New vehicles sit in a lot in front of the idled General Motors Co. Flint Assembly plant in Flint, … [+] Michigan, U.S., on Monday, March 23, 2020. The auto industry is escalating its push for U.S. assistance to help weather the impact of a global pandemic that has halted or will soon stop production at 42 out of 44 plants that assemble vehicles in the country. Photographer: Anthony Lanzilote/Bloomberg
© 2020 Bloomberg Finance LP
Economists typically view monthly new car sales as a barometer of the economy’s consumer sector. After all, a car is the second most expensive purchase after a home, so undertaking this multi-year financial liability is evidence of buyers’ confidence that they can afford the car and pay off the loan. We rarely think about used car sales and how they influence the overall economy and the new car market itself. In fact, during my early years on Wall Street, U.S. automakers paid little attention to the used car market until the 1990s, when they recognized that faster domestic model depreciation had become a major competitive disadvantage in terms of consumer perception and their own profits.
At the retail level, annual used car sales are estimated between 40 and 45 million units, compared to about 17 million new cars in recent years. Whereas franchised dealers and Tesla are the only sellers of new cars, used cars are sold by both franchised and independent dealers with about one-third of all used car transactions being between two private parties. All used car sellers, including private individuals, rely on valuations and appraisals derived from actual sales data in the vast and efficient whole vehicle auction industry.
At the wholesale level, physical and online whole car and salvage auctions determine a vehicle’s value, irrespective of its condition, title status, make, or model. International bidders often participate in these auctions, and the pricing data generated by millions of wholesale transactions enables dealers and third parties to provide appraisals on an individual’s current car, insurance companies to determine if a damaged car should be totaled, and financial institutions to set loan terms based on the value of their collateral. When used cars are in high demand, as they’ve been for several years, vehicles don’t depreciate as fast as anticipated. Similarly, when demand unexpectedly drops for particular models or the market overall, depreciation accelerates above forecasts.
Under normal circumstances, valuation changes take place over many months as supply and demand adjust. However, in a perfect storm of economic events, as we had in 2008 and 2009, the used car market can behave more like the Dow Jones’ performance in March. In fact, there are significant parallels between the stock and the used car markets when supply exceeds demand. Both operate on a simple, efficient proposition: prices rise when there are more buyers than sellers and fall when the opposite occurs. Beginning in March, nearly every passenger vehicle on the road lost value and will likely continue to lose value until a supply–demand equilibrium is established.
Used car values are plummeting, just as they did in 2007 and 2008, because of an excessive supply of cars at auction. The problem is exacerbated by hesitant bidders, who doubt they can resell what they buy and are, instead, waiting for prices to drop further. Besides a dearth of bidders, excess supply exists. Cash-strapped rental car companies and commercial fleets are defleeting due to reduced demand. Dealers are losing their floorplan credit lines, which has forced lenders to move their collateralized vehicles to auction. Off-lease volume, which is estimated at a record-high 4 million units this year, means that lenders have significant off-lease inventory to unload in the wholesale market. And given record unemployment, there are likely to be more loan defaults, which will contribute to the wholesale inventory buildup. Over the next few months, anxious sellers will have to accept lower values for their vehicles, but other pressures indicate this issue will continue in the fourth quarter of 2020.
Less obvious pressures on used car values come from the simple fact that every vehicle on the road will celebrate a birthday in the fall when the 2021 models fill showrooms. This additional year of age means lower values for car owners and less trade-in value toward the purchase of new or newer used cars. Prior to the COVID-19 pandemic, trade values were already hampered by loan terms as long as 84 months, putting many borrowers into negative equity (owing more than the car is worth). Another pressure that will come into play later this year is the likelihood that automakers will incentivize new car purchases, especially to help their dealers get rid of 2020 models sitting on their lots. Automakers will use zero percent loans and highly subvented lease deals to move this inventory, and that could briefly shift some payment-sensitive used car buyers into new vehicles.
In 2009, excessive used-vehicle supply was eventually absorbed but at much lower prices. Interestingly, in the years that followed the 2009 crash, used car values rose dramatically because a lack of supply resulted after the excess was depleted. We may see a similar trend after this crisis as a delay in consumer confidence will slow down new car buying, thus keeping used-car trade-in inventory constrained. Additional slowdowns in rental company and commercial fleet defleeting and a decrease in lender inventory from fewer lease returns and defaults are also expected. While used car prices may recover in 2021, the current excess supply must first be absorbed. So long as the relationship between demand and supply remain out of balance, used car prices will suffer.
Valuation trends in the used car market are often among the leading indicators of the auto industry’s overall strength. Right now, it looks like the meaningful recovery of car buying will wait until next year.