To describe the financial markets in 2008
as turbulent would be an understatement, to say the least!
After ominous rumblings all year as
to the potential reach of the meltdown in the U.S. sub-prime mortgage market,
the final quarter of 2008 saw stock market volatility on a scale not seen for
decades, if not generations. Less visible but potentially more serious was the
drying up of commercial credit, as banks curtailed lending in order to manage
their balance sheets with reduced equity.
And at the end of the year we saw the CEO’s of the Detroit’s Big Three automakers journeying to
Washington, DC, collectively in search of ‘bailout’
funding.
The most extreme financial turmoil
took place in the final quarter of the year, but there were earlier signs of
difficulties in the automobile industry affecting the vehicle leasing market in
particular. In July of 2008, GM and Chrysler announced that they were severely
curtailing their vehicle leasing activities going forward, and in future would focus
on sales rather than leases. In the same month, Ford announced that it was
taking a U.S. $2.1 billion write-down in the value of its lease fleet, and was also
curtailing its leasing activities going forward.
The extent of these announcements was
likely a surprise to most observers, but the underlying issues had been
apparent for some years: changing consumer tastes were making the residual
values of leased vehicles very difficult to forecast. As oil spiked to $150 a
barrel in the summer of 2008, and gas prices reached unprecedented heights, the
residual resale value of a large SUV (for example) coming off-lease could be
thousands of dollars less than originally contemplated.
Further pressure on the residual value
of vehicles coming off-lease was attributable to the rising popularity of
hybrids (another response to rising gas prices) and, in Canada, to a
strengthened Canadian dollar, which put pressure on prices in the second-hand
market as vehicles had to compete with direct imports from the US.
It has been said that automobile
manufacturers can live with either high gas prices or low gas prices, since
vehicles can be built for either context. (Just look at the typical size of
vehicles in Europe, where gas is always expensive.) But
what makes life difficult for the industry is fluctuating gas prices that cause
unpredicted changes in consumer taste. Such has been life in the vehicle
leasing business over the last few years.
The responses to reduced manufacturer-provided
leasing have been varied. In the Fall there were
promising signs that new purchase-financing options were adequately filling the
gap, with J.D. Power & Associates still predicting “a very strong year for
new vehicles sales in Canada” at a level that would be “close to
a record year.” (At the time of writing, statistics for the final months of the
year are not yet available.)
Independent leasing companies in
different parts of the country and in the U.S. have also stepped into the breach,
in some cases targeting quite specific niches. One independent leasing company
in the American mid-west commented in the financial press that “a recession is
always good for independent leasing companies.”
A further response to the residual
value problem, for dealers with captive leasing operations, is to consider
moving from closed-end leases (where the customer can walk away at the end
of the lease, subject only to wear-and-tear charges such as excess mileage) to open-ended
leases (where the customer must make up any eventual shortfall from the
pre-determined estimated residual value).
Such open-ended leases are intended
to transfer the residual value risk from the leasing company to the customer. However,
the record-keeping requirements can be quite onerous. An open-ended lease may usually be treated as
a lease for tax purposes, but in most cases it is considered to be a sale under
generally accepted accounting principles, with the financial statements showing
a long-term receivable that yields interest income.
The effectiveness of the customer’s
guarantee in an open-ended lease may also be subject to constraints under consumer
protection legislation. So, in addition to evaluating the market acceptance of
such financing products, you need advice from both your accountant and your
lawyer before taking this step!
This article was first published in
the January-February edition of Signals, the official
publication of the New Car Dealers Association of British Columbia.
