DISRUPTION in new car sales during the Covid-19 pandemic could cause major issues for the leasing market because there is an increasing risk in calculating residual values.
There is concern that borrowers could face a negative equity situation at contract maturity, according to global credit ratings business DBRS Morningstar.
RV risk occurs where a contractual future cash flow relies on the disposal of an asset at the end of its lease or loan period – where the leasee has the right or option to return the vehicle to the financing company at maturity.
Generally, and as a result of depreciation, the longer the useful life or lease/loan period of an asset, the lower its RV.Â
Contractual RVs are typically set according to published industry guidelines detailing predicted future values or as determined by proprietary models used by the originators using historical performance and insight into future market performance.Â
As part of a wider sales and marketing strategy, the manufacturer of the asset may subsidise RVs, setting them at a higher level, resulting in more affordable monthly payment amounts.
A reduced monthly payment is achieved through the reduction in the amortising element of the lease or loan, offset by an increased future RV. This approach increases the risk at contract maturity that the sale or realisation of the asset may not cover the required contractual payment.Â
Gordon Kerr, Senior Vice President, Head of European Research at DBRS Morningstar, said: “We expect to see downward pressure on vehicle valuations because of the closure of dealerships and remarketing channels, government-imposed restrictions on mobility, and deferral of big-ticket purchases because of uncertainty leading to an increase in supply of used vehicle stock.
“This may result in auto borrowers facing a negative equity situation at contract maturity as the RV becomes higher than the market value of the underlying vehicle.
“This will likely lead to the customer making a rational economic choice and electing to hand the vehicle back to the originator rather than prepaying the loan to finance a new vehicle. This will increase the turn-in rate at maturity and place an increased RV risk on the lenders.Â
“Under normal market conditions, we would expect to see a majority of customers choosing to hand back the vehicle at the end of their contract and take out a new PCP contract on a new vehicle using any equity built in the returned vehicle as a deposit.
“However, because of the downward pressure on vehicle valuations we are expecting to see, any potential equity will most likely be lost and in turn we expect to see the number of customers doing this to reduce.”
DBRS said that with dealerships still closed and vehicle production stalled, the automotive cycle has been interrupted and lenders may seek to support and even incentivise customers to refinance through a new loan contract in an attempt to reduce vehicle handbacks.
The Financial Conduct Authority has recognised that there is an increased potential for disparity between the balloon payment and the vehicle value.
It has stipulated that any solution a lender comes to with a customer that wishes to keep their vehicle at the end of their agreement must be appropriate and does not lead to an unfair outcome.
This does not rule out balloon refinancing but does mean that any balloon refinancing must be offered appropriately.Â
DBRS said that customers who are experiencing financial difficulties may not see this as a viable solution and will still opt to return the vehicle.
Furthermore, borrowers are likely to be able to hand the vehicle back prior to contract maturity under a voluntary termination.
Under the Consumer Credit Act, once a customer pays 50% of the total amount payable under the finance contract (which includes interest, fees, and the RV), they are permitted to return the vehicle to the credit provider and would only be liable for any costs if reasonable care has not been taken of the vehicle.
Kerr added: “This could result in a larger loss for the lender if the customer chooses to do this as the full term of the finance 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.”
