"History resembles itself" - The auto leasing boom and bust story
Updated: Nov 2, 2022
The Auto Leasing market is predicted to witness significant growth throughout the forecast from 2021 to 2027. - Affluence Market Report
Does this future auto leasing market growth quote give you pause? It gives me that in-the-gut agita that only comes from past experiences. Perhaps I've been through enough economic cycles to know how this movie is going to end for many lease finance companies. More on this is below.
First, according to Experian (1), about 30% of all Americans finance car purchases with an auto lease, compared to the remainder that finance car purchases with an auto loan. This is especially true for more expensive cars. Leases and loans have some similarities and differences. They both certainly provide the ability to spread payments over a particular period of time. The significant difference with leases is ownership. Generally, ownership of the car is kept with the lessor, like a bank or related entity. As such, the risk associated with that ownership has to be managed by the bank lessor.
Leasing has substantially higher risks than loans because leasing products, by the product's nature, lack ownership alignment between the beneficiary and the title holder of the collateral.
The bank lessor should be laser-focused on the potential future value of the car. The reality is, it can be very hard to predict. The used car market is notoriously fickle. Car values are impacted by a variety of factors, including:
Rental fleet inventory levels and changes,
Fiscal and tax law changes, (e.g., "Cash For Clunkers")
New car seasonal and cyclical trends,
Actual wear and model-specific factors impacting value.
Adding to the value predictability challenge is that often the lessees are provided an end-of-contract option to buy the car. Think of this customer-friendly option as a long-term lessee put option. It is probably one of the most underappreciated financial options available to lessees. The end-of-lease value, known as the residual value, is set at the time of lease origination. As such, the lessor must predict residual value years in advance. The lease business decisions (pricing and volume) are generally governed by lease valuation models called NPV models. Think about it....all but 1 cash inflow are VERY small and well-known contractual payments. Finally, the last cash inflow is a relatively VERY large and fickle residual value. Then, the kicker, the lease customer has a residual put option the bank has little control over. As such, the risk embedded in the NPV model is significant. While the model will render a precise value estimate, its accuracy will be impacted by the model assumptions. Because of the volatility described earlier, model accuracy is a moving target. (2) (The difference between “accuracy” and “precision” can be illusive. Please see this note for a quick reminder)
So, the auto future value prediction challenge creates risk. But why is this a particularly big deal today? In late 2021, the auto environment is significantly affected by the pandemic and the supply chain-impacted world. As such, car supply is a big problem. As expected, when supply is constrained and demand is increasing, prices have nowhere to go but up. In fact, according to Experian, new-car values have increased from $33.7k in 2019 to $35.7k in 2021. This is a 6% increase. Even more significantly, used cars have made a large percent increase, from $19k in 2019 to $24.8k in 2021, or a 30.5% increase! John Toohig, Head of Whole Loan Trading at Raymond James and closely tracks the auto finance market, makes an insightful comment that gets at the paradox facing many lessors:
"Everyone seems to acknowledge that car values are nuts but at the same time they appear OK with paying those higher prices. Is that stimulus? Is that savings? Is that ultra low rates? Is that supply chain fear and related to our natural FOMO (Fear Of Missing Out)? Is that COVID concern pushing people to drive themselves in their commute instead of taking mass transit? It's likely all of that and none of that."
So, if you have an existing book of leases, this is great news. The residual values are increasing significantly which means the current actual value of the lease likely exceeds the original estimated value. This is good news from an income standpoint as the bank can easily liquidate its residual car inventory and realize a gain. Some customers may decide to keep their car at the end of the lease, reducing the bank's residual inventory and processing costs. (3) (See this note for my thoughts on the applicable accounting standards.)
The potential “eye of the hurricane” problem manifests itself as a future risk generated from:
Originating a new lease today,
Analyzing and making decisions regarding those lease values, and
Absorbing the risk those lease values will not hold when the future used car asset market corrects.
One of the supreme economic laws of asset values is mean reversion. If today's asset value is above the long-term average (as clearly, the used car market is) we can only expect those values to mean-revert in the future. It is like the law of gravity for economics.
In the next section, we will tell the story of a "typical" leasing cycle. We may be in the "happy" part of the curve today, but auto leasing risk managers should be thinking forward to the "sad" part of the curve. The transition may happen faster than anyone expects and with a more significant mean-reverting reduction in future car values. By the way, if you are in the camp "This time it will be different," please contact me with your reasoning. I appreciate contrasting thoughts and learning something new! If I do not hear from you, I will assume you are too busy implementing sound risk management measures for your leasing business!
The Anatomy of an Auto Leasing Cycle - By the numbers
The upward cycle begins a new, emotions show hope...
1. Long-term cyclical auto demand hits bottom and is in the early stage of increasing cyclical demand;
2. New cars are produced as quickly as possible, buyers are buying, and demand is increasing;
3. Leasing products are created by smart auto finance folks. They are leasing product experts using NPV models or similar discounted cash flow models. The largest modeled value driver is based on the future flow at the end of the lease when the car is either a) returned to the lessor or b) purchased by the lessee. (aka, The residual)
4. Bank senior management believes residual insurance will fully cover the risk of not realizing the residual value;
5. Wall Street makes the auto securitization market because they believe in the smart auto loan folks. Also, the agent-based incentives are such that the market makers are not taking any of the underlying credit risks;
6. Lots of new cars are sold with attractive lease terms, demand is increasing and now cyclical auto demand is in the middle stage of the growth cycle;
The cycle matures and flattens, emotions show concern...
7. 3-5 years later when leases expire, residual values start dropping dramatically because of a glut of 3 to 5-year-old used cars. Lessees make smart economic decisions and stop buying out residuals. Cars get returned to lessors en masse. Cyclical auto demand is now at its peak, but demand is being hurt by falling auto values and tightening credit;
8. Banks are surprised the leases aren't performing, banks file residual claims with insurers, and the smart auto loan folks get reassigned to risk management. Cyclical auto demand is dropping quickly;
The cycle contracts, emotions show fear...
9. Impairments involving auto bonds and loss reserves increase dramatically (i.e., banks lose buckets of money);
10. Insurers refuse to pay residual claims, years of lawsuits ensue, and banks settle well below the face value of the insurance. This occurs because the banks already took the impairment, so now they just want the issue to go away and are fatigued by claim legal costs. Cyclical auto demand nears the bottom;
11. …….a little time goes by……
12. Earnings pressure hits the bank, some smart auto loan folks say, "Hey, auto demand is about to explode! I have an idea, let's do auto leasing….;"
Go to 1 - the cycle begins anew!
Managing an auto finance business is hard enough. Managing a leasing business when the bank does not have agency control of the collateral is even tougher. Then, the kicker is our current environment, with highly volatile car prices. The looming threat of car price mean-reversion will keep even the most experienced risk manager up at night. Our last massive asset pricing mean-reversion disaster was the 2007-08 mortgage crisis. Pre-crisis, home prices grew at unsustainable above-average rates, then quickly crashed in a mean-reversion panic. Clearly, the social and economic significance of cars is different than homes and the length of time of out-sized asset appreciation may be different. With that said, there is much to be learned from past mean-reversion cycles. Those learnings suggest there are storm clouds on the auto finance industry's horizon.
(1) Experian, State of the Automotive Finance Market Q2 2021
(2) The definition of "precision" and "accuracy" are often confused. There are subtle but important differences. The following graphic is my favorite way to show the differences. “Team B” is an example where an NPV model may be precise but lacks accuracy. There is some bias in the model assumptions driving the lack of accuracy. For a more fulsome definition, please see the article Good decision-making and financial services: The surprising impact of bias and noise. This article's background section does a nice job explaining the difference.
(3) In general, for this article, I am setting aside accounting rule considerations. I generally consider lease-related business valuation completed by the "smart auto loan folks" to be an economic, pricing, and business exercise. This is generally separate from the accounting rules. In other words, the objectives and assumptions for product-specific business valuation as compared to accounting-based lease valuation may share some congruence but are not always the same. A governance best practice is for the business and accounting groups to independently value the lease assets and to have a credible check and challenge to walk behind those independent values.
With that said, generally, lease accounting is governed by ASC 842. Accounting firm RSM does a nice job summarizing the rule if interested. From a calibration and information-sharing standpoint, it would be instructive for the accounting department and the auto leasing business group to periodically compare and contrast their independently derived valuation models. Especially the big model drivers, like the assumptions, residual value, and discount rate.