Auto Lease Deals on Rocky Ground: The effects of inflated residuals on securitizations and the used-car mart


It could be a slippery road ahead for existing auto lease-backed securitizations, thanks to inflating residual values of cars that are coming off three-, four- and five-year leases originated in the mid-1990's.

According to Joe Astorina, an analyst at Fitch IBCA, inflated residual values set by the lessors at the point of origination are poised to disrupt cash flows in these deals as these leases mature.

That's because when a lease reaches its maturity, the car that was leased might be worth substantially less than the projected value at the signing of the lease. As such, when the lessee has the option by contract to purchase the car for a certain price, he may pass on the sale because the identical car will likely be available on the used market for a fraction of the price.

"Basically, what that means is that the captive finance subsidiaries of the major manufactures - not just the domestic U.S. ones, but the Japanese and the Europeans as well - were setting the residual values on these vehicles at a pretty high level, higher than what could actually be expected," said Astorina.

As an example, Astorina described a vehicle with a lease purchase option of $16,000, when the same car in the used market might sell for $11,000.

"We would expect the lessee then to return that vehicle to the dealer, and the dealer would probably in turn return it to the manufacturer, which was the originator of the lease," he said. "And then the leasing company would be stuck with that vehicle, and would have to dispose of it in the used car market. They would sell it for $11,000 and realize a $5,000 loss."

This is all bad news for deals backed by leases originated in the mid-1990s, because, Astorina said, the securitizations will come up short of total cash flows.

"And this could end up in credit enhancement draws in the form of straining excess credit, excess interest collections," he said. "And if it gets severe enough, it could end up actually drawing down reserve accounts or hitting subordination."

However, Astorina does not expect the situation to get that severe.

"It's more likely to get to the point where it puts some pressure on excess interest collections," he said.

In the broader picture, inflated residuals may have a significant impact on the used car market, not so much in that these vehicles are coming back less than their stated residual values, but by virtue that so many could be coming back, Astorina said.

"We could end up seeing almost a flood coming onto the market," he explained. "You're going to have to give somewhere. What that translates into is a potential decrease in recovery values for vehicles that are repossessed."

If the obligor defaults, then the lending company that made a loan has to repossess the car and dispose of it, most likely in used car market. As a result, because so many other off-lease vehicles will be coming into the used car market, the market will already be in a saturated condition.

"It could end up putting pressure on the price these liquidators are trying to get for these vehicles, which could in turn end up pressuring some of the loan securitizations that are out there as well," he said.

However, he added, "[These things could happen] if it were severe enough. We don't really expect it to get severe. It's just an area that we are watching and continue to monitor closely."