Tight Money, High Prime Affect Fleet Financing

The federal government's moves in the past several months to break the back of inflation have resulted in a tightening of credit and an increase in prime interest rates. Both factors are critical to fleets and leasing companies seeking funds to acquire and use vehicles in their business. A popular topic among those attending the Automotive Fleet and Leasing Association Annual Meeting was the prime rate and its effects on financing. To put the future of financing and the ramifications of the current economic situation on the need for funds in perspective, a panel moderated by Bruce Hinlien of Chestnut Fleet Rentals tackled the subject at the meeting. Joining Hinlien in the discussion were Doug Horst of Ford Motor Company, Stan Penn of Penn Pontiac and Larry Sheffield of the Hibernian National Bank of New Orleans.

HINLIEN: Our topic today is the discussion of future vehicle financing. Though future projections related to vehicle financing have many ramifications, we're going to try to spend our time today analyzing one phase of this subject: that is, future thoughts on fleet vehicle lease financing and fleet purchase financing. Of course, the same factors facing fleet leasing financing are also prevalent with fleet ownership financing. From the selling dealer's standpoint, both types of financing present the same mechanical and internal administrative problems at the dealership. Now most of you dealers are cognizant of the financing problems faced by fleets who purchase vehicles from you. This discussion should allow you to service this market more intelligently and derive better profits. 

In this vein, I've presented various questions for our panel to discuss. Of the seven questions I've prepared, I've asked them to touch on at least three of them. Our first speaker is Doug Horst.

HORST: I'm going to take that first item mainly because it's not only number one on the list, but it seems to be the number one topic of discussion at this meeting and also in the press and television, no matter where you go. Everybody seems to be in the business of forecasting where prime is going. And Ford Motor Company is certainly no different. At Ford, we have what we call a corporate consensus on prime and I have one that was published this past Friday. When I talk about a corporate consensus on prime, I'm talking about various components of the company which have input into this consensus. This includes input from our economists, our portfolio department, our treasurer's office and even Ford Motor Credit Company. As of Friday, this is how they see things. In March, prime will hit a high of 18.25-percent for the month, April will have it going up to 18.50. May it comes down to 17.25, June 17.50, September 15.5, December 14.25 and March, 1981, one year from now, 13.25-percent.

Forecasting prime, as you know, is not an exact science. I think many of you conjure up a vision of a bunch of Harvard MBA's at Ford Motor Company going into a think tank with hotlines to the money markets of the world such as London, Zurich and New York and using computers to come up with projections. Really, I think the way they do it is that they get a group together in a room like this and say, "Okay, break up into groups of 10. We're going to pass out envelopes and someone is going to be "chairman" and go through the same exercise we went through yesterday. My point is this: I think yesterday, the one grouped that talked about where prime is going probably came as close to the truth as all those MBA's at Harvard. There are so many unknowns, so many factors. The number one factor certainly is what happens in Washington.

We talk a little about borrowing costs; I'd like to jump down to the third time, which is perhaps not as fuzzy. We talk about the cost of money, but now let's talk about, from a leasing company's standpoint, how they are going to pay it back. About 10 or 15 years ago, in leasing, the standard amortization rate, believe it or not, was 2.78-percent (per month), which equates to a full payout over 36 months. Then it got down to about 2.5-percent about 10 years ago and that was a standard payback. By the mid and late seventies, this had gone to 2.0 or 2.5-percent. Now it's down in the area of anywhere from 1.5 to 2.0-percent.

The factories have their various finance programs with various lending institutions. We have our own and call it the Ford Car and Light Truck Lease Financing Plan, and it provides certain features to the finance sources. We have about 35 banks and Ford Motor Credit Company (FMCC) that participate in this, and the program has an interest rate support features and a loss protection feature. Inasmuch as we underwrite the risk, we're very much involved the parameters of financing, how much they advance on a given vehicle and what the payback is. Commencing with 1980, we've lowered our standard payback to 1.8-percent. We had a little discussion up in Buick's suite this morning. There's some discussion and disagreement as to what that figure should be. We feel that a 1.8-percent is a very reasonable depreciation and amortization rate. The name of the game as far as we're concerned is cash flow. You set it too high, you put the leasing company in an upside down position.

As far as going forward, we think the payback will level out at that figure anywhere from 1.5 to 2.0. On the West Coast, they have a tendency to go even lower, but this is, perhaps, a function and reflection on the used car market there. As far as trucks, 10 years ago leasing companies couldn't amortize any lower than two-percent. The last couple of years, it's been down to 1.67, which is a five-year amortization, and now you can see them as low, on diesel powered units, as 1.39-percent.

That tells you about the leasing company and what they can expect to pay for their money and how they're going to pay it back. I'm going to jump down to the sixth question that has to do with leverage ratios. When you talk about cost of repayment, the next question is how much can a leasing company typically expect to be able to borrow on a given investment in the company. Going back about 10 years ago, it was the rule of thumb that for every dollar that a leasing company invested in business, they could borrow four or five dollars. So a four- or five-to-one ratio was standard. Then it seemed to move up to about six- or seven-to-one by the mid-seventies, and now it's not uncommon for leasing companies to be leveraged in excess of 10-percent, sometimes 15-percent, sometimes 20-percent. There is no set rule, in my opinion. It depends upon the type of leases involved, whether the leasing company is leasing to individuals, whether they are leasing to Triple A-1 large fleets, whether they are in open-end or closed-end leasing. As time goes on, that leverage seems to increase, and there's good reason for it. The 1970s proved one thing to the lending institutions in particular, and that is that leasing is a very low-risk business and a good investment from a lender's standpoint. Considering the fact that they've had this favorable experience, although there have been truck leasing companies that have gone out of business in the '70s while not too many car leasing companies have, it has helped the leverage situation for a lot of companies. The only risk of being high leveraged, and this is where a leasing company is certainly vulnerable, is if they have any problems with delinquency. All it takes is one large fleet lessee or a bunch of small lessees to start running past due, to skip a beat as they say, and a leasing company can be in trouble.

PENN: Today we're living in very interesting times. There are so many things happening and taking place in our economy, it's frightening. I'd like to touch on the first question, where the prime interest rate is going. If we had the answers to all these questions today, we could all retire. When you talk about the prime rate, really we have to turn to the president and you have to turn to politics. The prime basically is regulated by the feds, who in turn govern the banks, who in turn govern the banks, who in turn govern our economy. Now Carter has been trying to bring about a recession since he took office, and he hasn't succeeded yet. I think now, by regulating prime, he's trying to curb credit so that the people can't do what they want to do. As a result, if he's successful in slowing down our economy and bringing out that recession, we should look for some relief by the end of the year. If that's the case, I think we can all say inside the period of six months, primes should start turning around and start coming down to a level where we can all live and deal with it much better than we can today.

The next topic I would like to discuss is a more intelligent way to handle negative cash flow in financing arrangements. There's only way to handle negative cash flow - eliminate it, cut it out or bring it down to a level where it is virtually nil. From a dealer aspect, he should look at the number of cars he is carrying in stock. He should look at the type of sales and number of cars he's selling. If he's not realizing respectable profit on what he's selling, he should cut down the size of his inventory. He should eliminate those kinds of deals that are plaguing him and costing him money. That should enable him to reduce his overhead or some of his help. He has to analyze his own situation and make up his mind on what things are making him money, what things are costing him money, get rid of the cancers and the stores that are costing him money.

From the leasing company aspect, they should take a look at the fleets and their payment schedules. Maybe the name of the game isn't the number of leases you put out, its how many leases you put out profitably. In return, the leasing company should be forced to eliminate some of the kinds of accounts they are dealing with or have a discussion with those accounts to bring them in line with regard to payments or whatever else is necessary.

The next area I'd like to discuss is the relationship between the leasing company and dealer. This is very interesting. We are dealing with more leasing companies today than we did a year or so ago. We have been called and asked by leasing companies if we would like to handle their business. I think the key today (as a dealer) is you have to have an image of integrity and you have to have an image of solidarity. The pendulum has to swing back and forth so that the leasing company and the dealer can both survive. They need each other and in turn they should work together. Even though today I am doing more business with leasing companies than ever before, I have to also make sure that we understand our ultimate goals and the leasing company is not using me to help its negative cash flow. In other words, there has to be some dealing between the leasing company and the dealer, if the leasing company expects to be treated properly and also maintain the kind of attitude it needs with the dealer. I just want to emphasize that because you can't skin a cat both ways. You need the dealer and the dealer needs you.

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I'd also like to touch on the factors related to the extended term in financing at the end of the original note. If you're going to be forced to make longer leases and if you're going to have to wait longer until the car is turned in at the end of the lease, you better consider service and the service policy you have on your lease. You may want to consider the extended service policy that is offered by the manufacturer or by independent companies. It's a very important factor. In addition, it would pay you, especially when you're operating across the country, to have a dealer network and some kind of plan where you can send your customer or client into reputable dealers who you know will service them at reasonable costs. That will help keep your client happy and keep your residual value up where it should be.

There is one more thing you should be careful about. There are additional sources of money today for financing other than banks and factory-related finance companies. If you want to pay the price, there's foreign money, there's insurance money and there's pension money. You better be careful if you get involved in some kind of pension money that the money you get follows the code or restrictions that the pension fund has to maintain for operation. Or you can get involved in a very difficult or touchy situation.

SHEFFIELD: Looking at the future of prime rate, I think Doug summed it all up. Nobody knows. In the last 10 days we have sent out three interest letters for our dealers that increased their rate. I don't know what's going to happen in the next few months. I don't think anyone knows. All I know is that we're in an election year and that has a lot to do with it.

When I left the office Thursday afternoon prime was 17.25-percent. I understand Friday it went to 18-percent. As the rates continue to increase like that, it's going to slow down the demand for people to be borrowing and eventually it's also going to cause a decrease in prime. If you don't have it there to borrow, you're not going to borrow it. So that is going to mean sales are going to be down some as far as financing concerned. As a result, we anticipate around the first of next year, we hope prime will be around 15-percent. I don't believe we'll ever see 12-percent again over a long period of time. This may be discouraging if you have some floorplanning, whether it be from banks, GMAC or Ford Motor Credit. It's not going to get any better. This is also going to cause problems related to question two, the pros and cons of financing using floating interest rates.

Right now in our department we're on fixed rate. We're fixing the long-term rate at 14.5-percent this coming Monday. Our cap is 15-percent. You can float short-term money and if you can float four over prime, you're fortunate. That's 21-percent. If you've got a discount on floorplanning, the only thing I suggest you can do is lower the units coming in and see what happens. Using the fixed rates we have right now, as a banker myself, I like it. Today, it's going at 14.5, we'll pray in the next year or 18 months that prime will be dropping down and our yields will be increased. I think, as a whole, I hate to say this, but I believe some of the banks are in there getting what they can. On the other hand, we're looking at everyone very closely. At this time we cannot expect any losses at all. On the repossessions we have right now, we're taking too many losses on these units. Our average loss right now is approximately $2,500 a clip. So, you can understand, we as a bank cannot go in and lose this kind of money.

As for factors affecting extended terms of financing, right now in our particular division I'd say 95-percent of all our indirect loans are 48 months. Very few are below 48 months. If you go in now and extend a lease, I think Doug and I disagree on this, we feel it should be extended under the current rate. We, as bankers, feel we're extending this guy a lease for 36 months and he's going to come back in with a residual value. We have to ask at the beginning of the term what this car is going to be worth in three years. A person using this car in his business operation will probably have 56,000 miles on it. If he wants to come back in and continue this lease for an additional year, we're looking at a three-year-old car. My question is, why should I give him the same rate that I gave first-hand on this particular lease? If he wants to renew his lease, he needs to go in on the additional prices that the day's economy is having to pay for it. This is where Doug and I disagree.

Extended financing is here to stay as far as leasing, although I disagree with it completely. I think once the lease reaches term, it should be either paid off or have the consumer make it up through other arrangements. He'll have to conclude his lease. Things are too expensive right now. As far as lower amortization levels, I firmly believe that a 2.0 or 2.25-percent rate still should be paid across the types of vehicles that are being leased today. At that rate, it's an unfortunate situation when you look at the larger cars that have been leased in the past, but I think right now, the smaller cars some of our dealers are leasing use this rate with no problems. The larger cars are going to be a problem. I think the leases are going to be looked at, the residuals are going to be looked at really closely to see what is going to happen in the next two years. I don't think anyone expected what happened in the last 18 months, I know we as a bank did not expect things to hit like this. We had forecasted that our prime today would be around 13.5-percent. That was last October when we made the prediction, and we missed it badly. So in the next 24 months, who knows?

HINLIEN: As far as the prime interest rate, we finance with about 31 different financing institutions, and we get different opinions from each one. The general rate for January 1, 1981 that we're projecting is 15-percent. There is a big disparity in the current prime interest rate and what the cost of money to the bank is. There's a pretty good spread in various parts of the country between the prime rate and the cost of the money that adds up to a bank. The banks are having a heyday and pursing the prime probably faster than it should be going up. It's certainly dealing inflation, it's not stopping inflation. I think if any of you are talking about period loans at this time, I think the banks and lending institutions will talk to you even though prime reached 18 on Friday. These banks are still going to have to play off money for three to five years. They'll be happy to sit down with a company that will guarantee them 15-percent for the next five years. I think, on some basis, when banks say they don't have money, they're tightening on consumer loans on a retail basis as a result of limitations on interest rates set by state laws. They still have to put out money and they want to put it out at profitable rates.

I think most term loans in the future will be on floating rates. I don't think you can get a decent term loan of $100,000 or more that is not a floating rate today from any major bank. As far as a leasing company is concerned, the only way you can borrow on floating rates on your lease financing is to float with the customer. You can't gamble with one and stay firm with the other. If you're going to float with the bank, you have to pass that float on to the customer.

Here are a few projections on lower amortization rates. You're going to have to have lower amortization rates, especially if you take this typical $10,000 car we're talking about. The average two-year lease is repaid to the lessor at approximately 3.5-percent of cost per month. So today, if you have a $7,000 car, the leasing rate on a 24-26 month lease is 3.5 times seven, which is about $210 to $245 per month. You can't afford to pay 2.5 or 2.25-percent amortization to the financing institution with current rates on money. You start off with a negative cash flow from day one. You can project into 1983, when the $10,000 car will be here, what your costs would be. If you get 3.5-percent per month from the client, that's $350 a month. On a three-year lease the average rate throughout the country is probably 3.2-percent. Let's say you're only getting $350 a month. Using an 18-percent cost of money, if you're amortizing 2.5-percent or $250 to the bank and you're paying the first month's interest at 18-percent, which is 1.5-percent per month of that $10,000 or $150, it means your first month's cost is $400. You're only taking in $350 and you haven't taken into account overhead or profit. So the amortization rates are going to have to come down for the leasing companies to stay in business when the cost of money is where it is now.

The factors and ways to extend term financing at the end of the individual note is also a problem. About 25-percent of the time with our leases currently, the contract is due up in two years and the customer wants to keep the car an additional year because the cost of replacing that car is so high. The factory sets up financing on 24-month amortization with a 25^th month balloon note. They'll extend the term today on that 25^th month balloon note for another year, but they'll do it on current interest rates or the original interest rates, whichever is greater. If they do it on that basis and prime starts to come down and you want to extend a car you've leased today an additional year two or three years from now, you're going to be paying back at 1.5 percent per month. In dealing with your banks or both GMAC or FMCC, we're going to have to force them to give us relative economic factors at the end of the lease when we want to extend it. The only time you can really fight for that (equity) is when you go in, and not two or three years down the line when the original term is up and you want to extend.

As for sources of financing other than banks and factory-backed finance companies, another possible place to get money is a group of businessmen in your own hometown who will put up money. You can pass on some of the benefits of your borrowings, including the investment tax credit and an 18-percent interest rate, which is something they can't get conservatively through various banking sources. If you can get some businessmen to put up money, they have security because they have you, who they know in the hometown, and of course they'll probably be getting 1.5-percent per month return on their money, which is a good investment, plus the investment tax credit.

Doug talked about future acceptable leverage ratios, and the only thing I have to add is that I don't think that's the important element in borrowing money today, even though most banks and the factories think it is. The type of customers you have, the rates you're getting and the way your customers pay you is much more important than your ratios in borrowing.

Touching on more intelligent ways to handle negative cash flow and financing arrangements, from a leasing company's point of view, you have to fight for lower amortization rates. You can also get the last month's payment in advance, or move your billings up 15 days. If you've been putting billings out on the first of the month, move it up to the 15^th of the previous month. You have to do everything possible to cut this negative cash flow down which we all inherit with these high interest rates. You're restricted on how high you can go on your leasing rates because of your competition in the field. You have to be very careful in this type of economy to guard against negative cash flow.