The Perfect Storm Hits Used-Car Values: The Foundation Of The Auto Industry Is Faltering

Tyler Durden's picture

Submitted by Daniel Ruiz via Blinders Off blog,

The Perfect Storm

The following topics all have their part in fueling the storm to come:

1) Trade Cycles and How They Affect New Vehicle Sales Velocity

Used car values determine in large the velocity of new car sales. Most new car transactions involve a trade. The level of equity in the trade oftentimes determines whether a new vehicle transaction will be successful or not. Inclining used car values lead to faster trade cycles while declining used car values lead to slower trade cycles. Dismal new car sales volume during our last recession created a shortage of used cars. This created a large supply and demand imbalance that made used car values soar from 2009 till 2014 as seen on this chart.

This time period was extremely favorable for new car sales because consumers found themselves in an equitable position on their vehicles in a very short period of time. To illustrate this, consider this chart of a 60-month loan.

The black line represents the principal balance owed. An optimal trade cycle occurs when the principal balance owed on a loan intersects with the market value of the vehicle. The bullish used car cycle for passenger cars ended in 2014 as a result of extreme pricing pressure from new car leases. Since 2014, used passenger car values have corrected and continue to underperform. This underperformance is largely due to the effects that falling used car values have had on new car sales velocity. A longer trade cycle results in a slower velocity of new car sales. Today, we’ve seen data suggesting that used car values can drop as much as 50% from current levels. Refer to the above loan chart and consider what a drop that large would mean for new car sales velocity in terms of trade cycles.

2) Increased Dependency on Leasing

Used car values also determine the effectiveness of leasing. The most significant component of a lease is the gap between the residual value and the sale price of the vehicle. A residual value is little more than a guess at the future value of a vehicle. Manufacturers and third party companies like ALG use current and historic used car value data to establish residuals. Because of this process, residual values tend to lag used car values. As residuals rise, the gap between the residual value and the sales price gets smaller leading to lower payments. As residuals fall, the gap becomes larger leading to higher payments.

There are many benefits to leasing, but the most important is affordability. Affordability is most often measured in terms of monthly payments. As leases become more affordable, they become more appealing to consumers and penetrate at a higher percentage of total sales. The bullish cycle in used car values from 2009 till 2014 led to some of the lowest lease payments I’ve seen in my career. Consumers noticed and took advantage of the savings.

Residual values lag used car values. When used car values outperform residual values, lessees can trade early and utilize the equity in their lease as a down payment towards a new purchase or lease expanding the new car business. When used car values underperform residual values, new car business contracts as lessees are forced to go the full term of the lease and are left without equity in the end. As I mentioned earlier, used car values for passenger vehicles have been falling significantly since 2014. Aside from the negative effects that used car values underperforming residual values have on new car sales velocity, the lagging effect discussed earlier leaves captive banks open to a considerable amount of residual risk. Please use this link and read through the entire thread for a number of examples using BMW leases.

As used car values continue to decline, residual values will continue to adjust downward. Lower residuals will lead to higher payments, and leasing will produce fewer sales.

Leasing is responsible for a significant portion of total light vehicle retail sales. Here’s a look at the penetration rates by manufacturer.

The average new vehicle price has inflated by 20% since 2008. Leasing has become the best and/or only way for consumers to afford new vehicles while prices continue to rise. This is evident when you see manufacturers relying on leasing for most of their sales volume.  What happens to the sales volume for individual car companies and for the auto industry as a whole when residuals are adjusted lower and the affordability that leases provide is lost?

3) Credit Risk

While conventional auto loans only carry default risk, leasing adds residual risk. Leases do not have to default to become a problem; they can become a problem at maturity. Most of the outstanding leases have been securitized bringing us back to 2007 levels. The appetite for auto related ABS makes perfect sense since leases haven’t produced negative equity for years. This adds a layer of complexity that needs to be considered.

The gap between residuals, principle balanced owed for all auto loans and the recovery value for vehicles will grow as used car prices continue to fall. The larger the gap between balances owed and used car vales, the larger the risk and potential losses for the banks holding these loans.

4) What’s Holding It All Up?

The light truck and SUV segment is at a different stage in its’ cycle compared to passenger cars. The majority of US consumers prefer light trucks and SUVs instead of passenger cars. However, the performance of the light truck and SUV segment is very dependent on the price of fuel. Years of low fuel prices have kept the demand for light trucks and SUV very high. So what do you do when one segment (Light Pickups and SUVs) is outperforming the other (Passenger Cars)? Well, you build less of what’s underperforming (Passenger Cars) and more of what’s outperforming (Pickup Trucks and SUVs). Much like a stock market index where money can flow into big names like FANG while market breadth is lost and still move up, manufacturers have shifted their focus toward the more profitable light pickup truck and SUV market. This has experts very focused on oil to gauge the overall health of the automotive sector.

5) Think Fuel Prices Are Your Leading Indicator? Guess Again…

The same thing that caused the correction in used passenger car values is now affecting light pickup trucks and SUVs - ultra low lease payments. Note how lease volume is now favoring SUVs instead of passenger cars. (Residuals are correcting in passenger cars, which translates into higher payments.) 

Consumers purchase used cars because they are typically more affordable than new vehicles. Affordability is most often measured in terms of monthly payments. What happens to used car values when a new vehicle becomes more affordable than its’ 1, 2 or 3-year-old version?

6) Supply and Demand

Rate of sale calculations from a record setting year followed by 4 months of year-over-year misses, has left us with a high-day supply of new vehicles.

When sales velocity slows down, the expected reaction from manufacturers is more incentives, and increased incentives are exactly what we received. To illustrate this, let’s take a look at General Motors. GM had a 98-day supply of vehicles at the end March (2017). Ninety-Eight days is very high, but GM stated that it’s part of a strategic build in their inventory. Even if that is the case, the Malibu had a 124-day supply and the Silverado had a 115-day supply.  The response to the day-supply problem in Silverado and Malibu was a very aggressive lease and 20% off MSRP respectively.

This scenario triggers a series of events that places a lot of negative pressure on used car values.

This new car problem precedes a supply glut of lease returns. Supply will soon overwhelm demand as the record setting leases of the last 3 years mature. Here is a look at a maturity chart for Ford.

Lease maturities don’t necessarily turn into inventory problems. When used car values are outperforming residual values, most clients elect to buy the vehicle from the captive banks or utilize the equity as a down payment toward a new purchase or lease. A smaller amount of vehicles reaching wholesale auctions limits supply and supports higher used car values. However, when used car values underperform residual values, clients will exercise their right to return the keys to the vehicle and use the protection that the residual value provides. A growing return rate shown here on this slide from Ford’s Q1 earnings call is proof that this is happening today.

Dealers will also reject maturing leases at the residual value thus leaving the transfer of ownership from captive banks to the new owner at wholesale auctions. This will lead to higher auction volumes resulting in lower used car values.

7) The Competition Does Not Wait

Competitors will not sacrifice market share while another manufacturer manages a day-supply problem. As I expected, competitors responded quickly to the aggressive lease on Silverado:

These aggressive leases are exactly what triggered the correction in used passenger cars. Will it be different this time?

8) Manufacturers Start The Problem And Dealers Supercharge It

New car dealerships are being built in vast quantities. With demand slowing, more dealers have to fight for fewer sales. This supercharges the already large discounting effect created by the manufacturers. The unintended collateral damage becomes used car values. What market is left for used cars when new cars are less expensive?

9) 2016 Leftovers in May of 2017

A quick scan using your favorite auto search engine will reveal a staggering amount of new 2016 leftovers. On May 10, 2017, a simple internet search returned 145,763 leftover units nationally.

This is concerning for many reasons. Dealers place very heavy emphasis on getting rid of prior model year vehicles before the end of each year. At a certain time of the year (already past), manufacturers will give dealers a lump-sum payment per unit of unsold prior model year vehicles and remove incentive support in terms of special leases, incentivized rates and rebates. Dealers do not want to have any leftover vehicles when this happens, as those vehicles are extremely difficult to sell against the newest models that have manufacturer incentive support.

The amount of leftover new car inventory is also a sign of slowing demand. These vehicles represent the heaviest discounted portion of new car inventory at dealerships. The 2016 leftover models have not sold yet and we already have 2018 models at a showroom floor near you.

10) How Important is the Health of the Rental Car Market?

The problems facing rental car companies today are very serious. It’s important to understand how their monthly per-unit expense relates to profitability.

There is a direct correlation between used car values and the car rental company’s monthly per-unit fleet cost. The rise in per-unit cost has a direct effect on profit margins. You can see this very clearly if you overlay the NADA used car value index over a stock chart during the same time period.

The monthly per-unit cost at Hertz is currently $348.  Consider what happened to sales into rental  (below chart) in 2009 with a similar per-unit cost.

11) Expected Results Versus Reality

Many respected sources are projecting flat retail sales for 2017 and a modest 1% decline in 2018. I respectfully disagree. We are simply too far along in a used vehicle value correction that currently includes light pickup trucks and SUVs. Leases will become less affordable as residuals rise. Without leases, we simply will not have the volume needed to meet those projections. I also believe that sales to rental car agencies will significantly decline moving forward. At this pace, the possibility of a major rental car agency going out of business in the next year is not out of the question.

12) Not Simply a Retail Sales Problem

It is not only retail sales that we need to worry about, but also manufacturing - an important part of our economy. A 10% reduction in the automotive SAAR can trigger a nasty set of events. The possibility of losing the affordability of leases, representing a growing number of retail sales, and fewer orders from rental car companies are enough to make a 10% correction a considerable and respected threat.

13) What Comes Next

I have a hypersensitivity to both changes in inventory and catalysts that impact used car values. Stable used car values are an absolute necessity for a healthy new car sales environment. As manufacturers continue to discount new vehicles heavily, they are simultaneously destroying the value of the used vehicle that potential customers need to trade in for the purchase of a new vehicle. The destruction of used car values offsets the effect of heavy discounting, lowers lease offers and pushes trade cycles out further. I view the manufacturers’ day-supply problem as a catalyst for the next leg down in used car values. Take a look at this chart from Morgan Stanley Research.

The first time I saw this, I did not believe that a 50% correction would be possible. I asked myself, Do they know the impact that a 50% correction in used car values would have on the automotive industry and the banks that service the loans?

Well, I stand here today as witness to a perfect storm that could make a 50% reduction in used car values a very real possibility. I have already witnessed signs that the truck and SUV market have corrected. The manufacturer's’ incentive response to a growing day-supply problem along with the supercharged discounting effect of more dealers fighting over fewer sales is the equivalent of dropping the MOAB on used car values. This set of events has made new cars, in some cases, more affordable than used cars.

Used car values will fall as a result but not immediately. Inventory at wholesale auctions will begin to backup as demand from dealers dwindles and sellers unwilling to accept sharp losses reject offers. This can only continue for so long as a tsunami wave of lease returns starts this year (2017) and will provide an unrelenting amount of inventory until the end of 2019. If inventory backs up at auctions, the drop in used car values will be sudden and unexpected, as sellers will have no choice but to unload the vehicles to the highest bidder. The effects will ripple through the entire automotive sector. Trade cycles will be pushed out further, leases will penetrate at lower percentages as residuals adjust, retail sales will slow, dealers will reject inventory, rental car companies will shrink their inventory levels as per-unit cost continues to rise, and ultimately manufacturing will slow or stop for a period of time while the rate of sale is adjusted.

The auto industry desperately needs a YOY beat in retail sales to relieve some of the pricing pressure from a growing day-supply problem. Another miss in May would be a detrimental event that could bring a slowdown or stop to auto manufacturing sooner than expected.

 

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Alfred's picture

His name was Seth Rich

Deathrips's picture

SO driving a 2001 paid off honda was a great idea...cant lose much value..and ready to buy when the correction hits.

 

His name was seth rich.

 

RIPS

 

#pizzagate

tmosley's picture

If he thinks this is bad, wait until the driverless electric on demand cars hit the streets at a cost of something like 5-10 CENTS per mile.

DJ Happy Ending's picture

sorry tylers, i love you, but how many years have we heard this same trope repeated over and over?

j0nx's picture

This. About as much as the next real estate crash which never comes. Sorry doomers but the ones in charge have hands firmly on the control levers now unlike in 2007. Only a major terrorist attack or war etc will crash this train and then it won't really matter anyway.

AltRight Girl's picture

Looks like we're all moving from cars to camels.

But who cares, as long as chicks dig them. wonder what type of camel Flotus likes.

Saudi Newspapers Praise Melania Trump for “Classy and Conservative” Fashion Choices

http://dailywesterner.com/news/saudi-newspapers-praise-melania-trump-for...

john doeberg's picture

Uber camels app has just been lauched.

Both on iOS and Android.

 

manofthenorth's picture

No need for all the charts and bullshit analysis.

CASH FOR CLUNKERS.

They just picked the winners and losers and pulled in forward business that had no organic support.

Now the chickens come home to roost.

See the pattern.

Government FUCKS UP everything it touches.

Stuck on Zero's picture

As far as I can tell Americans are wising up to the fact that used cars are not maintainable anymore. A five year old Mercedes or BMW can easily chew up $10K in repairs every year.  Some of the German and Japanese automakers used to roam the streets buying their older cars and scrapping them to keep up resale values. Tesla did that until recently.

artichoke's picture

Especially BMW.  That's a car to lease, not to buy.  So many very fancy precise things on them that don't last forever.  Even the exhaust sound is tuned by some elaborate system.  The opposite of a simple maintainable car.  What a change from the early 5-series with the straight-6.  I had one that I could start in any gear, 1 thru 4.  (There were only 4 forward gears, widely spaced.)  Now you need a computer to do anything.

Merc used to be famous for their 90 degree V8 engines that ran forever.  Now you can't get one, everything is turbocharged.  Literally everything.  Will someone tell me what is the point of a Mercedes if it's not for stuff like that?  I am driving a 2001 that I hope to continue to drive a lot longer, but I have no interest in recent model year Merc's.

 

NidStyles's picture

No idea what any of you guys are talking about. My 24 year old Nissan truck works just fine.

manofthenorth's picture

Ha HA. Me too but I am driving a 1989 D21 4x4 pick up that has crashed into a moose. Actually the moose ran into me but that is another story. I have installed a new set of pistons, replaced the usual, brakes ,starter , alternator, exhaust, water pump, u-joints, battery, etc. and almost all the glass in the cab after the moose incident. I will drive that little truck until the wheels fall off then will fix it again ;-)

ghengis86's picture

Right on.  I had a 1985 dodge ram half ton.  In the span of 3 weeks one winter I hit 3 deer.  They all bounced off and I dressed them and threw them in the back.  Went to the auto salvage yard and pulled off a grill and bezel three times in a row.  The plastic shattered each time, but everything else was metal and didn't leave so much as a dent (and some hair and blood).  The third time i went there the guy looked at me in disbelief.  "Again??!!"

Loved that truck.  You could sit on the wheel well under the hood to work on the engine.  The only problem was the piece of shit chrylser transmission. 

trysaratops's picture

Same here. Driving a 2001 Subaru with 300K+ miles and no issues. No car payment. Regular Maintenance is all.

Jedclampetisdead's picture

Lololol so does my 93 toyota pick up

Stuck on Zero's picture

I know a bit about cars but a friend of mine just sunk $5K into repairs on his BMW for parts that I don't even recognize. There are a hundred little metal boxes in the car with wires hanging out. Each one is $1.5K with installation. They go bad one after the other. My old 535i with its straight six had tons of space under the hood. A great car.

new game's picture

simple shit maynard; free cars for college grads to look for a job, that is regardless of whether they file bankruptcy on college debt. double down on our future...

Lore's picture

Arrgh. Quite nerve-grating.

Feel your audience! A good presenter doesn't skip steps and make leaps and assume that the audience will somehow miraculously fill in the gaps.

The presentation would benefit greatly from conscientious application of PLAIN ENGLISH, with clear definitions and visual aids to match.  It helps to test on a sample audience.  By 'gap,' do you mean 'difference?'  By 'incline,' do you mean upward or downward, and in what direction?  Never express time graphically on a vertical axis.

JARGON IS THE ENEMY.

Above all, GET TO THE POINT.  "Tell your audience what you're going to present, then present it, then tell them what you just presented."

docloxvio's picture

I believe you have nailed it.

The_Juggernaut's picture

This is some ZH doom you can believe in. Subprime auto loan bubble is going to pop at some point. Between that and the implosion of Hertz, Avis, etc, there's going to be some great deals on used cars soon.

helloimjohnnycat's picture

OJ will save their necks.

He'll be out in time for a new Hertz ad.

Attn all Mudsharks : Line forms on the right.

mike_king's picture

After the collapse, mudsharks will hang as traitors to their own people.

j0nx's picture

Hold your breath. It will happen annnny minute now. Keep holding it.

The_Juggernaut's picture

It's already happening. See share prices for Hertz and Avis. Both companies operate on very slim margins and will choke on their own vomit if used car prices don't recover (and they won't). You missed the boat again, sucker. :-)

tmosley's picture

Saudis moving hard towards secularization already, it seems.

Peanutz will completely miss this.

sinbad2's picture

You gotta watch those camels, last chick I was dating ran off with my camel, now I'm down 2 rides.

John Law Lives's picture

***   SPAM ALERT   ***

Do not click on AltRight Girl's link.

AltRight Girl = SPAMMER  

Handful of Dust's picture

I agree. Despite the fact massive defaults will occur, the politicians in DC will bail them out again instead of allowing markets do their thing and let them go bankrupt and repossess hundreds of otusands of cars and resell them to people who can afford them.

At least Trump is creatin gjobs as opposed to Obama who bailed out bankers and the MIC while screwing over the middle class.

The BEST predictions show over 8,600 retail stores will close in 2017. My guess is the number will be much, much higher partially due to broke consumers and the Dems and media blocking any of trumps moves for tax breaks and job creation.

 

 

new game's picture

a given they are bailed out. these are too big a problem to let fail. why of course.

if i could print i would bail em out too. i'd bail out my wife too. fuk, call 1 800 bail out 24/7/365.

printers running full tilt for bail out. hell, another round trip to sa for another 350b and a stop here and the with our best econ hitman and like wheel of fortune a trillion underwritten.

what is the problem you speak of?

ZeroPoint's picture

Yeah, I suspect the Fed will be buying these cars (with tax payer money) and having them crushed, rather than sell them at market value.

 

 

mike_king's picture

But we just want all the statist scumbags get their just desserts, which is starvation in the streets. Think of the sick mentality that one would have to have to vote for a corrupt and insane Hillary.

Son of Captain Nemo's picture

"Only a major terrorist attack or war etc will crash this train and then it won't really matter anyway."

j0nx

With $24 trillion + ($160 trillion in unfunded liabilities) being dragged behind like a sphincter that can't "pinch the loaf"... Say when brotha!... Cause the next "9/11" is being broadcast "LOUD AND CLEAR", even if you don't talk to any Syrian(s), Iraqi(s), Ukrainian(s) or North Korean(s)!

EmeraldWI's picture

If only there were a union left to blame....

Dudeskis's picture

I've been shopping for a new car for the past 4 months and I can assure you what this article is claiming is happening.  One reason I haven't pulled the trigger is the prices keep dropping.  4 months ago what I was looking at in a 2015 model I can now get in a 2016 model.  European luxury cars in the 2014 model year are falling through the floor in prices.  China syndrome level price dropping I kid you not.  Want a 2014 Mercedes E350 with 20k miles?  You can have one for $28k and 1.9% financing.

sinbad2's picture

Fuck the finance, taking on debt at the moment is crazy.

If you ain't got the cash, you can't afford it.

jerry_theking_lawler's picture

Wrong...their 'debt' at low rates to buy this shit. You keep your cash. If things go tits up...let them have their 'thing' back and you still have your cash.  But you are right...if you can't 'afford' it, don't buy it.

clade7's picture

I concur Dudeskis, anecdotally, the Car Dealers here are listing vehicles on Craigslist under the "For Sale By Owner" category!  Fucking up the whole place!

 

I bet the realtors are too!

post turtle saver's picture

cars are like electronics... if you can wait, you're better off waiting...

j0nx's picture

Not happening with hondas. I can tell you that. They hold their value like a mofo, all models of them. I'd like to get a used 4-5 year old civic SI to play around in because I sold mine when my daughter was born and those things are still $14k with 40-50k miles on them. I sold my 2011 in 2012 for $17k and they have only dropped $3k in 5 years? Ridiculous.

Dudeskis's picture

It's hard to know what the true used car values are as well since dealers aren't willing to list what they really might take.  A Ford dealer with 25 used Explorers on their lot is waking up at night in a sweat and might take 15% less what advertise just to free up cash.

There are exceptions of course.  Honda sedans, the Pilots/CRV are dropping, always do well because Honda doesn't sell to rental agencies so the off lease market is smaller.  Lexus LS and SUV/CUV models hold their value.  And then we have the goliath of used value, the Toyota Landcruiser.  A 10 year old Land Cruiser with 150k miles is still worth half or more of it's new value(if you can find one for sale).  A true unicorn of lasting value. 

GatorMcClusky's picture

Cars which can also be controlled by someone other than the driver...

tmosley's picture

You didn't think that one through. ALL modern cars can be controlled by someone other than the driver. Might as well let the fucking drive so you at least don't get into random accidents, which are about 50 million times more likely to happen than CIA assassinations a la Michael Hastings.

robertocarlos's picture

A damn good point. But I like to think they only wired his car for that kind of control. Maybe when it was at the dealership. Mercedes were the first car with drive-by -wire brakes.

E-Team's picture

Putins driver was killed in the same way.

bigrooster's picture

Not unless there is Onstar or some other wifi/bluetooth built in.  If there is just pull the fuse or disconnect the wires.

Dave Whiteman's picture

you mean the backseat driver?

King of Ruperts Land's picture

Like that will actually come to pass. Only loosers hold out for that. I am looking for a used BMW sport model (do they still make the M3?). I want manual transmission. I tried "sport shift on an automatic. That's not driving! I want no automatic braking (ABS)! Or at least a switch to turn it off. I learned how to drive, and I am pretty good at it and I like it. I want wide low profile sticky tires and hot pavement and wooo haaa!

By the way, moron. It already has come to pass: Its called THE BUS. but there is a minimum charge like $1.50 or such.

AND

His name was: SETH RICH

tmosley's picture

That's a lot of cognitive dissonance you have there.

Worried?

man from glad's picture

This comment reminds me of how Solar was going to be soooo cheap one could do a system on a 2000 S.F. house for $2000. I'm still waiting....