What’s the Verdict on Subvented Leasing?
Guilty as Charged?

The Manheim 2006 Used Car Report is one of the essential references that industry professionals and analysts rely upon for definitive data and analysis on the automotive industry. It contains information of the used car market and the four automotive activities that most directly affect auction volumes and used car values:

		Leasing
		Rental
		Fleet
		Repossessions

Tom Webb, Chief Economist for Manheim, has forgotten more about the used car market than most of us will ever know! However, this year, AFU takes exception with some of Tom’s critique of leasing in the 2006 Used Car Report. In particular, we call to your attention the following points:

#1. 2006 Used Car Report: “Use of overly aggressive lease subvention to simply ‘push metal’ often forced the lessor to offset the artificially low monthly payments with unrealistic mileage limits, large mileage penalties, or excessive early termination fees.” [p. 17]

AFU: we don’t know of ANY major lessor that did those things. Captives and banks may have enforced wear and tear more carefully than in past years, but virtually all major lessors use an actuarial early termination formula and we are unaware of any higher, let alone excessive early termination fees. Thus, while the early termination deficiency may be greater because of lower used car values, there are no “excessive early termination fees.”

With respect to excess mileage, more than 50% of consumers have chosen mileage limits of 12,000/yr or less for 10 years. This is not a recent change from the standard 15,000 miles per year. It is true that some manufacturers have advertised especially low annual mileage such as 10,000 miles/year, to gain lower lease payments. Lessees who drive substantially above the lease allowance do then face large excess mileage charges at lease end that may not have been fully weighed at lease inception. However, for many consumers, a 12,000 or 15,000 annual mileage allowance exceeds their expected usage so having flexibility in the mileage allowance is beneficial to consumers. While dealers can alert consumers to the end-of-term charges, ultimately it’s the responsibility of the consumer to choose a realistic mileage allowance. Many people forget that the protection against excess depreciation is independent of any excess miles they may drive and that their trade-in value would also be less if they owned the higher mileage vehicle.

#2. 2006 Used Car Report: “In contrast, today’s contracts are more likely to be drawn up to fit the driving habits of the individual lessee.” [p. 17]

AFU: Not so. Low-mileage lease penetration continues to grow, as do longer term leases as well, even though people aren’t, on average, driving less or intending to keep vehicles longer. And excess mileage charges and early termination formulas haven’t changed either.

#3. 2006 Used Car Report: “A more fundamental drawback to the incentivized leases of the past is that they often put the wrong type of customer into the car. “. . . Subvented leases often ended up with the customer who couldn’t qualify for the retail loan on the same vehicle.” [p. 17]

AFU: Possible in rare circumstances but very unlikely. The captives virtually all adhere to similar or higher credit standards for leasing compared to retail loans. The high credit standards reflect, in part, the higher loss exposure that is present in leasing. Not surprisingly therefore, most banks and finance companies have higher credit requirements for leases. However, there are certainly cases where a highly subvented residual value and a longer term lease results in a low monthly payment that enables a consumer to satisfy the requirements for debt to income ratio, which would not be possible with even a very long term loan. This would be rare, however.

Customers generally follow the subvention promotion and take the “best deal.” When leasing was the best deal, that’s what was chosen. When cash rebates and 0% financing were offered instead of subsidized leases, which was the “best deal” so these same customers just “followed the subvention cash.” Leasing has always attracted “payment shoppers” and not just “true lessees” who understand all of the benefits of leasing including the residual value/fixed trade-in value and the conservation of capital benefits. “Payment shoppers” need more education to ensure that they understand the lease transaction and the restrictions as well as the benefits. But it is a bit elitist to say leasing should be limited to college graduates, 6 figure incomes, or “only the financially sophisticated.” The fact remains that leasing conveys a variety of benefits to consumers, whether or not they understand all of them.

From the point of view of lessors, while Mr. Webb is right that there have been fewer leases written to consumers with credit scores below 720 by major lessors, this is because leasing rates have declined for non-luxury brands while staying relatively constant for the luxury brands.

#4. 2006 Used Car Report: “The subvented leasing of the past benefited, in the end, only auction industry volumes.” [p. 15]

AFU: We disagree! First, we believe that Mr. Webb would agree that consumers who completed the lease term and returned the vehicle to the lessor benefited, often by thousands of dollars in savings, from the subvented leases, second, even in cases where the customer had excess mileage or wear and tear, that did not negate the overall savings from the depreciation savings. The consumer may not FEEL better off, but in fact they are better off than financing or having a lower residual value. In addition, not all lease subvention is the same. Third, lease rate subvention needs to be differentiated from residual subvention. Many manufacturer lease subvention programs combine both rate and residual subvention. Rate subvention benefits the manufacturer, dealer and customer by reducing the monthly payment just as it does in retail loan rate subvention. The cost of the lease rate subvention is generally easier to estimate than loan rate subvention since most subvented leases do not terminate early.

Dealers also benefit from the lower monthly payments made possible by lease subvention. Frequently, manufacturers also benefit in that there is not the immediate negative effect directly on used car values as there is in retail cash rebates and loan rate subvention. And indirectly there is less damage to brand image. Of course, there is the long term risk of too many vehicles being returned to the used car market simultaneously, which will depress used car values as we have seen. This is undoubtedly what Tom is referencing. When residual subvention is too large, residual losses increase geometrically, not arithmetically, since the return rate skyrockets (“loss frequency”) in combination with the loss per return (“loss severity”). However, it was the combination of the “100 year flood” decline in used car values from ALG predicted levels, particularly for SUV’s, that combined with residual subvention to cause catastrophic losses.

The same residual enhancement strategy paid off handsomely from 1989 to 1994 when ALG was understating actual residual values. Residual subvention is risky because of the unknown used car market factors and because too many returned lease vehicles channeled through the wholesale markets reduce trade-in values for the whole brand and increase new leasing costs by reducing future ALG residuals. In such cases, offering the subvented leases can damage brand value more than other types of subvention.

Finally, since the dealers have made additional marginal sales, and gotten the highly profitable used car trade-ins and service/warranty business, dealers certainly benefit from lease subvention in the short run, even if consumers complain about excess mileage or wear and tear. However, in an environment where ALG residuals are already overstated, dealers suffer the same long term effects on brand image and value as the manufacturers do. Certainly, the lessor loses if residual losses increase exponentially (or the manufacturer if full risk is transferred). On balance, consumers certainly benefit from lease subvention, dealers always benefit in the short run and the long term risk only occurs if overall brand value is affected. It’s really just the lessors and manufacturers that lose if future residual losses are substantially underestimated.

All and all, subvented leasing IS a highly leveraged product. It has the POTENTIAL to cost much more than the lessor estimates, and to even damage the BRAND for the manufacturer who takes too aggressive an approach. However, when ALG turns out to be conservative (as it was on the 1989 – 1994 RV’s for leases that terminated 1992 – 1997), subvented leasing is a WIN-WIN-WIN-WIN for the consumer, dealer, lessor and manufacturer! When ALG is accurate, even if the subvented portion of the residual value is lost on returned vehicles, lease subvention is more cost-effective, more profitable to the manufacturer, more powerful for the consumer and dealer than cash rebates and subsidized retail rates. Let’s not “throw the baby out with the bath water” with respect to subvented leasing. The manufacturers haven’t, for good reasons!

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