Another round of lease residual losses

About four million vehicles come off lease this year, sparking yet another round of big residual losses.

No one is predicting it will be the last go-around of residuals gone bad. But the leasing industry has reformed its ways, trying to avoid the additional pain of large-scale losses from rosy residual forecasts that turn out too high.

Most vehicles coming off lease are 1998-99 models with actual values less than forecasted residual values set at the start of the leases.

Those were set in the days when leasing was heady, the economy good and residuals were set aggressively high to entice customers with low lease payments.

“They were set at a time when everyone was bullish,” says Raj Sundaram, an analyst for ALG, which publishes the Automotive Lease Guide, a major residual setter.

Now those vehicles coming off lease “stand to lose money,” Sundaram tells the Auto Remarketing Forum in Las Vegas.

They won't be the first batch of off-lease vehicles to do that. Just the latest.

Lease deals are built on what the lessor expects — and in some cases, only hopes — a vehicle will be worth off-lease. It's cause and effect. The higher the residual forecast, the lower the customer's lease payments.

Banks, leasing companies and automakers' leasing operations got burned that way, losing hundreds of millions of dollars over the last few years. Some cut their losses and got out. The survivors now set residuals more conservatively.

But the sins of the past return with that crop of three- and four-year-old leased vehicles entering the used-car market this year — many carrying actual values below predicted residual values.

Colossal residual losses, that have plagued the leasing industry for the past five years, are expected to abate in 2003. That's because of the controls now in place, says Sundaram.

Today's more conservative residual setting means higher lease payments to consumers.

“Lease payments are $80-$100 a month higher than before,” says Sundaram. “A lot of people — driving Lincoln Navigators and Ford Expeditions through a good lease deal in the past — are in for sticker shock because residuals are more realistic. You're not going to find a $299 a month lease deal on an Expedition.”

But one of the first questions a prospective lessee asks is: “What's the monthly payment?” notes Stuart Angert, president of Remarketing Services of America.

“The temptation to that is to ratchet up the residual values as a way to lower the payments,” he says.

Last year, the average residual loss was about $1,450 a vehicle. In 2000, it was $1,365 per vehicle. Losses in 1999 were terrible — nearly $2,000 per vehicle. Lessors have been losing money on nearly 85% of off-lease vehicles returned to them, says the Consumer Bankers Association.

Lease portfolios contain millions of vehicles, and even residuals that are off by only a few hundred dollars can “add up to millions of dollars,” says Angert. “It's a direct hit on a portfolio's bottom line.”

Residual setting has come full-circle. When leasing first became popular, residual forecasters tended to underestimate the ultimate value of vehicles, setting low residuals.

Then they went the other way. They began overestimating values through higher residuals. Now, says Sundaram, they may soon be back to underestimating.

“By June, we could see residual values $500 lower than actual,” he says. “Residuals have been stabilizing. The big question is whether they'll go back up as we see increases in used-vehicle values.”

Leasing is losing some of its popularity. Reasons include the end of those unbelievably low-payment lease deals of yesteryear as well as manufacturers currently offering generous incentives to new-car buyers.

“The lease bug bit a lot of people already, so I don't see leasing going away,” says Tom Kontos, an economic analyst for ADESA Corp. “It just may not be as attractive as low APR rates offered for buying.”

Leasing peaked in the 1990s when it accounted for 33% of the new-car market. Now it's 23.8%. Sundaram sees it setting down at 26%.

Of cars that come off lease, about 20% are purchased by the lessee and 20% by dealers. The rest go to auctions, where forecasted residual values collide head-on with actual values in the bidding lanes.

“The value should be whatever the market dictates,” says Kontos. “Lessors who pumped up residuals did that for sales. It's not the fault of the market.”

For all its problems, missteps and lost money, leasing remains an effective way to move the metal, build customer loyalty and potentially make money.

Says Kontos, “Leasing is the most important automotive trend in the last decade. Some of the players are gone, but leasing will stay around.”