‘Killer Apps’ May Pressure Residuals
It’s obvious that in the auto finance sector, 72-month-term paper entails many risks. Those risks are amplified when it comes to loans with 84- and even 96-month terms. Of course there is the normal yield curve risk, particularly in a world of low interest rates where the only way bond prices can move is down. Then there’s default risk. As I’ve argued in previous columns, after seven years, the U.S. recovery remains anemic, and so the next recession will be more painful than average. (For one or another set of unforeseen reasons, there will surely be one in the next half-dozen years.) But again, that’s hardly novel, and the finance industry at least tries to factor that in.
In contrast, depreciation is, er, unappreciated. That’s because the pace of the introduction of new technology in the auto industry remains high. In the past 50 years, we’ve seen no “killer apps” in the industry. Except for the period from 1978 to 1982, when subcompacts boomed, we’ve seen no sharp swings in the industry. Yes, the U.S. market is now dominated by light trucks, SUVs, and crossovers; segments that barely registered 25 years ago are now king. The evolution away from cars has been gradual, however. It did not lead to a collapse of resale values for, say, midsize cars, and occurred in an era of generally shorter-maturity loans.
A shift in safety standards, too, has been slow and steady. In the early 1990s, I had to special-order a minivan to get an anti-locking brake system. Nowadays, consumers get electronic stability control in addition to anti-lock brakes. But those changes were driven by regulation rather than by consumer demand, so resale prices didn’t shift.
That dynamic may be about to change. The past decade has been marked by lots of new technologies, which I’ve seen firsthand as a judge for the PACE supplier innovation competition. Historically, new safety and convenience features first appeared on luxury cars. Once those options gained consumer acceptance, they became standard in luxury cars and optional for midrange vehicles. Now an increasing number of technologies appear at the first possible moment on whichever vehicle program is next, regardless of whether it’s a standard car or a luxury marque.
Yet few car owners realize their vehicles have oxygen sensors and engine-control computers, start-stop systems that improve fuel efficiency, or turbos and fuel injectors that allow engine downsizing to change the tradeoffs between weight and torque. The same holds true for many safety features. Vehicles now come with side-curtain airbags and seatbelt pre-tensioners, but even those of us who experience what might have been a severeaccident, likely don’t realize they were activated and saved life and limb. If we’re unaware they exist, we’re not likely to pay a premium for them. In short, such technologies don’t affect residuals or purchase frequencies.
In contrast, adaptive cruise control, blind-spot detection, lane-departure warnings, self-parking cars, LED headlights, and metallic paints are immediately visible. The same is true of the new generation of infotainment systems, and of a range of other convenience features. Volkswagen’s economy Skoda brand, for instance, offers ventilated seating, ahead of more upscale marques. Individually, no single feature stands out, but taken as a package, won’t they constitute a “killer app” that once-experienced consumers won’t readily give up? And what of the connected car, that will be able to detect a vehicle on a collision course with yours in time to warn you, if not to hit the brakes on your behalf?
The trend for two decades has been to more durable cars; the average light vehicle is now roughly 11½ years old. With longer life, residuals fall more slowly. I believe the next generation of vehicles will offer “killer app” features that will reverse that trend; the resale value of cars without the panoply of visible options will fall more quickly. If your business is based on slow-rising residuals, you could be in for an unpleasant surprise.
Michael J. Smitka is professor of economics at Washington and Lee University, in Lexington, Va. On the faculty at W&L since 1986, Smitka has spent his academic career focused on the auto industries in the United States and Japan. He has an A.B. cum laude in East Asian Studies from Harvard University and a Ph.D. in Economics from Yale University. From 2006 to 2007 he was a Fulbright Research Fellow at Chiba University in Japan. He can be reached at smitkam@wlu.edu.
