Typically, the majority of customers tend to hand back the vehicle at the end of the contract and take out a new PCP contract on a new vehicle using the equity built in the returned vehicle as a deposit. However, due to the aforementioned downward pressure on vehicle valuations, any potential equity is more likely to be lost and in turn, the number of customers pursuing this course of action is forecast to reduce.

With dealerships set to open today for the first time since March 23 when the lockdown was announced, the automotive cycle has suffered immeasurably and anecdotal evidence suggests that lenders may seek to incentivise customers to refinance the RV through a new loan contract in an attempt to reduce vehicle handbacks.

The FCA has acknowledged that there is a higher potential for disparity between the balloon payment and the vehicle value, and so it has ruled that any solution a lender comes to with a customer that wishes to keep their vehicle must not lead to an unfair outcome. This means that balloon refinancing must be offered appropriately.

Customers experiencing financial difficulties may still opt to return the vehicle, and borrowers are likely to be able to hand the vehicle back prior to contract maturity under a voluntary termination, still viable under the Consumer Credit Act. This could result in a larger loss for the lender as the full term of the agreement will not have been paid, a proportion of interest would have been foregone and depreciation levels are proportionately higher than the amortisation of the loan at the start of a contract compared with the end.

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