UK car finance business has ‘exactly the same problems’ as the mortgage market 10 years ago

by Christian Petersen/Getty Images

LONDON — Four out of five new cars in Britain today are bought
using a credit product that has “exactly the same problems …
that happened with the mortgage market” 10 years ago, Morgan
Stanley automotive analyst Harald Hendrikse tells Business

He believes the current state of car credit in the
UK — £41 billion ($54 billion) in loans last year — is

The reason: car finance companies are allowing drivers to buy
vehicles using a consumer debt product which requires car
dealerships to take cars back if their owners decide they don’t
want them anymore. Almost all the risk in these transactions is
carried by the car finance company, not the consumer. There is
virtually no other consumer credit product which allows borrowers
to simply walk away from an asset unpenalized if they don’t want
to pay for it anymore.

The scenario — of cash-strapped consumers handing back their
keys with almost no downside — might bring back memories of
the 2008 housing crash in the US, and a concept called “jingle-mail.”

In the depths of that recession, mortgage bankers experienced an
avalanche of envelopes from former customers that jingled when
they were delivered. American homeowners who couldn’t afford
their mortgage payments and couldn’t sell their houses simply
mailed their house keys back to the bank and walked away.
The houses then became the bank’s problem.

Morgan Stanley’s Hendrikse isn’t alone in worrying about the
condition of the UK car market.
The Financial Conduct Authority said this week it would
“whether consumers are at risk of harm” and whether
“firms managing the risk that asset valuations could fall [are]
ensuring that they are adequately pricing risk.” 

If the UK car market were to crash, dragging the car credit
market down with it, the situation will be less systemically
serious than the mortgage business in the run-up to the 2007-2008
financial crisis, Hendrikse says, because the value of the car
market is only about 10% the size of the housing market.

But it would still be a big problem: The personal contract
purchase, or PCP, market is creating a supply of high-quality
used vehicles which is greater than the entire aggregate demand
for new cars in Britain, in some years.

82% of new cars in Britain are bought with contracts that pay
less than the value of the car

The problem stems from the way new cars are bought in Britain. A
decade or more ago, drivers had three simple choices: pay cash
for a new car; lease the car (but not own it outright); or take
out a traditional loan with fixed “straight-line” payments over

Very few buyers take those options today. Eighty-two percent of
new cars in Britain are currently bought under
PCP agreements, according
to the Finance & Leasing Association
, which tracks car
credit data.

Typically, a PCP requires a cash deposit on a new car and then
three years’ of cash payments plus interest, similar to a lease.
The difference is what happens at the end of the three-year
period. Drivers a have a choice: They can either pay a lump sum
“balloon” payment to buy the remaining value of the car, or they
can hand the car back and walk away.

Either way, at the end of the three-year period, the car finance
company has received a stream payments which is worth
less than the total price of the car at the beginning.
The finance company makes its money because most people do
not simply give the car back to the dealer. Rather, they
use whatever “equity” they have in the vehicle as a downpayment
on a new car, which is then rolled over into a new PCP agreement.
The dealer can recoup the “lost” equity by selling the car as a
used vehicle.

Auto finance companies typically set the estimated “guaranteed
future minimum value” (GFMV) of the car at the end of the
three-year period at about 85% of its estimated future market
value. After three years, this gives the driver a good chance of
owning a car that might be worth more than its GFMV. For example,
if the three-year-old car was worth £5,000 on the second-hand
market, a PCP driver might only owe £4,250 to the dealer for the
balloon payment. 

The advantage for the driver is that they can either pay the
£4,250 and then sell or keep a car worth £5,000, or
— more commonly — use the £750 “equity” as a
downpayment on a new car with a new PCP. The advantage for the
dealer is that if the driver walks away it receives a car it can
now sell for £5,000, even though it is owed only £4,250.

This has never been tested in a recessionary market

There is an obvious problem with all of this: It only works as
long as the dealer/finance company has correctly estimated the
second-hand value of the car three years from now. If the market
heads south — due to a recession, an unexpected glut of used
vehicles, or Brexit — and the market values are less than
the GFMV, then everyone is in trouble. Drivers are left owing
more than their cars are worth; dealers are likely to get stuck
with cars whose value is less than the price they need to make a

We are repeating exactly the same problems in the US and the UK
specifically that happened with the mortgage market in 2007.

“The mechanics of the situation are exactly the same” as the
mortgage crisis, Hendrikse says. “We are repeating exactly the
same problems in the US and the UK specifically that happened
with the mortgage market in 2007 – well, 2005, ’06, ’07.”

“The dangerous part of it is that the residuals on those vehicles
would fall very sharply. And so that’s dangerous in the sense
that the consumers and owners of those cars would lose a lot of
money and would clearly be in negative equity on those cars.

“And obviously, if you’re a lease company or, a finance company,
you would potentially have to take very large losses to try and
get rid of those cars from your balance sheet.”

The UK market has never been through a period in which it has
taken significant losses on PCP cars. But it may be about to do
so for the first time, for three reasons:

  • A huge wave of new PCP cars, the most in British history,
    will come back onto the market in the next few years, creating a
    glut of good-quality second-hand cars and depressing prices for
    both new and used vehicles.  
  • Consumers are suddenly abandoning diesel cars in favour of
    electric, petrol, and hybrid cars due to the Volkswagen
    emissions-testing scandal, which has spread to multiple models of
    diesel cars. The UK government has promised to make diesel cars
    illegal by 2040, and London
    will begin imposing a “T-charge”
    on diesel vehicles driving
    through the city starting in October. About 44% of UK cars are
    currently diesel-fueled. Those cars will not be wanted in the
    years to come.
  • Brexit is likely to administer a negative shock to the UK
    economy. The UK has not been through a recession since 2008/2009.
    Back then only about 50% of new cars were on PCPs.

The unanswered question is, what happens to the PCP car market
when people are losing their jobs, and can’t afford — or
don’t need — their cars?

“It’s going to create enormous pressure on the whole

The challenge is compounded, Hendrikse believes, because of one
other unique factor about the UK market: Its cars are all
right-hand drive. Brits drive on the left. In Europe and the US,
cars are left-hand drive because everyone else drives on the
right. British cars cannot be sold anywhere else. That removes a
crucial market safeguard that exists on other continents. If a
dealer can’t get the price they need in Florida or France,
companies can transport those vehicles to a different state or
country where the market is more robust.

There were “2.7 million cars sold in the UK last year,” Hendrikse
says. The vast majority of those are on PCP contracts. “That
means that in each of the next three years we will have 2 million
units of these very good quality, low mileage, nearly new cars as
an alternative to people buying new cars, right? And obviously
that relative — 2 million versus 2.7 million — by definition is
absolutely huge.”

How huge?

Two million vehicles is potentially bigger than the entire
for new cars bought in Britain in some recent
years. Over the last 10 years, Brits have bought between 1.7
million and 2.7 million new cars every year, depending on the
health of the economy.

Obviously, the new car market is not the same as the used
car market. But the prices in one do affect demand in the

You’ve got more used, nearly new cars coming into the market than
you have of total car demand for new cars.

“It’s going to create enormous pressure on the whole system,”
Hendrikse says. “And that gets even worse when you get a downturn
in demand altogether. From 2007-2009, the UK market dropped from
about 2.6 million units to about 1.8 million, 1.9 million. So at
that stage, you’ve got more used, nearly new cars coming into the
market than you have of total car demand for new cars.”

Not everyone is so pessimistic. Adrian Dally is the head of motor
finance at the Finance & Leasing Association. “The UK car
market is very transparent,” he tells Business Insider, noting
that there might be one or two thousand PCP agreements on every
single different make of new car in the UK. All dealers and
finance companies have access to the same pricing information
through services like CAP and Glass’s. They use actuaries to
predict values into the future. There aren’t many surprises, he
says. Used cars lose between 8% and 16% of their value
in most years.

“UK auto securitization is rated very highly by ratings
agencies,” Dally says, referring to ratings on bundles of PCP
loans that are sold on by finance companies into the asset-backed
securities (ABS) market.

Ford Credit Europe, for instance, offered £542 million ($711
million) of financing contracts onto the ABS markets in late
June. A majority of them were PCPs,
according to the Financial Times
. In May, Volkswagen priced a
€1 billion ($1 billion) bundle.

That sounds like a lot. But systemic UK bank exposure to PCP
contracts is “pretty negligible,” Dally says.

The Bank of England agrees with him. UK banks are exposed to
about £20 billion in PCP assets,
according to BOE
. That is equivalent to 9% of “Common Equity
Tier 1” capital, one of the measures of capital banks are
required to hold to absorb losses.

“The cycle ends itself, right?”

Rather than the banks, the risk this time round is concentrated
inside the captive finance arms of the car companies themselves,

according to

Alex Brazier
, the BOE’s Financial Director for Financial
Stability Strategy and Risk.

“The main risks are with the finance companies offering these
contracts – typically arms of car manufacturers. Unlike credit
cards or personal loans, the lenders here are predominantly the
finance arms of car companies. Their losses – however painful to
them – pale in significance for the wider economy next to
situations in which it’s the banking system making the losses,”

he said in a recent speech
. (Ford Credit Europe did not
respond to messages requesting comment.)

Both the FCA and the Bank of England are conducting research into
the extent of PCP financing and UK banks’ exposure to it.

In the meantime, Hendrikse expects the system to come to a
self-fulfilling end, with car finance companies being the losers:
“When leasing as a proportion of sales is growing very sharply,
it automatically creates a very fast growth in the supply of used
vehicles in a three- to four-year time frame, which then causes
the residuals to weaken, which then means that leasing becomes
that much more difficult. And the cycle ends itself, right?”

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