Auto Lease ABS
The general characteristics of both auto loan and auto lease asset-backed securities have been discussed in the previous article. This article discusses characteristics that are specific for auto lease asset-backed securities (ABSs).
The auto lease ABS is based on the cash flow from auto lease payments. The fundamental difference of leasing from auto loans is that when a customer leases a vehicle, the vehicle is actually purchased by the leasing company under an agreement with the customer that the vehicle will be leased for a defined duration, when the customer will make monthly payments to the leasing company in exchange for its use. At the end of the lease, the customer will have the option of purchasing the vehicle for its residual value, which is the stipulated value of the vehicle at the end of the lease — it is the contractual price the customer would have to pay to buy the vehicle at the end of the lease. If the customer does not exercise the purchase option, then the lessor will seek to either lease the vehicle to someone else or sell the vehicle.
The advantages of leasing over borrowing include a lower initial cost, lower monthly payments, and less sales tax. Generally the same underwriting criteria are used for both auto loans and leases, and servicing the leases is also similar.
Auto Lease Securitization
A significant risk of auto lease ABS is the possible bankruptcy of the lessor. If the lessor declares bankruptcy, then the leased vehicles would be subject to creditors' claims. To mitigate this risk, a titling trust is created by the lease originators as a bankruptcy remote special purpose entity to actually hold the titles of the leased vehicles. The originators retain a beneficial interest in the trust, but the vehicles are owned by the titling trust, and the customers send their lease payments to the trust.
The leases are purchased by the titling trust directly from the dealer as they are executed. When the number of leases is sufficient for a securitization, a beneficial interest in a specific pool of leases is transferred to a securitization trust, which then issues the auto lease ABS to investors based on the pool.
Another risk involved in owning vehicles is vicarious liability, where the owner of the vehicle is held liable for any accident caused by anyone who had permission to use the vehicle, which, of course, includes the lessee. To mitigate this risk, the lessee must purchase insurance naming the titling trust as beneficiary. The risk is further reduced by the titling trust by accepting only leases from states that do not extend vicarious liability to the lessor of the vehicle.
Pension liabilities of the originators could also pose a significant risk. The Employee Retirement Security Act of 1974 (ERISA) empowers the Pension Benefit Guaranty Corporation to put liens on the assets of companies with underfunded pensions. If this happened to a lease originator, this claim would be superior to any others. Hence, most auto lease securitization contracts contain warranties by the originators to keep their pensions properly funded. Credit rating agencies may also require more credit enhancement if there is any evidence that the pension fund of any originator is inadequate.
Although both auto loans and leases suffer from default risk, only auto leases are subject to residual risk, which is the risk that the residual value of the vehicle, which is stipulated in the lease contract, will be more than its market value, which is the price at which it can be sold to the public. Since the market value cannot be known until the end the of the lease period, auto lease ABSs require more credit enhancement. Because the vehicles are purchased by the lessor or titling trust, auto lease ABS values will suffer if the residual value is significantly greater than the market value of the vehicle. Although residual risk can be lowered by assuming a lower residual value at the end of the lease period, this would entail higher lease payments by the customer, which would lower sales by the dealer. Hence, dealers have an incentive to assume a high residual value for their vehicles.
Of course, residual risk will only be present if either the dealer or the customer decides not to exercise their option to purchase the vehicle. The main factor that determines the amount of residual risk is the difference between the residual value and the market value of the vehicle — the more the residual value exceeds the market value, the greater the risk. This factor will also increase the turn-in rate, and a higher turn-in rate also raises residual risk. Turn-in rates will also be influenced by the customers' desire for new models, by customer satisfaction, and by extrinsic factors such as the price of gasoline. For instance, in the summer of 2008, the market values of gas-hogging SUVs and pick-up trucks was significantly less than what dealers had anticipated, because the price of gasoline increased significantly.
Hence, residual risk can be summarized by the following equation:
Residual Risk = (Average Residual Value - Average Market Value) × Turn-In Rate
Sometimes, lessors purchase residual-value insurance which pays 80% to 90% of the difference between residual value and market value, which helps to reduce the uncertain risk.