August 25, 2008
August 25, 2008
Oregon’s small business sector is about to get smacked by another unexpected and unwelcome hit. Already Oregon’s state economist has determined that Oregon has slipped into another recession (two consecutive quarters of decline in the gross domestic product – GDP) while the rest of the nation appears to have narrowly escaped a similar fate. The housing collapse has resulted in the bankruptcy of several builders and the loss of countless well paying jobs. The financial catastrophe caused by the ill-advised low equity and subprime mortgage practices has caused credit tightening at the very time that small business may need additional credit to bridge the economic downturn. And collectively they have sent the stock market reeling.
And now, a new element looms caused in large part by the rapid increase in fuel prices – automobile leasing.
The use of automobile leases has been a popular practice amongst the nation’s small businesses. Leasing permits the users to avoid upfront capital outlays. The tax advantages are well known and easily used and the upgrade of transportation is done on a regular and predictable basis. But there is a fly in the ointment that may cause “sticker shock” to current leaseholders and spell the end to the practice for small business owners.
Automobile leases are calculated to recover the price of the automobile less its projected trade-in value amortized over a specific number of years (usually two to four years) plus an inherent rate of interest on the declining balance. These “lease” contracts have proven to be extremely lucrative for the automobile dealers who routinely sell those “lease” contracts at a discounted net present value.
The “fly in the ointment” is the requirement that lessee (the small business owner) make up the difference between the actual trade-in value and the projected trade-in value. That provision was inserted to protect the lessor (automobile dealer) from instances of excessive wear and tear on the vehicle.
And while “excessive wear and tear” continues to be a factor in determining the actual trade-in value, a larger impact is being felt by the rapid depreciation in the value of larger cars and SUVs which are the favorite subjects of these leases. That rapid decline is due, in large part, because the fuel efficiency of those vehicles is low and the price of fuel has increased by thirty to forty percent since the execution of many of the leases.
The net effect of this is that small businesses utilizing vehicle leases are about to receive notice of unanticipated deficits in their lease contracts at a time in which cash flow is already tight. And just as in the subprime lending mess, those providing the financing for such leases may find themselves in a situation where their financing is under collateralized – the value of the automobile is substantially less than the residual value of the lease.
And, just as in the home construction and financing collapse, we are likely to see that the unanticipated deficit for the lessees will be the tipping point for their ability to continue in business, while the under collateralization leaves the lessors without recourse to recover their financing.
The resulting damage to small business owners and automobile dealers (and their financing agencies) will be significant. There may be more shoes to drop but this one will likely be felt by the heart of Oregon’s economy – small business.
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