Editors’ note: This feature first appeared in the June issue of Auto Finance News, available now.
Ten weeks after the coronavirus outbreak halted vehicle sales, the automotive industry was slowly seeing signs of recovery, but the economy had placed pressure on the used-car market that could have the industry bracing for residual value backlash.
In fact, 1 million lease contracts are scheduled to mature between April and June, according to JD Power estimates. “We ended up seeing 179,000 less returning lessees in April who could have extended their lease contracts, which means that about 175,000 extended their leases,” said Jonathan Banks, vice president of vehicle valuations and analytics at JD Power.
In May, lease return volume is expected to be down 83,000 compared with 373,000 lease maturities. For June, JD Power expects returning lease volume to be near pre-virus levels.
Moreover, wholesale used-vehicle values in April were unable to bounce back from Manheim’s first mid-month progress report, falling 11.4% from March. As such, the used-vehicle value index clocked in at 125.8, a 9.2% year-over-year decrease, its lowest level in three years.
Black Book, for one, recorded the largest month-over-month decrease in wholesale prices in April, said Alex Yurchenko, the company’s senior vice president of data science. In fact, Black Book’s monthly retention index dropped 7.9 points, reaching its lowest level since 2010.
“We saw a 5.9% depreciation in wholesale prices in the month of April,” Yurchenko said. “We expect the prices to decline at similar rates for the next two months due to an increase in supply of used vehicles.”
Black Book projects used-vehicle depreciation to exceed 25% this year. Last year, 2- to 6-year-old vehicles depreciated by 16.8%. From a wholesale price standpoint, Black Book expects an 18% drop in the remaining months of 2020, compared with pre-COVID-19 projections.
Moreover, there will likely be a “larger drop over the summer with some recovery early in 2021,” Yurchenko noted. “We also anticipate that older — more than 6 years old — cheaper vehicles in average condition will not decline as much due to increased demand for these units,” he said.
With lease-return delays, rental fleet downsizing, and inventory that remains unsold due to depressed consumer demand — along with pricing pressure on newer used units as OEMs promote new-vehicle incentives — the auto finance industry is gearing up for potential losses on off-lease residual values.
In January, the auto market felt rock solid, but the extent of the COVID-19 economic fallout is becoming apparent as the crisis has hammered the industry in ways never expected. Moving forward, the industry can look to China’s rebound as a signal of hope for the U.S. market. The “speed and magnitude” of the recovery in Chinese auto demand is a sign of hope for the industry, according to a research note by Moody’s Investors Service.
After plunging 42% during the first three months of 2020 from prior-year levels, China’s auto sales climbed back to post a 4% YoY gain in April, signaling “a healthy rebound in demand,” Moody’s noted. Still, the rating agency expects auto unit sales in China to contract 10% to 23.2 million units — including both passenger and commercial vehicles — this year, despite signs that demand is beginning to return to normal levels.
The U.S., however, has only begun to experience notable signs of recovery after April sales figures posted a 34.3% decline in used-vehicle sales and a 47% drop-off in new-vehicle sales, according to Manheim. Yet, Moody’s noted the decline in U.S. light vehicle sales in April was “less severe than some forecasts predicted,” due to incentives offered by automakers that kept sales “surprisingly resilient.”
GM Financial, for one, looks to its experiences in China for guidance on its North American operations, company President and Chief Executive Dan Berce told Auto Finance News.
“Operationally, there are lessons,” Berce said. “The auto industry was impacted more deeply in China than in the U.S., so the sales decline was deeper. But our GM originations in China are up year over year in both March and April, and our penetration of the OEM sales are higher than they’ve ever been.” The captive’s U.S. total loan and lease originations clocked in at $11.5 billion for the first quarter.
From a residual value standpoint, the captive noted a $3.7 billion economic cushion to absorb a potential depreciation in its off-lease vehicles, according to the GMF’s first-quarter earnings results.
“The first quarter, as it relates to our earnings, didn’t have much of an impact from the decline in residual values that we’re seeing today,” Berce said. “That impact to earnings is going to happen through the rest of 2020 through what we call ‘accelerated depreciation.’”
The $3.7 billion cushion is equal to 12.5% of GMF’s residual value estimates at quarter end, giving the captive additional cushion if vehicle values drop further than expected. Residual value estimates are the prices at which the captive expects to sell its off-lease vehicles at auction.
In fact, GMF has 22% of its outstanding leases set to terminate this year, representing $9.1 billion of its total $41.3 billion lease portfolio at quarter end, according to the earnings presentation. In the coming years, 32% of its lease portfolio terminates in 2021, and 34% in 2022, with the 12% remaining portfolio expiring in 2023 or beyond.
“We would normally depreciate our leased vehicles over time to the estimated residual value when the residual value declines,” Berce said. “We have to accelerate the depreciation even more than we otherwise would have. So that will be a big headwind to 2020 earnings.”
Accelerating depreciation more than anticipated, based on residual value estimates, is a smart practice for lenders. While analysts try to determine when the pre-coronavirus 16 million SAAR might return, they do know that 400,000 to 600,000 lost lease sales have already occurred, said Eric Ibara, director of residual value consulting at Kelley Blue Book.
“The impact this will have is that there will be a void of returning off-lease vehicles starting around February or March 2023, perhaps even sooner,” Ibara explained. “The impact of this shortage will be different by vehicle segment, but the forecast for the July-August period will be mostly flat or down just slightly for most segments, when comparing 36-month residual values to the May-June residuals.”
This compares to a normal cycle that would show average drops of about 1.0 to 1.5 percentage points. Compared to residual values issued last year during the same period, it is expected that residual values will be up for car segments and down slightly for trucks and SUVs.
Out of all the various moving parts in the automotive industry, it’s no secret that rental car conglomerates such as Avis and Hertz have been hit the hardest as consumers shelter in place and the travel industry screeched to a halt. In fact, there is no foreseeable end in sight for the $88.2 billion industry, as it is difficult to forecast when consumers will feel comfortable traveling at pre-pandemic levels.
With demand nearly nonexistent, hundreds of thousands of vehicle fleets are sitting idle on lots across the country, and rental car companies will most likely have to downsize their fleets to bring their business operations in line with the new normal, Black Book’s Yurchenko said.
“Our current projections anticipate that some larger rental fleet companies will be able to hold most of their vehicles longer, but most others will sell a large part of their inventory during the summer and fall months, Yurchenko said. “This practice will lead to over 250,000 additional rental units hitting the wholesale market over the next six months.”
Hertz, for one, will have to calculate how many of the 730,000 vehicles it needs to liquidate to satisfy obligations to its creditors after filing for Chapter 11 bankruptcy at the end of May. Hertz has $6.08 billion in outstanding asset-backed lease securitizations, according to Fitch Ratings, all of which have been downgraded by the rating agency.
After the rental car company missed its $498 million March payment obligation to investors, there was concern that additional late payments would trigger an early amortizing event, which would require Hertz to pay down the total interest and principal balance on the notes. Now, with a bankruptcy filing, Hertz intends to sell as many vehicles as it can, according to the company’s bankruptcy lawyers.
A flood of fleet vehicles from a Hertz bankruptcy could further stress the used-vehicle market, in a worst case scenario, Jonathan Smoke, chief economist at Cox Automotive told AFN.
“The worst case scenario would entail the bankruptcy of a large rental car company at the same time the off-lease extension bubble hits the market that is still not recovered and dealing with recurring waves of the pandemic,” Smoke said. “At this point, we can’t rule out that clearly negative scenario. The odds of a bankruptcy are likely higher if we see the market struggle to recover and continue to see new COVID-19 cases amidst recurring outbreaks.”
About 17.5% of Hertz’s $12 billion fleet are “program vehicles,” or those under agreement with auto manufacturers that carry little to no residual risk, according to Fitch. In addition, those vehicles would not “hit the market immediately,” Smoke said.
That leaves nearly $9.9 billion in nonprogram assets that would be flooded into the market in a total liquidation event, which could take up to six months. Fitch forecasts Hertz’s fleet could depreciate 2.5% every month on current market trajectories.
In fact, ALG estimates that a rental fleet liquidation could put over a million unexpected units into the used market by yearend, Morgan Hansen, vice president of data science, told AFN.
Still, “what is yet to be seen is if the impact will be spread over the next eight months or a couple isolated sale offs,” Hansen explained. “A tapered approach to releasing rental fleet into the used market would help retain as much value as possible for the liquidated units and oversupply shocks for already overflowing used-vehicle inventories.”
The lack of demand caused by stay-at-home measures implemented across the nation slowed demand for retail sales and nearly halted wholesale markets in April, Hansen said.
“April should be the low point for values, which lost more than 15% of value compared to the pre-COVID-19 expectations,” Hansen said. “Used supply is expected to increase through the summer and used values will be down 8% to 14% from our initial estimates,” he added.
One potential way lenders can help mitigate the risks of a volatile residual value market is through a bolstered Certified Pre-Owned program, Kelley Blue Book’s Ibara said.
“A strong CPO program, properly executed and effectively marketed, could help a brand absorb abnormal spikes in return volume and mitigate the corrosive impact on used car values,” he said.
“However, these solutions are very situational and could be effective for one manufacturer, but not be ideal for another. It would depend on the projected volume of returns and the timing of those returns, in which segments the volume occurs, the projected values in those segments, and new-vehicle launch plans,” Ibara explained.
For GM Financial, an enhanced CPO program is just one way the captive is working with its OEM to “relieve the pressure on residual values,” Berce said.
“CPO programs are a great way to enhance used values and control the customer experience for the OEMs,” ALG’s Hansen said. “The problem with increasing CPO inventory in spring is the lack of demand from customers in the current economic environment. And the best case for extending leases into the summer is to provide a bigger customer base for CPO. As employment numbers stabilize in the summer, more buyers should be in the market to buy both new and used vehicles.”
With the details of a Hertz liquidation still up in the air, off-lease vehicles returning to market at an inconsistent rate, and used-vehicle values slowly crawling back toward pre-virus levels, it remains to be seen how tightly residual values will be squeezed into the summer and through the rest of the year.
Still, one thing is for certain: The industry has at least started down the road to recovery.
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