I’ve been reading an article in the Wall Street Journal this morning reporting Fed data that indicates auto loan defaults are on the rise in the US, particularly in poorer areas in the southern US.  This follows recent comments from automakers that the market for new cars is peaking and from used car dealers that prices declined last year and will dip further in 2017. Part of the downward pricing pressure is due to a larger number of cars coming off lease.

car leases

All this should come as no surprise, since the auto industry is cyclical and we’re closing out year eight since the US economy bottomed in 2009.  If there is still a shoe to drop–and I think there is–it will come in the car leasing market itself.  Here’s why:

Let’s say I want to buy a $30,000 car on a three-year lease.  What determines my lease payment?

The leasing company buys the car I want to lease from the auto company and rents it to me.  Its charges consist of:  interest on the purchase price; recovery of the loss in value of the car over the lease period; and the price at which the leasing firm figures it can sell the car for at the end of the lease.  The key figure here is the lender’s estimate of what the car will be worth when I turn it in.  This is called the residual value.

Examples:

1.  The lender estimates the car will be worth $15,000 in three years.   At 4% interest, that’s a monthly payment of $490.  In total, I’ll pay $2743 in interest charges (an average of $76/month) over the three years and $15,000 in principal.

2.  If the car is estimated to be worth $20,000, that translates into a monthly payment of $360, with a total of $10,000 repayment of principal + $3029 in interest ($17.50/mo).

At rates close to zero, an interest rate change makes little difference.  The difference between $490/month and $360 is the residual value assumption.

(Note:   real world leases can be much more convoluted, but these are the economic basics.)

how leasing companies get into trouble

Historically, lenders–and especially those affiliated with automakers–have made the residual values too high.  Why?  To my mind, it’s because a lower monthly payment (i.e., a higher residual value estimate) makes the car sale easier.  In the moment, the day of reckoning appears to be far in the future.  It can also be that the accounting framework the lender uses permits assumed profits on new loans to offset realized losses on old ones.  If so, as long as lease volumes increase, reported profits probably won’t reveal the damage being done.

Experienced auto stock investors are doubtless already worrying about the potential negative effects of leasing.  I imagine, though, that as/when the issue becomes better known–that is, when writeoffs from leasing operations start to emerge–this will be more bad news for auto stocks.