About a month ago we warned that declining used car prices could spell disaster for subprime auto securitizations (see "Slumping Used Car Prices Spell Disaster For Subprime Auto Securitizations"). While it's always difficult to predict the exact timing of when bubbles will burst, a combination of record-high lease returns in 2017 and 2018, combined with rising interest rates could imply that the auto bubble is on the precipice.

As Bloomberg recently pointed out, strong used car pricing is a critical component required to prop up the overall auto market. While American's love their brand new cars, if used car prices become too soft then substitution can hurt new car sales. Add to that the impact of falling residual values on the finance arms of the auto OEMs and you have all the ingredients required for an auto market meltdown.

Thanks in part to low interest rates, leasing has become an increasingly popular way to drive away a new car. It accounts for almost a third of all new car transactions in the U.S. and it's also huge in the U.K., as I explained here. For BMW and Mercedes-Benz in particular, it's been a boon for sales. Typically a lease lasts about three years, after which the customer returns to the showroom for another vehicle -- which is when things could get difficult for the industry. "There's going to be a lot of units coming back over the next several years," Ford Motor Co. warned last month. "They're going to get to levels that we have never seen on an absolute basis in the industry before". In 2017, about one million more off-lease vehicles will be available in the U.S. compared with 2015. That additional volume will put downward pressure on used car prices. If cars depreciate too quickly, consumers will be unwilling to pay high prices for new vehicles. High residual values also help to keep monthly lease payments low. In other words, if used car prices fall, the whole system comes unstuck: automakers' earnings will likely fall and car finance companies (often a subsidiary of the manufacturer) may have to book writedowns on the value of their leased assets.

As the following chart depicts, with nearly 1mm more cars coming off lease in 2017 than 2015, it's difficult to envision a scenario where used car prices don't come under tremendous pressure.

Of course, how we got here is fairly obvious. The majority of Americans buy cars based on one factor: monthly payment. And when it comes to managing your monthly payment to the lowest level possible, leasing is the way to go. Per the Bank Rate calculator below, buying a $30,000 car comes with a monthly payment of around $600 while leasing the same vehicle might only cost $420 per month.

Of course, why buy a $30,000 Ford for a $600 monthly payment when you could lease a $40,000 BMW for $560? You can afford it so long as you can cover the monthly payment, right?

Not surprisingly, these dynamics have caused lease share of U.S. vehicles to skyrocketed in the wake of the "great recession" as people seek to maintain their excessive lifestyles on smaller budgets.

Of course, the problem is that leased vehicles get returned to their originating lenders every 3 years for brand new leases...we wouldn't want anyone driving around in a 5-year-old clunker now would we? But, as we all know, vehicles have useful lives of 15-20 years. Therefore, it doesn't take too many excessive lease cycles to flood the market with used supply and bring the whole ponzi crashing down.