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"Losing the Leasing Option"

by Greg Mermel, C.P.A.

Published in the "Money and Taxes" column in PerformInk on August 29, 2008

Recently, the "Big Three" American car makers announced changes in the way they would finance their buyers' vehicles. Chrysler said that its finance arm would no longer write leases -- only loans. Ford and General Motors sort of mumbled into their coffee that, well, they would still write leases but the terms would be somewhat less generous; in fact (cough, cough), lease payments would no longer be less than loan payments for most buyers.

The Asian and European car makers have not said much. I have no doubt that they, too, are quietly making lease terms less attractive even though they are generally thought to have written fewer leases than the Americans and to not be as badly affected by declining residual values.

Leasing as the Other Side Sees It

Usually when I have written about automobile leasing, it has been from the perspective of a driver choosing whether to lease or to buy. As I wrote last time ("Saving the American Economy with New Cars"), when you lease "... all you are buying is the use of a car for the first X months of its life, after which your leasing company has a nice used car to sell. Because the residual value remains with the lessor, they don't have to make their entire profit on the transaction from you."

Let's look at that from the seller's viewpoint. (For simplicity, I will assume that you finance through the car maker's own affiliate rather than your bank, and will not try to distinguish the manufacturer's profit from that of the dealer.) Under either a lease or a buy scenario, the manufacturer and dealer have two opportunities for profit: (1) difference between the interest they charge you and the interest they must pay, and (2) the sale of the car for more than it cost to make, ship, etc.

Whichever way you finance the vehicle, the lender knows the amount of its interest-based profit (or loss) up front since the interest rate you pay, their cost of funds and the amount financed are all fixed. But they will only realize that profit (or loss) as you make your monthly payments.

"Loss??" I hear somebody say. "How can that be?"

It's easy. You have seen all the ads for zero percent financing (or 1.9 percent or some other low rate). You surely do not think Santa Claus or the tooth fairy gives them the money to lend. They have to borrow it, and at a significantly higher interest rate.

Why would they willingly lose money? The short and obvious answer is that their profit on the sale could more than make up for it. I think there are other and subtler reasons, and will come back to them later.

How Many Times Is the Same Car Sold?

If you buy a car, the manufacturer/dealer profit is also established up front.

If you lease, their ultimate profit is not known until the lease ends. Two sort-of sales occur up front: from the manufacturer to the dealer and from the dealer to the manufacturer's finance affiliate. (If the dealer were not in the middle, accounting rules would not even let the car maker recognize a sale having occurred.) So some element of profit or loss is set at the beginning, though those numbers can be charitably described as easily manipulated.

But the key determinant of profit or loss is what the car sells for at the end of the lease, its "residual value." At the beginning, that has to be an estimate. If those estimated residual values prove to be high, that nice little profit can turn into a big honking loss.

And that is exactly what happened. The current residual value of many SUVs may be half what was expected at the inception of the lease. Other types of big, relatively inefficient vehicles are seeing less drastic, but still hefty, markdowns.

Ultimately, it reduces to "who bears the risk?" In a sale, the buyer takes the risk of the car being worth less than expected. In a lease, the finance company does. So how did these car finance companies -- presumably expert and experienced -- get it so wrong?

The Sin of Hubris

For various historic reasons, American car makers have always had factories optimized to turn out large numbers of mostly identical cars. The technology to allow more flexible factories, both as to product mix and volume, came later and was largely developed by the Japanese. The American manufacturers were slow to adopt this new way of working. Partly, this came from the curse of many big organizations, "not-invented-here syndrome."

But they also figured that they did not need to change, that they had evolved a successful system to manage supply-driven marketing. If inventory built up, they maintained their sales volume by selling the unwanted to the daily rental companies, cheap. Very cheap.

Going back to my earlier point, they might offer generous loan terms to consumers. Book a profit on the sale now ("Gotta make those quarterly numbers look good!") and the loss on the financing over the next few years. ("We'll figure something out later.")

Or they could boost their current sales numbers with cheap leases. They could make the leases extra cheap, of course, by estimating the residual values high. Naturally, they were scrupulously honest and conservative in making those estimates, so it's not their fault everything went terribly pear-shaped.

You say you don't believe that? Good, because neither do I.

The, er, generous residual values on leases did more damage than just deferring the day of true economic reckoning. They also shared an ugly co-dependency with manufacturing's unwillingness to make changes in the product mix that academics, newspaper pundits and the foreign car makers could all see were going to be needed. "Why should we switch to smaller cars, when we make so much money on big ones?" But were they?

Or did they just forget that Icarus's wings melted?

Free Offer

Every year during the income tax season, I offer free copies of my “Checklist of Potential Deductions...” for those in the arts. Just call my office, or send an email to checklist@gregmermel.com.

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