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Bubble Economics: Predicting the Used-Vehicle Correction

ALG’s Eric Lyman talks to the magazine about the potential pricing bubble looming over the used-vehicle market in this exclusive interview with F&I and Showroom magazine.

July 2011, F&I and Showroom - WebXclusive

by Jennifer Washington

Eric Lyman, Director of Residual Value solutions for ALG, says a correction in used-vehicle prices will happen. When the bubble will burst is anyone’s guess, but Lyman says the company has been tracking its impact since the downturn took hold of the industry three years ago.

F&I: There was an article in Automotive News a month or so ago that warned of a possible bubble bursting in used-vehicle pricing. That article quoted ALG stats. Was the article’s conclusion about your stats accurate, and, if so, do your current numbers still reflect that possibility?

Lyman: It’s something we’ve considered in our forecast modeling, so the article’s conclusion wasn’t a surprise to us. Now, the forecast that was reported on in early June was based on values we published on May 15. Our next edition will be finalized on July 15. And if you look at where our forecast has been and where the current values are, you’ll see that it has been quite a bit more conservative than the current returns we’re seeing in the market. There are a variety of reasons for that, one being the correction we’re anticipating regarding used-market values — a downward adjustment. What drives our forecast is things like gas prices, housing prices, wage growth and used supply. We also look at incentives and fleet penetration on an individual model basis. We also have what we call editorial adjustments, which take into consideration the lifecycle of a vehicle and the overall shift in demand that we are anticipating.

F&I: So, what spawned this used-vehicle pricing bubble?

Lyman: Well, as we saw during the downturn, demand for both new and used vehicles really took a hit, with new-car demand feeling it the most. Coming out of the recession, used demand began to recover faster than new, which is what’s contributed to the existence of this used-car bubble. And as we see that demand shift start to return back to pre-recession levels, we would expect that new-car demand will increase and used demand will soften a bit.

F&I: So when do you see this bubble bursting?

Lyman: It’s difficult to say. But let me back up for a second. We have what we call a volatility adjustment that we use when tracking market values. So, as we’ve seen used-vehicle values increase over the last year or so, we look at the rate of that increase and the rate of potential sustainability of those values relative to what we’re expecting over the long term. So, basically, we’re taking out some value in anticipation that there will be a correction.

By doing this, we won’t have to make a sweeping adjustment to our forecast when the bubble does burst. So, again, there is no timetable, but we’ve already built in a cushion into that volatility adjustment to account for that correction.

F&I: In other words, the bubble won’t be as devastating since it’s already built into your values. So what should dealers be doing now?

Lyman: The crux of that article was that we were seeing a buildup in wholesale demand without a corresponding increase in retail demand. As far as advising dealers on specific purchases, it’s difficult to make a recommendation globally because things vary by region and by brand. Ultimately, there are just too many variables at play to make an all-encompassing recommendation.

The one thing I can say is that supply will continue to be an issue, which will continue to support higher values. Ultimately, the dealers are going to have to stock their used car inventory, as forfeiting a customer due to lack of inventory is not a risk many dealers are willing to take. So, these high wholesale values are a cost of doing business in the current environment

F&I: Toyota said it would increase residual values by two points on all 2011 model-year vehicles. Hyundai said it would guarantee the trade-in value for customers who purchase a Hyundai vehicle and finance through its captive. There also have been some aftermarket companies who have introduced similar programs. Is there any risk to what they’re doing?

Lyman: Toyota increasing their residual values is only applicable to lease customers. It’s basically providing some residual support for their leasing product, which isn’t any different from what other captives have done.

 It’s just that they’ve made some adjustments to try and build up their lease pen a bit in anticipation for what they see as a short fall in supply due to the market trends we’ve seen recently and over the last couple of years.

The Hyundai offer sounds a lot like GAP to me, but what makes it different is that it’s a guaranteed trade-in for a cash or finance customer that enables them to trade in a vehicle at a specific agreed-upon value rather than just for total loss of a vehicle due to an accident. Obviously, there are conditions that apply, such as you have to buy a Hyundai product and finance it through Hyundai Motor Finance Company. So, this program creates other potential revenue streams for the finance organization and for dealers, because the dealer is obviously going to sell another vehicle to that customer to comply with the requirements. The way we look at it is it’s basically a deferred incentive.

Now, we assume that there will be some costs associated with the program and depending on where their residual values end up, there could be some potential risk there. For instance, let’s say customers are trading in their vehicle and those guaranteed trade-in values are say $1,000 higher than what the current market value is for those vehicles in the used market. Essentially, that program becomes a $1000 cash-back incentive at the end of the program rather than at inception. We haven’t fully evaluated the potential impact of that, but we’re doing so in our September/October edition. We’ll have some news on that in the next month or so, as there are obviously other factors that come into play.

F&I: Sounds like you don’t think these companies are taking that big of a risk with these programs?

Lyman: Their program residuals are a bit higher than ours, but, again, we’re forecasting open auction average condition values at 15,000 miles per year. And while we are the industry benchmark for residual values and all the major finance organizations use ALG, many of them will adjust the ALG-based forecast for their own specific situation. So, there is some risk involved, but that risk might be offset by the potential revenue streams these program create. The manufacturer and its captive get to sell and finance another Hyundai vehicle. The dealer benefits in that the program drives customers into his or her service department, as the Hyundai program does require that customers comply with specific service intervals and that that work take place at the dealership.

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