Pumping up a Leaking Tire

Guest Post by Eric Peters

Every kid knows what happens when you try pumping up a leaking tire. As soon as you stop pumping air into it, the tire begins to go flat.

New car sales have been working that way for the past couple of years – with effectively free (zero or little to no interest) loans extended over the horizon – and leases counted as sales – serving as the “air” in the tire.

We’ve been told that business is great.

In fact, it’s as rickety as a Jenga tower.

What’s happening in the used car market is a portent. Prices are collapsing – chiefly because of historically unprecedented depreciation. During the past twelve months, the average used car lost 17 percent of its value. This is almost twice the annual average depreciation rate just three years ago. It smacks of the post-2005 collapse of housing prices.

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There are several reasons for what’s happening, all related and feeding off one another like chum-crazed barracudas.

The first is the inflated prices – as distinct from value – of new cars.

Things that have value – intrinsic worth – tend to retain it. Things that merely cost a lot – when they are new – but whose value is essentially a function of their newness and not intrinsic worth – hemorrhage  value the moment after they are no longer new.

This used to be almost uniquely true of high-status cars, which people bought largely on the basis of their being the Latest Thing. A year – six months – later, of course, they no longer are. This is why a high-end car that sold for $80k three years ago is worth maybe $50k today.

And will be worth next to nothing – relative to its purchase price – five years from now.

But this canker now afflicts cars generally.

Part of the problem is that all cars are now priced – and sold – to a great extent on their being the Latest Thing. Not on the merits of the parts of the car that serve to make it go, which get you from A to B. The internal combustion engine is a near-perfected technology. Has been, for at least 20 years. There are few new Big Strides to be made.

Instead, little steps at big expense.

But there is not much value in this.   

How does the buyer benefit from – as an example – the changeover from a six-speed transmission to one with nine or tend speeds? The car now gets 2 MPG better mileage – on the EPA’s test loop – but it costs $600 more than it did last year. And it will cost much more to repair when the more complicated components fail.

The price goes up – but the benefit doesn’t track with it.

Gadgets – electronic things – have an extremely short shelf-life. From the resolution of the touchscreen to the speed of the processor that runs it. And modern cars have become more gadgets than cars. Cell phones that roll. But very, very expensive cell phones. The average cost is now well over $30,000.

So people rent rather than buy. That is to say, they lease.

Leasing is a short-term (2-3 year) commitment; it is a revolving-door way to perpetually drive something new. And a way to avoid being stuck with something old.

It is also a way to hide the inflated value of new.

The monthly rental payment is much less than it would be if the car were purchased (i.e., financed). Leasing also helps the car industry hide the growing problem of people not being able to afford new. A 2-3 year lease (and revolving debt) rather than trying to spread payments over seven or eight years, in order to make them manageable. But then arises the almost-inevitable problem of the buyer owing more on the car than it’s still worth after making five or six years of payments on a seven or eight-year loan – which is becoming a general problem.

KAR Auction Services – a major industry player – expects vehicles repossessions to more than double this year, in the vicinity of 2 million or more than twice the number of defaults at the bottom of the post-housing collapse recession/depression (which we’ve never really recovered from, Happy Talk and Wall Street notwithstanding).

Leasing used to be a small slice of the new car business; something realtors and a few other professional people did in order to take advantage of tax deductions for their business-related car expenses.

Less than 10 percent as recently as the late 1970s.

Today, leases account for a third of all new car transactions (see here). This fact – which ought to send a cold chill down the spine of anyone with a stake in the health of the car industry – tells us a lot about the fundamental unsoundness of the new car business. When roughly triple the number of people who used to buy now rent, you have a problem, Houston.

You also have blowback.

The main factor driving today’s alarming depreciation rates is the glut of used cars on the market. And a very large number of these cars are ex-lease cars. The presence of vast fleets of 2-3 year-old cars on the so-called secondary market depresses the primary market. Why buy a new car for $35,000 when you could buy the same car – more or less – with 30,000 or so miles on it (hardly broken in, for a late-model car) for $20,000?

Conversely, it’s hard for the new car salesman/dealer to make a decent profit on a new car given the downward pricing pressure created by all those barely-used/ex-lease cars sitting on the lot.

Either way, margins are slimmer than a Dachau inmates thighs at this point. And that is unprecedented. Usually, new car sales are strong – and profits good. Or used cars are selling at a healthy profit. Today, there is the scent of desperation in the air.

The earnings being reported are Enron-esque. A spreadsheet Potempkin village. There is a reason why the entire car industry is frantically investing in ride-sharing and “transportation as a service,” the latter amounting to leasing by the hour and day.

It is like a starving man scraping the bottom of the barrel, hoping to find some leavings.