In the last few weeks, the Big Three American automakers have all rattled the retail auto market by announcing big changes in their leasing programs. Chrysler led things off by telling customers that the lending arm (majority owned by Cerberus Capital Management LP) would stop offering leases for new cars and trucks on August 1st. Ford and General Motors followed within a few days, saying that they were dropping the lease deals for SUVs and light trucks.
The Detroit Three have been using accommodating leasing terms to move about 20 percent of their products for years. And many of the vehicles delivered through leases were the ones with the largest gross margins (in basic terms, gross margin is the difference between the sales price and the cost to build). Margins, gross or otherwise, have been hard to come by for the purveyors of American iron for some time, so why cut off a profitable source of revenue now?
The answer is found in that important concept “profit,” so let’s follow the money. A lease for a car is essentially the same transaction as a lease for a house or apartment; a monthly payment entitles you to the use of an asset you don’t own for a specific period of time. You are expected to take reasonable care of the asset (be it a place to live or a source of transportation) and return it to the owner in decent condition. A key difference with auto leasing: At the end of the lease the owner (the leasing company) is planning to sell the vehicle, not find a new “tenant.”
So the basic transaction looks like this: After the customer (“lessee”) has agreed to the terms, been determined to be credit worthy, and signed the contract, the leasing company pays the manufacturer for the vehicle (the purchase price) and hands it over to the customer. Besides the purchase price, the size of the monthly payment is mostly dependent on two more numbers, the length of the lease (how many months the customer has signed up to enjoy their new ride) and the residual value (how much the leasing company can sell the vehicle for when they get it back, which largely depends on the number of miles driven.) Generally speaking, the longer the lease, the lower the monthly payments.
The big unknown is the residual value; what the vehicle value is expected to be at the end of the lease, three or more years in the future. For many years the decline in value for a particular vehicle has been reasonably predictable. The Kelley Blue Book makes a business out of tracking actual sales prices for used vehicles and those figures can be used to predict future values of new cars today. If a new $50,000 , GMC Denali, or typically sells for $30,000 on the used car market after three years of service, the leasing company knows the payments over three years must cover that $20,000 difference. Toss in the prevailing interest rate, adjust for promotional offerings, such as rebates, and voila! A monthly payment is calculated. For the last couple decades, auto leasing has been a stable, profitable business. But when unexpected, rapid economic conditions change the facts, the leasing companies can find themselves locked into thousands of existing contracts with terms guaranteed to lose money.
In the past couple years, two waves of an economic tsunami slammed into the auto leasing equation and put leasing company profits deep underwater. The first wave rolled in when defaults on mortgages and credit card debt increased, making it much tougher to qualify for a lease and pushing up the price of money (interest rates). Many car manufacturers chose to pick up some or all of this financing cost to help keep cars moving off dealer lots, so the pain was masked to some extent. But the second wave was huge! The explosion in fuel costs suddenly made vehicles which burned more than a gallon every 20 miles less desirable across the land. With many buyers shifting to smaller, less fuel hungry transportation, sport utility vehicles and pickup trucks dropped about 25 percent in value overnight. Our example SUVs $30,000 resale value slumped to between $20,000 and $25,000. Now the money the customer paid back over the term of the lease, combined with the new lower resale price, totaled substantially less than the amount the leasing company had paid the manufacturer for the new vehicle. Bummer!
Faced with the reality that it is not possible to lose money on every deal and make it up in volume (though not for lack of trying), the leasing companies decided to pull the plug. Unfortunately the pain is almost certainly going to continue for some years to come as leases written recently by the finance arms of GM, Ford, and Chrysler continue to carry optimistic residual value figures. Of course generalized finance companies such as banks and credit unions continue to offer leases, but their numbers reflect the new market reality and the previous advantage over purchasing, of lower monthly payments, is either minimal or non-existent. U.S. manufacturers are now pushing the benefits of purchase over lease, hoping they can use other promotional techniques to keep their lease customers. It’ll be a difficult and expensive effort, made even tougher by the imports. In the end, to stay in business, you gotta make money.