Hi Perlican, how are you thinking about this one at the moment? Excluding Novitas, the business appears to be chugging along, albeit no sign of management taking any actions to increase value for shareholders (even with price to book at 0.85x!). Obviously some heightened risk given economic circumstances / interest rates but nothing they have not dealt with before. It just puzzles me a bit - you can map out double digit IRRs even in pretty draconian scenarios, like taking a full 5 years to revert to book value, no book value growth in that period and only maintenance of the divi. That scenario roughly approximates what happened in the GFC (took until end 2012 to recover book value to end 2007 levels, while divi was maintained). An 11% IRR in the circumstances of a repeat of the GFC seems....wrong? Slightly more optimistic scenario where we get back to 1.5x book and that takes 3 years with low single digit book growth built in yields 30%+ IRRs at this level. Sorry for ramble but I suppose what I am asking is what am I missing here?
Hi Mike, I don’t think you are missing anything and my view has not changed from the investment case. Once the cycle turns and the market recovers I expect patience to be rewarded. Not sure when that is, but in the meantime we are getting dividends and nav growth.
Hi Perlican, the good news keeps coming! I don's suppose you have any idea of the potential scale of the impact of the FCA action in relation to the discretionary commission arrangements on CBG? I assume that they were involved with such arrangements given 2023 annual report disclosure "Following the FCA’s Motor Market review in 2019, the group
continues to receive a number of complaints, some of which
are with the Financial Ombudsman Service, and is subject to
a number of claims through the courts regarding historical
commission arrangements with intermediaries on its Motor
Finance products. Whilst the review of these complaints and
claims is ongoing, any potential financial impact remains
I have seen Numis estimates it could be in the region of £120m but I think this is vastly underestimated and I think it could be multiples of that, all depending.
I think CBG sits squarely in FOS’ crosshairs.
It did use discretionary commission structures and as it distributes via small dealers my guess is it its terms were fairly standardised across dealers. The FCA review also reported that the structure was especially used in mid-cost lending, where CBG lends, with the FCA’s estimate being that it accounted for 75% of lending in this segment.
Furthermore, I think the commission CBG paid is likely to have been high as a proportion of the total interest paid during the loan life. There is a semi-fixed nature to the commission given the costs it is covering on the one hand and on the other hand CBG’s average loan size was relatively small and its rates near-prime, such that the total interest paid over the loan life would not be that large. This is borne out for eg in the Black Horse decision the FOS published on 10 January where the commission accounted for around 50% of the total interest on a loan of £7,600, which is a similar average loan size to CBG’s. This is consistent with the FCA’s commentary in its review of discretionary commission where it observes that on average commission did account for around half the interest paid. I think for CBG the proportion would be slightly lower given its higher rates, but still sit at around 33%.
The significance of this is that although FOS has given alternative bases for its judgment, I believe a court on a judicial review would uphold FOS’ conclusion on unfairness because of the way FOS balances the following factors:
- The fact that the discretionary model in particular so actively incentivises the dealer as credit broker to work against the customer’s interests;
- The fact that the resultant commission is material relative to the interest the customer has to pay; and
- The limited disclosure offered by dealers acting as credit brokers (and therefore on the lender’s behalf) was an inadequate mitigant to the above
So in the BMW decision FOS has published, which was not upheld, a smaller, flat commission was paid and although disclosure was not up to the standard it should have been, on balance FOS concludes the lending relationship was not unfair.
I do not think this will be the case with the majority of CBG’s lending. I believe in the majority of cases (i) it will have used a discretionary structure, (ii) the resulting commission will be material as a % of the total interest paid, and (iii) the disclosure will have been the same boilerplate widely used in the industry (“… we may be paid commission by the lender…”).
So in theory there could be a lot of customers owed redress by CBG. The question then is how many will complain, even with the help of claims management companies, as customers would not know what commission was paid and under what structure in the same way they might remember having being asked to take out PPI. However, the FCA has halted the normal claims process to do its own investigation and could order an alternative redress process – one that would put the onus on the banks to determine what redress is owed to whom and therefore be more equitable to the whole population of affected customers and take the pressure off FOS and other lenders, who may have transgressed less but nonetheless be inundated with complaints that incur time and money to process. A blanket approach will be easier for the FCA to take with clear criteria like the above, for example:
i. For any loan subject to a discretionary commission scheme;
ii. Where you did not explicitly notify the customer about the existence and the terms of the commission; and
iii. Where the commission was greater than x% of the total loan interest
You must pay redress equivalent to the difference between the rate at which 0 commission would be paid and the rate the customer paid, with interest (FOS ordered 8% simple p.a.).
The FCA has made reference to accessing the Financial Services test case scheme, which could be used to ask the court to determine the % in iii. This was the approach taken with payday lending with the test case Kerrigan v Elevate providing a template judgment that any more than 3 rollovers of a payday loan could be used as the benchmark for judging when a loan was deemed unaffordable, with any interest on relending beyond 3 months ordered to be repaid to customers.
So the reason I am not sanguine about the outcome here is the combination of these two factors, ie the fact that I believe CBG’s loans fall squarely in the target zone and the likelihood of a FCA scheme.
To make a ballpark estimate, I have gone back over CBG’s segmented information from 2007 to 2021, when the ban was implemented, and estimated the total interest earned in motor finance. I’ve assumed 2/3rds of the lending is in scope as some of the lending was for commercial vehicles and some of the retail loans won’t meet the criteria – but I assume most will. I assume that on average commission was 33% of total interest, so this would be the amount deemed to be excess interest to be repaid. I then apply 8% simple interest to each annual amount. This gets me to around £500m. If on average commission was 50%, then it gets me to £700m.
There are a couple of data points from within the materials published by FCA and FOS which suggest that I may be too pessimistic. Firstly, in a press release of 14 December FOS notes that for motor finance complaints brought by CMCs – of which a significant proportion will be commission-related – the uphold rate is only 8%. However, as I have noted above, I believe CBG’s lending falls more squarely within the the type of lending FOS is ruling against. Subprime lenders like Moneybarn and Advantage for example use mostly flat commissions structures.
Secondly, in the Barclays decision, Barclays refers to a statement by the Finance and Leasing Association that it is aware of 86 cases brought before the courts of which 55 were dismissed and others abandoned before trial. However, again these may have been different loans to CBG’s or it may be that the first instance judge took a different view to the FOS, which in and of itself will not be determinative of the likelihood of FOS’ judgment being overturned on judicial review. The court generally upholds FOS’s decisions and I do not believe their decision in the two published cases would meet the standard of irrationality required to be overturned on judicial review.
I have sold down half my position in CBG since the FCA’s announcement and am mulling over the rest. On my original thesis and valuation and with my estimate of the potential liability from above, CBG is undervalued at the current share price. However, as pessimistic as my estimate is compared to the brokers, I still could be on the low side. Furthermore, there could be other such problems lurking in CBG’s portfolio – premium finance in particular has been firmly in the crosshairs of the FCA with FCA’s head of insurance recently labelling it a ‘tax on poverty’. While I think other firms like Admiral and Direct Line have bigger targets on their back than Close Brothers, I can’t be sure.
More generally, the overall thrust of the Consumer Duty and especially the fair value obligation presents at worse a restriction and at best a high level of uncertainty over future returns. This has been the direction of travel since the FCA took over consumer protection in 2014. Whilst there have been warm noises recently like the Lords putting in place a committee to rein in the FCA and to make sure it fulfils its obligations around promoting growth and competitiveness, I have yet to see tangible evidence of the FCA or FOS wings being clipped, which means they can quite easily put banks like CBG out of business without anyone really batting an eyelid.
Missing this specific risk – ie discretionary commission – was a mistake. I don’t know how I missed it. I was aware of it and fully aware of where it could lead give the outcomes for Provident, Amigo, Morses, etc etc once CMCs get involved. Moreover, I allowed this position to grow more than I had originally felt comfortable putting in a banking business, as I added as the price went down.
Thanks Perlican for the detailed response. This echoes my own thoughts - I had seen the estimated numbers quoted in the press and thought that they seemed like they could be orders of magnitude too low, so good to know I am not alone in being pessimistic on this. I have closed out all of my position, as I think the risk is definitely skewed to the downside here given the likely trading dynamics if any action on this meant a dividend reduction or pause, or any kind of capital action. Obviously if the £120m estimate turns out to be correct and there are no other goblins then this will be a terrible time to sell, but there it is. Hope everything is going well otherwise
Hi Perlican, how are you thinking about this one at the moment? Excluding Novitas, the business appears to be chugging along, albeit no sign of management taking any actions to increase value for shareholders (even with price to book at 0.85x!). Obviously some heightened risk given economic circumstances / interest rates but nothing they have not dealt with before. It just puzzles me a bit - you can map out double digit IRRs even in pretty draconian scenarios, like taking a full 5 years to revert to book value, no book value growth in that period and only maintenance of the divi. That scenario roughly approximates what happened in the GFC (took until end 2012 to recover book value to end 2007 levels, while divi was maintained). An 11% IRR in the circumstances of a repeat of the GFC seems....wrong? Slightly more optimistic scenario where we get back to 1.5x book and that takes 3 years with low single digit book growth built in yields 30%+ IRRs at this level. Sorry for ramble but I suppose what I am asking is what am I missing here?
Hi Mike, I don’t think you are missing anything and my view has not changed from the investment case. Once the cycle turns and the market recovers I expect patience to be rewarded. Not sure when that is, but in the meantime we are getting dividends and nav growth.
Hi Perlican, the good news keeps coming! I don's suppose you have any idea of the potential scale of the impact of the FCA action in relation to the discretionary commission arrangements on CBG? I assume that they were involved with such arrangements given 2023 annual report disclosure "Following the FCA’s Motor Market review in 2019, the group
continues to receive a number of complaints, some of which
are with the Financial Ombudsman Service, and is subject to
a number of claims through the courts regarding historical
commission arrangements with intermediaries on its Motor
Finance products. Whilst the review of these complaints and
claims is ongoing, any potential financial impact remains
uncertain."
Hi Mike
I have seen Numis estimates it could be in the region of £120m but I think this is vastly underestimated and I think it could be multiples of that, all depending.
I think CBG sits squarely in FOS’ crosshairs.
It did use discretionary commission structures and as it distributes via small dealers my guess is it its terms were fairly standardised across dealers. The FCA review also reported that the structure was especially used in mid-cost lending, where CBG lends, with the FCA’s estimate being that it accounted for 75% of lending in this segment.
Furthermore, I think the commission CBG paid is likely to have been high as a proportion of the total interest paid during the loan life. There is a semi-fixed nature to the commission given the costs it is covering on the one hand and on the other hand CBG’s average loan size was relatively small and its rates near-prime, such that the total interest paid over the loan life would not be that large. This is borne out for eg in the Black Horse decision the FOS published on 10 January where the commission accounted for around 50% of the total interest on a loan of £7,600, which is a similar average loan size to CBG’s. This is consistent with the FCA’s commentary in its review of discretionary commission where it observes that on average commission did account for around half the interest paid. I think for CBG the proportion would be slightly lower given its higher rates, but still sit at around 33%.
The significance of this is that although FOS has given alternative bases for its judgment, I believe a court on a judicial review would uphold FOS’ conclusion on unfairness because of the way FOS balances the following factors:
- The fact that the discretionary model in particular so actively incentivises the dealer as credit broker to work against the customer’s interests;
- The fact that the resultant commission is material relative to the interest the customer has to pay; and
- The limited disclosure offered by dealers acting as credit brokers (and therefore on the lender’s behalf) was an inadequate mitigant to the above
So in the BMW decision FOS has published, which was not upheld, a smaller, flat commission was paid and although disclosure was not up to the standard it should have been, on balance FOS concludes the lending relationship was not unfair.
I do not think this will be the case with the majority of CBG’s lending. I believe in the majority of cases (i) it will have used a discretionary structure, (ii) the resulting commission will be material as a % of the total interest paid, and (iii) the disclosure will have been the same boilerplate widely used in the industry (“… we may be paid commission by the lender…”).
So in theory there could be a lot of customers owed redress by CBG. The question then is how many will complain, even with the help of claims management companies, as customers would not know what commission was paid and under what structure in the same way they might remember having being asked to take out PPI. However, the FCA has halted the normal claims process to do its own investigation and could order an alternative redress process – one that would put the onus on the banks to determine what redress is owed to whom and therefore be more equitable to the whole population of affected customers and take the pressure off FOS and other lenders, who may have transgressed less but nonetheless be inundated with complaints that incur time and money to process. A blanket approach will be easier for the FCA to take with clear criteria like the above, for example:
i. For any loan subject to a discretionary commission scheme;
ii. Where you did not explicitly notify the customer about the existence and the terms of the commission; and
iii. Where the commission was greater than x% of the total loan interest
You must pay redress equivalent to the difference between the rate at which 0 commission would be paid and the rate the customer paid, with interest (FOS ordered 8% simple p.a.).
The FCA has made reference to accessing the Financial Services test case scheme, which could be used to ask the court to determine the % in iii. This was the approach taken with payday lending with the test case Kerrigan v Elevate providing a template judgment that any more than 3 rollovers of a payday loan could be used as the benchmark for judging when a loan was deemed unaffordable, with any interest on relending beyond 3 months ordered to be repaid to customers.
So the reason I am not sanguine about the outcome here is the combination of these two factors, ie the fact that I believe CBG’s loans fall squarely in the target zone and the likelihood of a FCA scheme.
To make a ballpark estimate, I have gone back over CBG’s segmented information from 2007 to 2021, when the ban was implemented, and estimated the total interest earned in motor finance. I’ve assumed 2/3rds of the lending is in scope as some of the lending was for commercial vehicles and some of the retail loans won’t meet the criteria – but I assume most will. I assume that on average commission was 33% of total interest, so this would be the amount deemed to be excess interest to be repaid. I then apply 8% simple interest to each annual amount. This gets me to around £500m. If on average commission was 50%, then it gets me to £700m.
There are a couple of data points from within the materials published by FCA and FOS which suggest that I may be too pessimistic. Firstly, in a press release of 14 December FOS notes that for motor finance complaints brought by CMCs – of which a significant proportion will be commission-related – the uphold rate is only 8%. However, as I have noted above, I believe CBG’s lending falls more squarely within the the type of lending FOS is ruling against. Subprime lenders like Moneybarn and Advantage for example use mostly flat commissions structures.
Secondly, in the Barclays decision, Barclays refers to a statement by the Finance and Leasing Association that it is aware of 86 cases brought before the courts of which 55 were dismissed and others abandoned before trial. However, again these may have been different loans to CBG’s or it may be that the first instance judge took a different view to the FOS, which in and of itself will not be determinative of the likelihood of FOS’ judgment being overturned on judicial review. The court generally upholds FOS’s decisions and I do not believe their decision in the two published cases would meet the standard of irrationality required to be overturned on judicial review.
I have sold down half my position in CBG since the FCA’s announcement and am mulling over the rest. On my original thesis and valuation and with my estimate of the potential liability from above, CBG is undervalued at the current share price. However, as pessimistic as my estimate is compared to the brokers, I still could be on the low side. Furthermore, there could be other such problems lurking in CBG’s portfolio – premium finance in particular has been firmly in the crosshairs of the FCA with FCA’s head of insurance recently labelling it a ‘tax on poverty’. While I think other firms like Admiral and Direct Line have bigger targets on their back than Close Brothers, I can’t be sure.
More generally, the overall thrust of the Consumer Duty and especially the fair value obligation presents at worse a restriction and at best a high level of uncertainty over future returns. This has been the direction of travel since the FCA took over consumer protection in 2014. Whilst there have been warm noises recently like the Lords putting in place a committee to rein in the FCA and to make sure it fulfils its obligations around promoting growth and competitiveness, I have yet to see tangible evidence of the FCA or FOS wings being clipped, which means they can quite easily put banks like CBG out of business without anyone really batting an eyelid.
Missing this specific risk – ie discretionary commission – was a mistake. I don’t know how I missed it. I was aware of it and fully aware of where it could lead give the outcomes for Provident, Amigo, Morses, etc etc once CMCs get involved. Moreover, I allowed this position to grow more than I had originally felt comfortable putting in a banking business, as I added as the price went down.
Thanks Perlican for the detailed response. This echoes my own thoughts - I had seen the estimated numbers quoted in the press and thought that they seemed like they could be orders of magnitude too low, so good to know I am not alone in being pessimistic on this. I have closed out all of my position, as I think the risk is definitely skewed to the downside here given the likely trading dynamics if any action on this meant a dividend reduction or pause, or any kind of capital action. Obviously if the £120m estimate turns out to be correct and there are no other goblins then this will be a terrible time to sell, but there it is. Hope everything is going well otherwise