Cheap auto leases really were too good to be true

August 2, 2002

Dorin Levin writing for Bloomberg posted this story:

Automotive leasing, a nifty financing method that lets some motorists drive new cars they couldn't afford to buy, has dwindled to its lowest popularity in years.

Think of it as another now-deflated, too-good-to-be-true bubble from the era of day traders and billion-dollar startups that never earned a dime: Motorists driving shiny new sedans and sport-utility vehicles whose true prices were beyond their reach.

The reason for the decline isn't because consumers have grown disenchanted with leasing's low monthly payments. It's because the companies that owned and leased the vehicles had unpleasant losses as automakers raised and lowered new-vehicle production, creating volatile used-car prices.

The latest annual survey by the Consumer Bankers Association of 41 lenders and automaker finance companies shows they lost an average $2,451 a vehicle in 2001, up from $2,342 in 2000 and more than twice the $1,200 average loss in 1998. GE Capital Corp., Bank of America Corp., KeyCorp and others are among lenders that have dropped leasing entirely in the past two years. Finance companies owned by automakers are cutting back.

In a lease agreement, the driver of the vehicle agrees to pay a fixed monthly sum based on the vehicle's presumed value -- the residual -- at the end of 36 months or some other term. When the lease expires, the leasing company that actually owns the vehicle sells it at market price.

If the market price equals or exceeds the presumed residual price, all's well. If the market price is lower, the leasing company eats a loss.

The residual value is a forecast -- a guess, really -- based on factors such as used-car price trends. Like any forecast, it should be conservative. Leasing companies, however, were over-inflating residual values, either by miscalculation or as a way of lowering monthly payments to attract buyers.

General Motors Corp.'s Pontiac Aztek might be a poster child for overinflated forecasts. According to Edmunds.com, an online automotive information service, the projected value of a 2001 Aztek leased for a year was set at 66 percent of its retail price. The actual value turned out to be about 55 percent. Likewise, Ford Motor Co.'s 2000 Ford Explorer sport should have been worth 56 percent of its original price; instead, the value was 52 percent.

The 2000 Lexus RX300 sport-utility, on the other hand, produced a windfall for companies that leased them. After two years, it's commanding about 69 percent of its original price, compared with a forecast of 63 percent.

In the case of Aztek, it's likely that General Motors intentionally set the residual high. The homely model wasn't selling well, so the gap between the residual and market price probably represented a financing incentive to lure customers.

Automotive Lease Guide, a Santa Barbara, California-based service that provides residual values, came under pressure from lenders in 1999 to raise its forecast of residuals because used-car prices were strong. Higher residuals, remember, mean lower monthly payments and more lease closings.

Automotive Lease Guide succumbed. Then, in 2000 used-vehicle prices collapsed, and with them the value of the vehicles owned by the leasing companies and lenders. No one had counted on automakers building as many vehicles as they did, which depressed used-car prices.

The guide decided to avoid wishful thinking a second time. "We were criticized for reducing residuals in January 2001," said Raj Sundaram. "We were ahead of the curve. I'm pleased."

Today, leases account for about 25 percent of financings, down from 40 percent in 1999, according to Carol Knorr, vice president of marketing of General Motors Acceptance Corp.

"When you flood the market with used cars, it hurts used-car prices," Knorr said.

At Ford Motor Credit Corp., the percentage of retail sales financed with leases fell to 18 percent in this year's first half, from 24 percent year earlier. Ford still allows buyers to apply cash incentives to leases to reduce monthly payments. Instead of paying $302 a month for 60 months on a $20,495 Taurus, a customer can lease it for three years at $270 a month.

To the extent that automakers set residuals unrealistically high, their risk was offset partly by the opportunity to sell customers parts and lease or sell a subsequent vehicle when the lease expired.

Non-automotive lenders such as banks enjoyed no such offset. While it's tempting to predict that banks and others will take care before jumping back to the go-go variety of leasing, history has shown that memories are short when it comes to delusions, speculation and market bubbles.