A number of years ago, I helped my oldest daughter with a project for her science class. The assignment involved monitoring short-term weather forecasts and comparing them to the actual outcomes a few weeks later. As a large part of my career has revolved around predicting the future performance of things, I decided to have some fun with her in order to make a point.
I instructed her to track all of the major national forecasts for the Dallas area (i.e., AccuWeather, WeatherBug, The Weather Channel), as well as the daily forecasts from our four local network news stations. To her surprise, the local weather forecasts were consistently more accurate than those produced by the major national forecasting groups.

The reason for this is simple – local meteorologists are much closer to the problem. They place substantially more focus on local factors that influence how weather systems move through the area, and tend to be better at recognizing when a quantitative model spits out nonsense. This is a lesson that I am certain would be useful for those who follow the auto finance industry.In March 2017, Ally Financial issued guidance suggesting that earnings could be lower due to a decrease in vehicle recovery

values. The next month, MarketWatch quoted Jamie Dimon, CEO, JP Morgan Chase, warning that lenders would likely be impacted by negative trends in vehicle values. Never ones to miss a potential crisis, the national media outlets set to work sounding the alarm on the next meltdown, issuing a slew of stories over the last year, which included the following:

• “How much Morgan Stanley thinks used-car prices will crater — in one chart”, MarketWatch, April 10, 2017.
  Most people abuse the acronym “LOL”, but in this case, I actually did laugh out loud. The analyst produced a chart that projected a potential 50 percent drop in the Manheim index by 2021. The Manheim index is pegged to 1995 dollars, and is not adjusted for inflation, or the value of new vehicles. This prediction essentially says vehicle values will drop to 68% of 1995 dollars. A two-year-old Toyota Camry presently sells for around $16,000, which equates to $9,000 in 1995 terms. Therefore, a two-year-old Camry will sell for about $6,100 in 2021 – LOL.
• “Off-lease vehicles are flooding the market, pushing prices down”, FoxNews Auto, May 26, 2017.
  The U.S. has seen approximately 500,000 off-lease vehicles enter the market each year since 2013. Predictions of a vehicle value cliff resulting from off-lease volume have been made for the last four years, but that has not happened. Supply does matter, but it has been offset by compensating factors.
• “Your car is now worth less than you think – a glut has used cars depreciating at a breakneck pace”, Bloomberg, August 21, 2017.

A massive shortage inventory between 2010 and 2013, combined with the return of capital and consumers following the downturn, led to record high used vehicle values. Demand levelled off in late 2016 followed by a temporary increase in supply. The Bloomberg article measures the drop in values from the peak in 2014 through the end of the buying season in 2017, when values were at their seasonal low point. This is kind of like measuring the change in population rate from Adam to Cain, and using it as a baseline for future growth.

I suppose I should be grateful every time one of these stories is published, because I receive loads of consulting work from bond and equity investors. On the other hand, the fear induced by these articles creates disruption among investors and lenders alike. The time has come to switch to the local weather forecast.

A multi-dimensional problem

The focus on this issue is not so much about the current state of used vehicle values, but where they will be at specific points in the future and what that means to the bottom line. For lenders, the concern is what the car will be worth at the time it is repossessed and put through the auction, which on average occurs 15 to 18 months out for sub-prime lenders. For lessors, the problem relates to what the vehicle will be worth at the end of the lease, which is on average 36 months out.
Many conceive of future vehicle values as a simple function of supply and demand. While those factors are important, they do not alone adequately account for the variation in recovery or residual rates. A robust forecast must include:

• Vehicle mix – “Supply of what?” and “demand for what?” are the critical questions to ask. Many of the off-lease vehicles have been in the truck and SUV class. For the past several years, recovery rates have been high in that category due to strong demand. In contrast, small to mid-size vehicles have been in oversupply, leading manufacturers to make production cuts at plants where those units are produced. Small to mid-size car values have trended 3-5 percent down for year over year comparisons since 2015, but production cuts made in 2016-2017 have started to reverse that trend.
• Availability of credit – In 2009 to 2010 there was high demand for autos, but with little credit available, it did not matter. From 2011 through 2015, a tremendous amount of capital poured into auto lending, and as a result, used values were very strong. Consumers’ normal buying patterns are often influenced by things like incentives, interest rates or other promotions. When this happens, demand is pulled forward in time (i.e., the transaction would have otherwise happened later). An abundance of credit allows people to respond to these influences more frequently, whereas a capital crisis prevents this, subsequently putting downward pressure on values.
• Economic factors – Consumer expectations around employment, inflation, global stability and income play a large part in the supply and demand equation. Uncertainty around the election and economy was high in 2016, resulting in a levelling off of overall demand. Since that time, GDP has picked up, tax cuts are on the way and unemployment is at record lows. We are now seeing a seasonally adjusted annual rate of new auto sales rise in 2018. On a micro level, low fuel prices have directly contributed to a strong demand for trucks and SUVs, which have propped up their values while other classes have declined.
• Lender behavior – In the July 2016 edition of Non-Prime Times, I wrote an article on recovery values, and provided an illustration of what happens to net credit losses with a 10 percent drop in auction recovery values. All things being equal, it amounted to half a percent on an annualized basis (visit www.nafassociation.com/subscribe.php to view the article). Of course, anyone who follows auto lending knows that lenders can see 500 basis point swings in recoveries across the credit cycle – so what is driving such volatility? In my estimation, 70 percent of credit performance is determined by what happens at origination. Approximately 20 percent is related to servicing strategy, and perhaps 10 percent is the result of exogenous factors such as the economy. If the company is allowing higher loan-to-value ratios, for example, recovery rates will subsequently drop. How a lender validates vehicle-adds or books out the vehicle will also have an impact. Over the last four years, I have observed some lenders increase the use of deferments, and push out repossession assignment dates. Much of that amounts to delaying the inevitable charge-off, which can rapidly drive a 45 percent recovery rate into the high 30s.

Used vehicle outlook

There have been two periods in the last 20 years where there was a shock to vehicle values. The first was in the quarter one of 2003, when manufacturers were offering employee-pricing incentives at the same time rental car companies were dumping their fleets. Sub-prime auto recovery rates for large mid-tier players dropped from 45 percent to 38 percent within two months. A similar downward recovery spike happened in the fourth quarter of 2008, when the capital markets suddenly contracted and credit availability evaporated. The drop was short-lived, and within a few months, values were back up again.

When sudden shocks to vehicle values occur, opportunistic consumers rush to take advantage of the situation. This causes the excess inventory to rapidly disappear, which pushes prices back up. The vast majority of the time shifts in used vehicle values happen at a modest pace over several years. This is true of most market factors, including economic catastrophes. The Great Recession began in 2007, when unemployment was at a low of 4.5 percent. It took a year for it to climb to 5 percent, and another year to reach 7 percent. As such, any change coming in the near future is much more likely to be modest and gradual as opposed to a sudden bottoming out.

Production cuts by major manufacturers, starting in late 2016, are already starting to have a positive effect on dealer inventories. In addition, the inventory glut from 2017 has completely turned around (refer to the Production and Inventory graphs on page 15 – Charts 1 & 2). While this data relates exclusively to new cars, it is relevant to lenders because this determines the supply issues two to three years down the road, when these vehicles are traded in. All of this suggests we are not likely to see a major mismatch in supply versus demand, barring a major economic setback.

With regard to the availability of credit, there has been a modest contraction in sub-prime auto. In some cases, this is due to capital constraints for privately held companies. In other cases, large lenders, such as Santander, have tightened credit. This notwithstanding, credit availability remains strong, and is not likely to change in the near term without a major capital crisis (refer to the Consumer Credit graph – Chart 3).

There is little question that the economy is the strongest it has been in many years. Gross Domestic Product and Consumer Sentiment are on a sustained upward swing, while inflation, unemployment and interest rates remain at record lows. While the Federal Reserve is likely to raise interest rates over the next 24 months, it is not expected to be more than a percent. Such small increases are easily absorbed, particularly by sub-prime lenders where the customer tends to be payment sensitive instead of rate sensitive.

Final considerations

The largest increase in vehicle values in recent history occurred between 2009 and 2011, which was a side effect of the last economic crisis. The abiding fear has been that “what goes up must come down”, and so market watchers have been anxiously awaiting a collapse; but the overall state of used vehicle values is not related to what happened nearly a decade ago – it is a direct outcome of the market dynamics today.

Production has been adjusted, the economy is strong and consumer credit is widely available. All of these signs point to only modest changes in the coming year. A spike in fuel prices will affect gas-guzzlers, an interest rate increase may influence prime demand and an increase in off-lease could put pressure on sub-prime recovery rates. None of these possibilities will impact lenders to the degree that their own underwriting and servicing practices will.

It is easy to predict doom and gloom. If things turn out well, no one will remember. If they turn out poorly, one could claim market clairvoyance. With that in mind, I will close on some very real, and positive, possibilities. Businesses and consumers have not yet experienced the full effect of the tax cuts. This is also the first recovery that did not involve housing starts, which are only half of where they were at their peak in 2006. A robust housing market combined with employment levels that push wages higher could lead to a significant increase in consumer spending. If that happens, we may find that the production cuts to small and mid-size cars may have been too much to meet increased demand, leading to a sizeable increase in recovery values for those vehicle classes.

Overall, the data suggests that used vehicle values will remain stable for the near term, and are not in danger of cratering. Lenders and analysts should keep in mind that change is gradual, and inventory issues are often compensated for by a host of other factors. Many lenders model depreciation rates on their own portfolio data, which is better than not modeling anything; however, I strongly recommend that lenders take advantage of the excellent auto valuation data products provided by major national vendors, as most of the answer for future values is not contained in the company’s own historical data. Strong analytics combined with disciplined underwriting and servicing will prove very powerful in mitigating any unforeseen shifts in used vehicle values.

If you would like to receive TruDecision’s free quarterly Auto Finance Market Report, or our monthly update on forward looking vehicle values, please e-mail Solutions@TruDecision.com.

Daniel Parry is co-founder and CEO of TruDecision Inc., a fintech company focused on bringing competitive advantages to auto dealers and lenders. He is also co-founder and CEO of Praxis Finance, a portfolio acquisition company, and co-founder and former chief credit officer for Exeter Finance Corp.