Data processing: financial – business practice – management – or co – Automated electrical financial or business practice or... – Finance
Reexamination Certificate
2000-02-14
2003-09-16
Rice, Kenneth R. (Department: 3627)
Data processing: financial, business practice, management, or co
Automated electrical financial or business practice or...
Finance
Reexamination Certificate
active
06622129
ABSTRACT:
BACKGROUND OF THE INVENTION
1. Field of the Invention
The present invention relates to a method of creating an index of residual values for leased assets, transferring residual value risk, and creating lease securitizations and, in particular, to a method of creating an index of residual values for leased vehicles and of transferring residual value risk and creating lease securitizations such as futures, options and insurance products in consideration of the index of residual values.
2. Description of the Related Art
Residual Value Risk.
Auto leasing has become quite common in the last 15 years. In the United States, currently about 30% of all new cars are financed through leasing. In lease financing, the auto is technically the property of the finance company, even though the lessee is driving the vehicle and otherwise has rights and responsibilities very similar to owning that same car.
Unlike traditional financing, where the purchaser assumes the risk of fluctuations in used car prices, a lease makes the finance company the primary party exposed to changes in market value. Thus, banks, automakers' finance units, and other financial institutions have large risks relating to the market value of leased vehicles when they are returned at the ends of leases.
Although the resale value of a used car does not factor into traditional financing, it is very important in setting lease terms. For example, if a new year 2000 Toyota Camry has an initial cost of $20,000, Finance Company A might assume that its residual value would be $15,000 at the end of a three year lease. Finance Company B might assume that the same Camry would be worth $16,000 at the end of the same lease. Since Finance Company B assumes the vehicle will have a higher resale value, if the effective interest rates offered by both finance companies are the same, Company B will require a lower lease payment and obtain substantially more business than Company A.
Either finance company would have to wait until the end of the three-year lease to be sure of the final residual value and the exact profitability of that lease. If the actual residual value is $14,000, Company B will experience a residual value loss of $2,000. While $2,000 is immaterial for most finance companies, it is likely that similar overestimations of residual value were made on other vehicles of the same model. During times of intense competition, many finance companies have overestimated the residual values of large portions of the leases originated during an entire model year. In 1999, the Consumer Bankers Association estimated that banks lost money on about 75% of auto leases and that the average shortfall was $1,800 per car. Overestimates of residual value can cause unexpected losses of tens of millions of dollars for large finance companies. Many finance companies use residual value estimates from third parties, such as the Automobile Lease. Guide. However, these third party estimates are not guarantees and are subject to problems similar to any economic forecast.
If the actual residual value at the end of three years is over $16,000, Company B will not experience a loss on sale. However, because of the way most leases are structured, finance companies do not derive most of the benefit when residual values are higher than expected. The auto lessee usually has the option of purchasing the vehicle at the lease residual value when the lease ends. If the car is worth substantially more than the lease residual value, the lessee will likely buy the car at the lease residual value and keep it or resell it at the higher actual market value. Thus, finance companies bear considerable downside risk with respect to residual value, but obtain little benefit from residual values which are far above expected.
Accounting Problems
Leasing companies also have a second problem with leasing which does not occur with traditional financing. Payments on traditional financing are accounted for as receivables. However, on lease financing, the lessee has not contracted to pay the residual value at the end of the lease. The lessee can simply return the car to the finance company in good condition. For this reason, the estimated residual value of the lease is not accounted for as a receivable.
Most finance companies are borrowing the money required to create leases. The finance company is paying cash to the dealer for the entire price of the car, but only has a receivable for the lease payments. Depending on the model and length of the lease, the residual value might be 30-80% of the purchase price of the car. Unless something is done with the leases, a leasing company will accumulate a large amount of volatile residual values as assets and a large amount of liabilities related to the money the finance company borrowed to buy the vehicles which were leased.
Securitizing Lease Payments
Many prior attempts to reduce residual value risks involve moving the ownership of the automobiles to other entities. Many finance companies bundle together large portfolios of automobile leases and create new securities from them. The process is similar to the method which Fannie Mae uses to bundle together large numbers of home mortgages to create a mortgage-backed security. With automobile leases, the process is referred to as lease securitization. Securitizing leases allows the finance company to remove large numbers of leases from their books and use the proceeds to initiate new leases. However, the uncertainty of residual values for the leases involved can create accounting problems and problems with selling the lease-backed security.
A retitling problem is also associated with automobile lease securitization. Purchasers of a lease-backed security generally prefer a security which is insulated from potential bankruptcy of the issuer. If the finance company has not planned in advance, this will take considerable effort to create. Unlike most other assets, an automobile can only be transferred if the owner, in this case the leasing company, signs the back of the certificate of title and certifies the odometer reading. After this step the new owner (in this case, the owner of the lease-backed security) applies for a new certificate of title in its own name. This would normally need to be done for every auto which is to be included in a lease-backed security and, therefore, imposes a significant administrative burden on purchasers of such lease-backed securities.
A common method of insulating purchasers of lease-backed securities from issuer bankruptcy and reducing administration is the creation of a titling trust. Title for leased vehicles is placed with the titling trust from the time of sale. The securitization is then accomplished by selling “beneficial interests” in the titling trust. The finance company services all of the leases from the trust and receives a servicing fee. Such trusts are usually limited partnerships insulated from the finance company's potential bankruptcy, however, they have their own administrative burdens.
In lease securitization, Generally Accepted Accounting Principles (“GAAP”) accounting treatment is quite different from income tax accounting. Under bankruptcy rules and for GAAP accounting purposes, a lease securitization is typically treated as a sale. With care, many of these same securitizations are not treated as sales for income tax purposes. This allows the finance company to take depreciation on the vehicles each year.
Residual Value Protection
If a finance company wishes to securitize a group of leases, the potential purchasers and rating agencies will be concerned about residual value risk. If the finance company overestimates residual value, the lease-backed security may not be able to pay off its full interest and principal obligations. Three conventional approaches to reducing the residual value risk for purchasers of lease-backed securities are discussed below. See also, Stuart M. Litwin, “Unlocking the Mysteries of Auto Lease Securitization”,
Business Credit
, September 1996, p. 28-30, incorporated herein by reference.
1. Purchasing residua
Henricks Slavin & Holmes LLP
Rice Kenneth R.
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