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Friday, April 15, 2011

Long Term Residual Outlook

I have been privileged to discuss residual values and the pre-owned market with a number of industry experts over the years. An thought that was born in a late 2008 discussion over a beer with Matt Traylen, then Chief Economist for Automotive Leasing Guide, has since become full-blown reality.
At the time, the stock market was tanking, new vehicles sales had slowed to a crawl, the auto manufacturers were begging for money before Congress, the acronym TARP had just been coined and the economy and our lives were looking bleak and uncertain.
Most lenders had announced in previous weeks that they were getting out of the leasing business, or dramatically “pulling in their horns.” The asset backed securities market had disappeared, pulled down by the mortgage backed securities market and we were hearing unpleasant terms like “toxic assets.” This reminded me of some earlier dark days in the auto industry when a dealer or leasing company might take particular vehicles to auction and they wouldn’t even draw a single bid, a particularly difficult position when one had a payroll due.
It was easy to understand how a bank holding a lot of “toxic assets,” but little cash, could become a “zombie bank,” a term invented to describe the Japanese banks after their own real estate bubble burst. That is a bank with a “strong” balance sheet but no cash to loan or to return to depositors who arrive “electronically” at the bank to make a withdrawal. Marking these assets to market was not practical because values could not be established as no one would bid on these mortgage backed securities or their “first cousin,” auto loan backed securities. Regardless, “mark to market” would have rendered the U.S. banking system insolvent and caused a complete meltdown. A strong case can be made that the U.S. banking system WAS, in fact, insolvent but for a few accounting entries.
After acknowledging that most of the major players had announced their exit from the leasing business, the collapse of available financing for fleet and daily rentals, and the dramatic drop off in overall new vehicle sales volume, Traylen and I asked, “Where will pre-owned inventory come from down the road?”
While used vehicle sales plunged from a high of about 44 million units in a single year to about 35 million units in 2009, it became apparent that once demand began to trend upward toward historical volumes, there would be an acute shortage of available inventory.
Within a few months, GM and Chrysler went through bankruptcy and Cash for Clunkers plucked another 600,000 potential pre-owned vehicles out of the system and fed them to the crusher. What was really crushed was the Buy Here Pay Here business. What the government called a “clunker,” they call “inventory.”
Today, there is considerable pent up demand for pre-owned vehicles and the banking system has recovered to the point that ready financing is available again. There are still serious issues to be resolved in the economy, not the least of which is high unemployment, but demand is building.
Other than unemployment, the biggest impediment to full economic recovery is the fact that 25% of American mortgages are in negative equity territory. The large numbers of foreclosures have left empty and/or abandoned houses in neighborhoods across the country further depressing home values. Few neighborhoods, regardless of affluence, are immune from this.
Economist Alan Greenspan, past chairman of the Federal Reserve Bank, recently stated that he did not believe the economy could reach full recovery momentum until the real estate market experienced at least a 10% increase in home values. It just is not clear how long it will take for home real estate to become stabilized, let alone regain value. On the other hand, the rebound of the stock market has restored almost 16 trillion dollars of mostly American wealth.
Against this mixed backdrop of economic news and general economic uncertainty, there is much more demand than available pre-owned inventory, which is driving wholesale pre-owned prices ever higher. We see pent up demand in the new vehicle business by the steady increase in sales results.
New vehicle incentives have a considerable impact on pre-owned values. If incentives lower the true transaction price of new vehicles, the value of same make/model pre-owned vehicles drop a commensurate amount.
Restraint of late on the part of auto manufacturers to refrain from over production is keeping dealer inventory levels in line with demand. It is likely that OEM restraint on overproduction and incentives will be ongoing as they have new policies and labor agreements in place. The fact that dealer floor plan arrangements with lenders are much more restrictive than before has also helped maintain this equilibrium. Few dealers have the liberal floor plan arrangements these days that once allowed for the massive stocking of vehicles on behalf of a manufacturer looking to “force the market” with incentives.
But now that financing for leasing has recovered, OEM captive finance arms are focusing on shorter terms to try to create additional supplies of pre-owned inventory. Financing for the daily rental business has allowed rental companies to begin to return to more traditional replacement cycles. The same is true for fleets. But the shortfall that began in 2008 will not be able to be made up in the short term.
So what is the outlook going forward and how will it impact residual values?
Experts say we will continue to experience pre-owned shortages for at least as long as 5 years. Some niches will be more acute in this respect than others, and segment values could change with fuel prices and other issues.
But the tremendous shortfall in pre-owned inventory supply will take years to balance out as demand increases in line with economic recovery. In talking to experts like Tom Webb, Chief Economist for Manheim Auctions, Tom Kontos, Chief Economist for Adesa Auctions, Ricky Beggs, Managing Editor and Vice President for Black Book, Rene Abdalah, Vice President of Residual Value Insurance Group, Eric Ibara, Director of Residual Value consulting at Kelly Blue Book and Traylen who is currently head of M.A.T. Consulting, the consensus is that the shortage will be with us for at least 5 years. Residuals are expecting to stay quite strong!
However, in projecting residual values, there is a somewhat different outlook between Abdalah of RVI and Ibara of KBB and their counterparts at Automotive Leasing Guide. Both companies are convinced that as long as fuel prices increase gradually, American consumers will adapt without drastic short-term consequences. Consumers will tend to buy the largest vehicles they can afford.
Other than “early adopters,” most consumers will only pay a technology premium for “electrics” and hybrids if the government pays it for them through tax credits or other subsidies. When fuel prices suddenly spike, as they did in 2008, fuel economy becomes the consumer’s primary motivator. However, experience shows this is a short-term circumstance.
As we have seen repeatedly, and as recently as the price spikes in 2008, high fuels prices are followed by oil gluts and extreme fuel price declines as oil producers rush oil to market to capitalize on the high market prices, creating over supply. In 2008, the cycle began in April when the price threshold broke $4./gallon. By the time January 2009 arrived, a gallon of regular was $1.90.
So while there may be some price spikes along the way, Ibarra and Abdalah expect the overall fuel price trend will be gradual. As a consequence, manufacturers will have to deal with substantial Corporate Average Fuel Economy (CAFÉ) fines if consumers do not naturally purchase a product mix that lends itself to the auto manufacturers’, and the government’s, CAFE objectives.
In the past we have seen manufacturers prefer to pay significant consumer incentives to move vehicles they need to move to avoid the CAFÉ fines. With CAFÉ requirements at extremely high levels, it is logical to expect the focus of OEM incentives to be on fuel efficient vehicles. The CAFÉ standard for 2016 for cars is 39 mpg and 30 mpg for trucks. This will drive down the values of like make/model pre-owned vehicles. Lessors need to consider this very real possibility looking down the road.
At the same time, manufacturers can be expected to raise the price of larger less fuel efficient vehicles and reduce incentives to try to make more gross profit per unit, while somewhat depressing volume to enhance their CAFÉ calculation. As a consequence, Kelly Blue Book and RVI Group residual projections are higher for “heavies” than ALG’s projections while ALG’s projections are higher for smaller fuel efficient vehicles.
If a cataclysmic event takes place and oil goes to $200. plus per barrel, and stays there, all bets are off anyway.
Lenders, fleet operators, and private capital leasing companies will have to make their own overall residual setting decisions and come to their own conclusion about each size and fuel economy segment. However, there is no doubt that overall residual values will stay historically strong in the years to come as strong demand for pre-owned vehicles overwhelms the available supply.
David Ruggles has spent his career life in every phase of the retail automobile business and has consulted and trained with hundreds of auto dealers in the U.S. and Japan. Ruggles has been a dealer for Chrysler, GMC, Mercedes Benz, Ford, Mazda, and Subaru. Author of the Ruggles Report, and a regular contributor to the National Bureau of Asian Research, he blogs at autosandeconomics.com and writes regular columns for several trade publications and The Daily Post.
David can be reached at ruggles@msn.com and by phone at 312.925.1863