Measuring, Managing and Monetizing Auto Lease Risk — A New Paradigm

By Brad Emerson, Gary Schurman, and Laurent Schwartz

Auto leasing has become the bad boy of the auto finance world. Some lessors can’t exit fast enough, while others are wary, wondering if they have missed seeing leasing’s problems. Is this the time to jump on the bailout wagon or is this the opportune time for savvy lessors to reprice their lease program and/or capture marketshare? Finance company executives are paid to measure, manage and monetize risk. We measure the risks inherent in leasing (measurement), we choose a level of risk that we are comfortable with (management), and we ensure that our pricing incorporates the risks that we choose to take on (monetization).

Most lessors use historical averages and published residual value estimates as the primary tools in their risk-management process. These tools are too simplistic and do not measure risk. Scott McKim, a senior vice president at Huntington National Bank, says: “Relying on historical averages is not a viable option. There are far too many variables that can change and generate results that are well off the historical norms.” How can we convince management that we are both pricing for risk and have enough allocated capital to survive negative events that have not yet occurred? How can we convince management that the auto lease business is the right business to be in?

The mathematics of risk relies on a branch of calculus called Stochastic Calculus, which is, in essence, a combination of regular calculus and probability theory. The real power in this branch of mathematics is that random variables which define risk in the auto lease world can be represented by a Monte Carlo process, which, at a minimum, should model the following:

• Vehicle values as a stochastic process (i.e., how residual values vary from their expectations. For example, when a residual guidebook publishes a 40% residual on a 2009 Chevrolet pickup, that is the average expected value for that model, but does not capture variation for factors like color, options, geography, etc.).
• Macroeconomic events (i.e., a jump in oil prices)
• “Optionality” inherent in leasing (i.e., the tendency of lessees to purchase vehicles that are in-the-money but return vehicles that are out-of-the-money)
• Lessee price sensitivity (i.e., lessees occasionally purchase vehicles that are out-of-the-money and return vehicles that are in-the-money)
• Prepayments, which are a function of prepayment experience, vehicle values, price sensitivity, and other factors
• Defaults and credit losses, which are a function of credit score, vehicle values, and other factors
• Vehicle value and default correlations
• Purchase option and disposition fees

The model should produce not only the results that one can expect on average, but also a distribution of losses and their attendant probabilities (i.e., losses that lie outside the “expected” range). With this model, we can ask the right questions:

• Is the loss distribution (risk profile) acceptable to our stakeholders?
• Does our lease program pricing structure incorporate these risks?
• How much capital and loss reserves should we have?
• How can we restructure our lease program such that we strike the desired balance between risk and return?
• Should we enhance residuals? If so, by how much?
• Should we purchase residual value insurance? If so, how much?
• How well does our residual value insurance policy protect us?

The current environment in leasing may be an opportunity of a lifetime. A state-of-the-art risk-management model allows us to demonstrate to our stakeholders that we can measure our risk, manage our risk, and monetize our risk by pricing accordingly. Rather than fearing the lease business, we can be in a position to make money, increase market penetration for our dealers, and provide a product to our customers.

Brad Emerson, Gary Schurman, and Laurent Schwartz are senior consultants at Decisive, a Santa Barbara, Calif.-based company that offers portfolio analytics software and services, as well as loan and lease origination software to banks, credit unions, and finance companies. They can be reached at info@decisiveonline.net.