With senior leaders in vehicle finance warning lenders against gaining an edge by promising high residual values for PCPs, Lorenzo Migliorato explores whether there is a bubble developing, or if the worries are largely unwarranted
Wishful thinking over used car values could drive the vehicle finance industry to a point of no return.
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At least, that is the opinion of Karl Werner, chief executive of MotoNovo, who in a recent statement warned that lenders cannot “overlook the changes that are becoming increasingly evident in our market”.
The cost of money is going up, manufacturers are pushing aggressively with scrappage schemes, pollution regulations are set to tighten, and the Financial Conduct Authority (FCA) is conducting a review of motor finance practices. In the face of this, the trajectory of used car values is becoming harder to predict, and the industry should tread carefully on products like PCP.
Werner added, “Lenders counting on a strong disposal price to sustain residual values (RVs) and guaranteed minimum future values (GMFVs) against [this] backdrop is just delusional economics.”
Werner’s words might have contained a sense of urgency, but he says he was not prompted by a particular event. He did not come across any specific number, any ledger that he reckoned should be quickly defused before it transformed into the industry’s own Lehman Brothers.
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By GlobalData“It is more of an industry insight,” he tells Motor Finance. “I am concerned about the sustainability of some other lenders who have built up extreme portfolios of PCPs at extreme residual value.”
In Werner’s view, this is hardly a new problem. Over his career he has repeatedly witnessed the industry build bubbles out of residual value products. “We have seen it in cycles over the last 20-plus years,” he says. “There are those who start with a sensible offer, but over a period of time some lenders take a higher degree of faith in future residual value, and a higher level of risk.”
The higher the GMFV for a car at the end of a PCP agreement, the lower the monthly payments for the customer, as the asset depreciation they will have to cover is assumed to be reduced. This obviously makes the product more enticing.
The problem, Werner says, arises in how PCP might be sold: “Rather than building in a standard, prudent revenue margin by setting GMFVs at 80% or 85%, they make it 98%, 102% and so forth – all off the back of the belief that they have to compete at any cost on monthly payments.”
These high GMFVs make the PCP offer more attractive to the customer, and in turn dealers, but when the contract is over, as Werner points out, it could lead to the car being worth less than the set GMFVs.
In this scenario, from a customer’s point of view, paying the balloon payment would not make sense – why pay a £10,000 balloon payment for a car worth £9,000? Instead, the prudent option would be to hand the car back to the lender, and buy something else.
The customer has not lost out – they got cheaper monthly payments than they should have done, and can rebuy the same car elsewhere for its real value if they want.
It is from the lenders point of view where the problems arise. The net result is they now have a car whose actual depreciation has not been covered in full, and which will fetch less than intended at an auction. And this can become a problem if a lender is selling thousands of PCP deals on this basis.
The question is to what extent has this been going on in the industry?
“I think there is quite a big divergence in the quality of the product, if I am honest,” says Chris Bosworth, director of strategy at Close Brothers Motor Finance. “There have been people doing bad, arguably risky things with PCP, which I know is what Karl [Werner] was trying to get at.”
Bosworth believes lenders are driven to overblow residual values primarily because of competitive pressure, often as part of a short-term volume drive. “A good way to make yourself heard to dealerships is to do things that other people will not do,” he says.
“If you take the companies that have done quite risky things around GMFVs and RVs, they have been trying to grow market share. But I think that any business that wants to be in the business for the long term will know that is not a sustainable model.
“You can use it to get a foot in the door, but it is not going to help you when those deals come to an end, and the customer has no deposit left, because they burned through it during the loan period.”
Of course, there are some actors who offer 0% deposit PCPs with high residual values as their central marketing strategy – such as captives. “As a captive of a major manufacturer, my objective might not be to make any profit,” says Bosworth. “My objective may be to help the manufacturer sell their car.”
Bosworth does not blame the captives for what he says is simply a different business model, but he thinks overly generous PCP deals are something that should be left to them. Lenders that make their profits purely on finance, mostly from used cars, should use better judgment: “You see GMFVs that are over 100% of forecast prices. Why would you do that?”
Yet not every player in the industry sees a problem in how PCP is being handled by some lenders. Mark Gow, sales director at broker DSG Finance, sees the problem of overblown GMFVs mostly confined to the captives, which are driven by their own commercial reasoning.
“If you were to look at a range of different providers, is there an appetite in terms of residual value? Yes, there is,” he says, referring to independent lenders. “Now, is there an adverse effect on the customers at the moment? Not that we can see.”
Gow cites some figures from DSG to support his argument: On a 48-month PCP, the average customer change cycle is 27 months, nearly the same as on a 60-month HP agreement. “If residual values were that bad, we would be finding that customers’ change cycles are 36, 42 months,” because it would take them much longer to get out of negative equity and close the PCP without incurring a loss.
He adds that, to his knowledge, most lenders that are not captives already take a fairly conservative view.
“PCP [makes cars] more affordable to customers, and we are not seeing any evidence of GMFVs delaying the change cycle of the customer. So, based on those two things, why would you reduce residual values?”
To be fair, neither Bosworth nor Werner believes that there are imminent signs of a “bubble”, something the industry should defuse by lowering RVs across the board.
“A bubble would imply that it would burst [by itself],” Bosworth says, adding that if demand for PCP dampens in the future, the cause would probably be an external factor, not how the product is structured.
One such factor could be the FCA review into car finance, whose results will be published in a few months’ time. In light of that, could lenders like MotoNovo be urging the industry to self-regulate before the FCA enforces a set of rules from above?
“I would have to acknowledge that there are lenders who have [already] acted,” says Werner. “The scrutiny of regulators is always welcome. There are some leading independents who have started to move already, but others need to give the [GMFV] question more thought.”
Bosworth thinks that sounding the GMFV warning now, as MotoNovo did, is also a way of making sure the FCA knows where each lender stands: “If you are at the conservative end of the spectrum, you do not want to be painted with the same brushes as people who have been quite aggressive.”
He says that what might come out of the FCA is a more standardised approach, possibly consecrating the business models of the likes of MotoNovo and Close Brothers as best practices for the industry.
“People leading the motor finance industry have a responsibility to do the right thing,” Werner concludes. “Competitive pressure should not have reached the stage where lenders are doing the wrong thing. We are supposed to lead our position.” <
