If you see a millennial in a hot car, chances are it’s leased. Here’s why leased cars are causing problems in the world of auto lending.
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Leasing has become all the rage, and it’s quickly creating a car-lease bubble that’s quickly becoming a huge problem in auto finance.

In recent years, leasing has helped drive auto sales to new record highs. Millennials comprise the “largest demographic for vehicle leasing.”

Borrow it for a while, then give it back

Leasing is pretty straightforward: instead of buying a car, you pay to use it for a given period and return it to the dealer when you’re done. Leases come with mileage limits and penalize consumers for excessive wear and tear. For millions, leasing is a no-brainer, as you can often drive a luxury car such as a Lexus for the same price as a regular car such as a Toyota.

Of course, after you’ve returned the car, you start at zero again with no equity or a trade-in that you would have had if you had purchased the car. On the brighter side, leasing allows people to always drive around in new cars and change them out every four years or less. That means your car is likely under warranty, and mechanical problems are covered by the manufacturer.

Numbers-wise, leasing prices are are all dependent on residual values, or the value of the car once the lease is over. Once that sweet ride that your neighbor likes to cruise around in is turned in, auto companies have to sell that auto on the used-car market. This is where automakers are beginning to hit a major snag.

Used-car market beginning to cool

As a member of a large extended family who leases all of our cars, I started noticing after the Great Recession that lease prices were coming down significantly.

This was strange because car prices continued to rise, so there was obviously a part of the lease formula that was being manipulated by auto lenders. Of course, lease prices were lower because of  low interest rates, but that was only part of the explanation for dramatically lower prices.

Essentially, when interest rates came down after the recession, the used-car market boomed. Most of decline was because the blossoming used-car market caused a surge in residual values for leased cars. As a result, millions of leases were originated with inflated residual values.

Confronting their fudged math

Now, as interest rates trend up, the used-car market is beginning to cool down, sending residual values downward. But auto lenders have millions of cars out there that haven’t been returned yet. As those cars get turned in, these lenders face massive losses that amount to a ticking time bomb.

Automakers fell asleep at the wheel when creating their lease portfolios. Many of them even openly admit that they’re not really paying attention to residual data at all, even though they concede it’s a critical part of their profit model for leasing.

According to the Wall Street Journal, Japanese automakers Toyota, Honda and Nissan are beginning to confront their past bad habits in auto leasing. For many years, they saw strong growth in sales because their growing lease volumes.

For these manufacturers, residual or recovery values have been much lower than expected. Simply, their estimates for how much money they would make post-lease were off by a lot. Toyota has already set aside billions for “losses in residual value.” Many analysts expect other auto companies to face a similar scenario.

If used car values drop significantly, it could really hurt many car companies’ balance sheets.

Pop goes the bubble

Auto lending has enjoyed massive growth since the Great Recession, and the automakers have low interest rates to thank for the boom. This lending boom isn’t limited to auto leasing, as the entire car market has been stoked by cheap money. There’s little doubt that this level of credit in the car market is unsustainable.

Last year, people began sounding the alarm and labeling auto lending a bubble. Banking mavens such as Jamie Dimon, the CEO of J.P. Morgan, have guided their financial institutions away from loose lending in this sector because they see a correction around the bend.

Takeaway: Leasing will increase in price soon

As cars leased three and four years ago are returned, auto lenders will face massive losses, especially if used car values drop like a stone.

Leasing can be a good deal, especially if you’re in the market for a luxury car that has high maintenance costs. We can reasonably expect that the price of leasing will go up soon, so if you’re in the market for a new car, now is as good a time as ever.

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Header image: Getty Images

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Posted 03.24.2017 - 06:44 pm EDT