The Chapter 11 petition of Hertz Global Holdings Inc. signals the potential addition of meaningful used vehicle supply to what the company described as a "manifestly non-functioning" market.

With industry forecasts calling for declines in used vehicle values of 7% or more in large part due to fallout from COVID-19, some auto finance companies such as captives General Motors Financial Co. Inc. and Ford Motor Credit Co. LLC have lowered their expectations for recovery rates on repossessions and increased the depreciation rates over the remaining terms of leases. Lender forbearance policies and operational disruptions at auction houses have already created prospects for a backlog in supply at a time in which a dramatic macroeconomic downturn and reduction in the number of miles driven could continue to depress demand.

That a key creditor group is urging Hertz to rapidly right-size a rental fleet that peaked in 2019 at more than 770,000 vehicles and averaged 518,580 in the U.S. during the first quarter of 2020 could exacerbate the supply/demand imbalance.

Deutsche Bank AG - New York Branch, acting in its capacity as administrative agent for nearly $4.86 billion in variable funding notes used by Hertz as part of broader securitization structure that finances its U.S. rental vehicles, said in its filing that "both parties understand that a significantly smaller U.S. rental vehicle fleet is required in the present environment and, as such, a focused defleeting plan is urgently required." Such a plan, the agent said, would reduce Hertz's administrative expenses and reduce risks for noteholders as proceeds from vehicle sales could be used to reduce outstanding principal and interest.

"This is particularly important as the vehicle collateral ultimately securing the [variable funding notes] is depreciating and losing value each day," Deutsche Bank argued. But it voiced concern about the lack of detail provided by Hertz as to how the company intends to execute defleeting as it likened the value of the noteholders' collateral to a melting ice cube.

Hertz CFO Jamere Jackson said in his bankruptcy court declaration that the pandemic had "distorted the market for used vehicles in the U.S. and globally by severely constraining demand." As such, the company's preferred strategy of selling down its fleet to generate cash and reduce its debt was essentially unavailable. Though Jackson said Hertz had been unable to develop a restructuring strategy prior to initiating the bankruptcy case due to the uncertainty about when the pandemic might end, its stated objectives for the case include adjusting the scope of its operations and developing a business plan "that is feasible in the post-COVID-19 crisis environment."

But even if the economy rebounded, Deutsche Bank argued, Hertz would still need to "rapidly and materially pare down the rental fleet."

Prior to the Hertz bankruptcy filing, KAR Auction Services Inc. CFO Eric Loughmiller discussed during a virtual investor conference the implications of a hypothetical rapid defleeting of rental vehicles that have been underutilized due to the pandemic. Such a defleeting could "be a source of high supply in the near term," he said, adding that "you may be moving the cars quickly and driving price down temporarily." KAR's ADESA Inc. subsidiary reported that it sold 834,000 vehicles in North America during the first quarter.

Rental car companies have not traditionally limited fleet monetization strategies to physical auctions. Hertz, for example, resells vehicles directly to consumers through a subsidiary, to dealers and at auction. But, Loughmiller predicted in the event of a rapid defleeting that "our marketplace will be the only place if they have large volumes of cars to sell quickly to do that, in my opinion, efficiently. It will be very difficult for them to do that."

To date, Loughmiller said, entities that consign vehicles to auction had been acting with prudence and discipline in not sacrificing price in order to move vehicles quickly. But if a rental car defleeting were to cause supply to spike, he suggested that the likes of captive finance companies and banks might "take a more cautious view on how many cars they're willing to sell."

Service providers like ADESA shifted their focus to online auctions from physical auctions in mid-March in response to stay-at-home restrictions, Loughmiller said. Those restrictions also delayed reconditioning and other work needed to get vehicles ready for auction.

"It's not flowing like it will eventually, and it was just quite a mess," said Jeffrey Williams, president and CEO of buy-here-pay-here used vehicle retailer America's Car-Mart Inc. in comments about the wholesale market during a May 22 conference call.

Physical auctions may be back up and running just in time to accept multiple new sources of supply, whether it is from the likes of Hertz or the numerous bank and nonbank auto lenders that implemented temporary moratoriums on involuntary repossessions.

"Any time supply exceeds demand," Loughmiller said, "Econ 101 kicks in and price has to be the variable that changes and declines."