In the now seemingly halcyon world of 2019, motor finance was a buoyant business. Lending for car purchases in the U.K. alone rose to £48 billion from £24 billion in 2012.

With the COVID-19 crisis continuing to rock industries and cost jobs around the world, the repayment of much of that lending now looks much less certain, and authorities in the U.K. have intervened following calls from industry bodies to take action before the problem spiraled out of control.

The Financial Conduct Authority confirmed April 24 the introduction of a package of measures to support consumer credit customers facing payment difficulties due to the impact of the coronavirus pandemic. The centerpiece is a three-month payment freeze for motor finance and other credit customers who are having temporary difficulties meeting finance or leasing payments due to the pandemic.

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Much of the concern relates to low-cost personal contract purchase, or PCP, agreements, which financed more than 75% of new cars bought by private customers in the U.K. in 2019. PCP allows consumers to pay for a car in affordable monthly installments over a limited time period, usually two to five years. At the end of the agreement, the consumer either pays the outstanding balance, known as a balloon payment, to take full ownership of the car or the car is handed back to the manufacturer who then recoups the outstanding balance on the used car market.

The long-term sustainability of many of these agreements is now in question as government lockdown measures aimed at delaying the spread of COVID-19 causes unemployment to soar. "This story doesn't end in three months' time," Adrian Dally, head of motor finance at the U.K.'s Finance and Leasing Association, said in an interview.

"There will be a continuing need for forbearance from lenders and, therefore, there will be continuing costs on lenders. It is those longer-term issues that are more significant."

FLA data show that there was a 30-fold increase from the long-term average in requests from customers for forbearance on car finance payments even before the FCA declared the three-month payment holiday. Only a portion of those requests have been accepted, Dally said.

Concerns around the scale of cheap motor finance have existed for some time. In 2016, the Bank of England warned that "the industry's growing reliance on PCP has made it more vulnerable to macroeconomic downturns." It also highlighted the exposure of car manufacturers, many of whom fund the purchase of their vehicles through large in-house finance arms, to "the impaired value of rented and leased vehicles returned at the end of their contracts should the balloon payments exceed the vehicles' market values."

"The bottom line is these deals are underpinned by the value of that car when it comes back into the market and has to be resold," said David Kendrick, head of corporate finance and chair of national automotive group at U.K. accountancy firm UHY Hacker Young. "If, for example, COVID-19 causes a prolonged worldwide recession, then you could see used vehicle values being hit quite heavily."

An April 28 note from DBRS Morningstar said that lenders faced a hit as residual value levels in lease agreements will likely not be able to be adjusted as part of forbearance and holiday agreements. It also sees a potential increase in vehicle turn-in rates as borrowers opt to hand over the keys instead of refinancing or purchase options.

Carmaker financing

The role of car manufacturers in financing new private car sales is considerable. Many of the world's largest car manufacturers, such as Volkswagen AG, Toyota Motor Corp., and Ford Motor Co., have large finance houses, known as "captive finance companies," to fund the purchase of their new vehicles. Volkswagen Financial Services AG, for example, held 11.2 million customer financing and leasing contracts as of the end of 2019, according to its annual report. The manufacturer's banking arm was owed €68.52 billion from customer financing and €46.28 billion from leasing agreements at the end of the year, it said.

In a first-quarter earnings call April 29, Volkswagen CFO Frank Witter assured investors and analysts that Volkswagen Financial Services had a "very good, high-quality portfolio" of loans and leases. "Given the high quality of our portfolio, we believe that we will be able to move through this crisis rather well," Witter said. Still, Volkswagen has taken precautions by ensuring that the provision ratio for bad debts is above the failure ratio, he said.

Many traditional financial institutions, who are already exposed to motor finance through standard car loans, are also operating in the PCP space. Barclays Partner Finance, part of Barclays PLC, and Santander Consumer (UK) PLC, part of Spain's Banco Santander SA group, are among such lenders operating in the U.K.

ABS brakes

The packaging of car leases into asset-backed securities poses a further risk to traditional financial institutions, many of which hold such investments on their books. For example, Volkswagen Financial Services placed in February a €1 billion ABS transaction backed by leasing receivables.

Moody's said April 23 that the performance of such auto loan or lease ABS will deteriorate as the coronavirus outbreak causes job losses and reduces household incomes. "The degree of weakening in deal performance will depend on the sharpness and length of the recession and transactions' exposure to borrowers with increased likelihood of disrupted incomes, such as self-employed and contract workers," said Moody's analyst Rodrigo Conde. Coronavirus disruptions will adversely affect auto manufacturers and are credit negative for auto ABS, he said.

Moody's also highlighted the potential impact of car dealership closures during the crisis on car manufacturers' finance houses, which provide billions in funding to car dealerships to buy their stock. For example, the finance arm of Volkswagen Group, the world's largest car manufacturer, was owed €23.09 billion from dealerships as of the end of 2019.

"The inability of consumers to buy vehicles, irrespective of previous demand will significantly reduce payment rates on dealer floorplan receivables," it said. "Dealers' ability to repay the financing used to buy their vehicle stock, provided by the captive finance companies, will erode if the credit quality of auto manufacturers weakens materially."

This could then have longer-term consequences for vehicle sales, it added. "Manufacturer credit weakness would more permanently reduce demand for their vehicles, amid questions around warranties and the availability of parts for repairs."

The FLA's Dally said that there are few, if any, car manufacturers safe from the effects of the pandemic due to its impact on a broad spectrum of society across all markets. "This forbearance affects everybody," he said.

"It's every single lender. It's indiscriminate in that sense."