10.23.2015 An Inside Look at the CFPB-Auto Dealership Dispute

As we’ve been discussing in a series of blogs this month, the Consumer Financial Protection Bureau (CFPB) issued guidance two years ago designed to eliminate racial discrimination it said was occurring at car dealerships that make auto loans to customers. The CFPB wants to limit dealership discretion in marking up the interest rates lenders offer car buyers (i.e., the “buy rate”) for auto loans, ideally replacing dealer markup with a flat-fee compensation structure.

Dealer markup is a common practice among automobile dealerships as a way to compensate the dealership for helping arrange financing for their customers. However, the CFPB believes that some dealers are marking up minority borrowers’ rates more than they’re marking up non-minorities’ rates, resulting in discrimination against legally protected groups.

Long-Running Disputes

The CFPB’s guidance has led to disputes between auto dealerships, third-party lenders and the CFPB every since it was first announced in 2013. Most dealerships strongly denounce discriminatory lending practices and deny that dealer markup results in discrimination against car buyers. The CFPB, meanwhile, says that its goal isn’t to do away with dealer markup, but rather to eliminate discrimination in auto lending.

Last month, the American Banker published a fascinating inside look at the CFPB’s internal discussions about how to deal with the issue of dealer markup. Since the CFPB does not have direct oversight of automobile dealerships, it doesn’t have the legal justification to simply write a rule banning dealer markup or restricting dealer discretion in marking up interest rates.

So CFPB staff debated other options available to them. One of these was to take high-profile enforcement actions against a few large third-party auto lenders. More specifically, the agency considered negotiating a “market-tipping settlement” from one of these lenders that would “resolve the discriminatory disparities caused by dealer markup by eliminating markup at many major auto lenders,” stated an internal CFPB memo from May of 2013.

Since then, the CFPB has taken enforcement actions against three major auto lenders. In late 2013, Ally Bank agreed to pay $18 million in penalties and $80 million in damages for alleged discrimination against minority borrowers. However, Ally admitted no wrongdoing in the settlement, nor did they agree to eliminate dealer pricing discretion.

In July of this year, American Honda Finance Corp. agreed to pay $24 million in consumer restitution and lower the amount by which dealers could markup their auto loans. And Fifth Third Bank agreed in September to pay $18 million in damages to minority auto loan borrowers who were allegedly discriminated against between 2010 and 2015 and to change its pricing and compensation system to minimize the risks of discrimination.

Are Settlements Market-Tipping?

All told, that’s $140 million in settlements agreed to by three major third-party auto lenders. However, these settlements don’t appear to have achieved the tipping point the CFPB was apparently hoping for, the American Banker analysis concludes. It reports that so far, only a few lenders have moved to a flat-fee structure or lowered their dealer markup price caps from the customary 2.5 percent.

In the American Banker article, an executive vice president of legislative affairs with the American Financial Services Association put it this way: “The CFPB’s hope was that they could tip the market through a few enforcement actions, but no auto lender has been running to embrace the flat-fee structure because they’re afraid that business will just move to other companies that don’t have flat rates.”

“The years have proven that the CFPB’s hope to tip the market was misplaced,” added a former CFPB staff member. “There’s been broad resistance to any fundamental changes to how auto loans are priced.”

So What’s Next?

Where are things headed from here? The CFPB is continuing to use highly questionable data derived from a controversial proxy method to claim that some dealerships are discriminating against minority car buyers applying for loans. But bipartisan legislation passed the House Financial Services Committee this summer (H.R. 1737, the Reforming CFPB Indirect Auto Financing Guidance Act) that would rescind the CFPB’s guidance from two years ago.

This issue bears close observation in the months to come. Whatever the resolution is, it will have a huge impact on how dealerships are compensated for arranging third-party auto loans for their customers.

We’re interested in hearing from you. What do you think about the CFPB’s attempts to prohibit dealerships from discounting the interest rate they offer on car loans? Send me an email at steven@lendtrade.com.

10.22.2015 CFPB and Auto Dealers Remain at a Standstill

When the Consumer Financial Protection Bureau (CFPB) was formed as part of the 2010 Dodd-Frank Act, the federal agency was given wide-ranging authority over a broad swath of the financial services industry. But one sector that’s indirectly involved in financial services was specifically excluded from the CFPB’s oversight: automobile dealerships.

Automobile lending represents a significant portion of the consumer credit marketplace, and dealerships assist buyers in 85 percent of all car loans that are made. So the CFPB started looking for a way around this exclusion. In 2013, they hit upon a solution: Since they couldn’t oversee and regulate auto lending done by dealerships directly, they would target the lenders that partner with dealerships in making auto loans to customers.

CFPB Guidance Issued

In early 2013, the CFPB issued new guidance via a controversial bulletin warning lenders that they would be held responsible for any statistical bias that occurred in the interest rates dealers charged customers of different races. The CFPB calls this bias and what it deems to be the resulting discrimination against legally protected groups “disparate impact.”

A little background: Dealerships are allowed to mark up the interest rate lenders offer customers (or the “buy rate”) by a percentage point or two as compensation for arranging the financing. However, the CFPB believes some dealers are marking up minority borrowers’ rates more than they’re marking up non-minorities’ rate.

But the CFPB faced a problem in proving this: Dealerships cannot ask customers their race or ethnicity when submitting their auto loan applications, so there’s no way for lenders (or the CFPB) to know if discrimination is actually taking place. To fix this problem, the CFPB came up with a proxy method it said would establish borrowers’ race and ethnicity so discrimination could be uncovered.

The method they used is called the Bayesian Improved Surname Geocoding (or BISG). This proxy, which uses a loan applicant’s name and census data to determine the probability of his or her race, is commonly used by healthcare organizations to gather random statistical information on various ethnic groups. But it is not an accurate way to determine the ethnicity of car buyers applying for auto loans.

This isn’t just me saying this. The American Financial Services Association (AFSA) commissioned an independent review of the CFPB’s use of BISG to determine the race of auto loan customers. After conducting a detailed analysis, AFSA stated that “alleged pricing discrepancies between minorities and non-minorities for auto financing rates are simply not supported by data.” Specifically, the AFSA study determined that:

  • When the proxy said there was an 80 percent probability that a borrower was African American, it was correct in actually identifying the borrower as African American less than 25 percent of the time.
  • Applying the BISG proxy as a continuous method not only overestimates racial and ethnic disparities and the degree of alleged discrimination. It also provides no way of identifying which auto loans are associated with buyers who were supposedly discriminated against.

Small Differences

According to the CFPB, African Americans pay an interest rate that’s 0.29% higher than average, Asians pay a rate that’s 0.22% higher, and Hispanics pay a rate that’s 0.20% higher. So even if the CFPB’s flawed data were 100 percent accurate, the differences are small. For example, on an average auto loan amount of $27,000, 29 basis points would result in an increased loan payment of $6.50 per month.

It’s worth noting that the CFPB does not believe that dealerships shouldn’t be compensated for helping arrange auto loans for their customers. It just doesn’t like the current model in which dealers mark up the buy rate. Instead, it would like for dealerships to be paid a flat fee for this service.

It’s also worth pointing out that most dealerships strongly denounce discriminatory lending practices. They believe that the current system of marking up the buy rate works well for everyone and does not result in any form of lending discrimination. Not only will the CFPB’s efforts not end auto lending discrimination (assuming there is any), but they will raise the costs of auto financing for car buyers.

We’re interested in hearing from you. What do you think about the CFPB’s attempts to prohibit dealerships from marking up the interest rate they offer on car loans? Send me an email at steven@lendtrade.com.

10.12.2015 The CFPB’s War on Auto Dealers and Auto Finance Companies

Two years ago, the Consumer Financial Protection Bureau (CFPB) established a new policy that it said was designed to eliminate racial discrimination supposedly occurring at car dealerships that make auto loans to their customers. The guidance limits the ability of dealerships to mark up the interest rates they offer to car buyers.

A Little Background

Many if not most car buyers finance their purchase via indirect financing offered at the dealership. Dealers have flexibility in terms of the rate they offer their customers — for example, they can mark up the interest rate they receive from a third-party lender.  These markups can generate additional revenue for dealerships.

Here’s how it works: Dealerships submit auto loan applications on behalf of their customers to one or more third-party lenders. If a lender approves a loan, it sets a minimum interest rate — referred to as the buy rate — at which is till purchase the loan. This rate is based on the lender’s cost of funds adjusted to account for the borrower’s credit history and other risk factors associated with the loan.

The CFPB believes that some dealerships are discriminating against minorities by offering them a higher rate than a comparable non-minority borrower. Therefore, it wants to force auto finance sources to change their dealership compensation model in such a way that dealerships would limit the ability of dealerships to mark up interest rates to customers. In fact, most lenders have now taken steps to cap how much dealerships can mark up interest rates, giving them less discretion.

Surely, the CFPB must have concrete evidence to support its belief that some dealerships are discriminating against minorities when it comes to interest rates on auto loans, right? I mean, the auto loan market in the U.S. is a $907 billion market, so you wouldn’t think a government agency would want to disrupt something this big (and, for the most part, successful) without clear proof of discrimination.

Think again. Lenders are prohibited by law from asking borrowers their race or ethnicity, so the CFPB has no way of knowing for sure if car buyers have been discriminated against. So it used a highly questionable proxy methodology called the Bayesian Improved Surname Geocoding (or BISG) method to supposedly establish borrowers’ race and ethnicity.

Making Best Guesses

In short, BISG makes a best guess as to the race and ethnicity of borrowers based on their last name and address. So, for example, if a borrower’s last name is Martinez and he lives in the inner city, BISG would assume he is Hispanic. In reality, maybe he is, maybe he isn’t — but the CFPB wants to fundamentally change the U.S. auto loan market based on this kind of flimsy assumption.

A prominent research firm recently did a study to test the accuracy of the CFPB’s conclusions about interest rate discrimination based on BISG. It applied BISG to a large database of mortgage loans, which do identify borrowers’ race and ethnicity. The study concluded that the BISG methodology was “inaccurate, incomplete and unreliable” as used by the CFPB, frequently failing to correctly identify a borrower’s actual race or ethnicity.

For example, the methodology overestimates the number of African-Americans in a given ZIP code by 41 percent, according to the study. And it also fails to consider legitimate business factors (like discounting to meet or beat a competitor’s rate) that could explain loan pricing differences between groups.

For its part, the CFPB says it disagrees with the findings of the research firm’s study, though it acknowledged last September that its methodology does overestimate the African-American population. Thus far, however, it shows no signs of backing off on its attempts to prohibit dealerships from discounting car loan interest rates.

We’re interested in hearing from you. What do you think about the CFPB’s attempts to prohibit dealerships from discounting the interest rate they offer on car loans? Send me an email at steven@lendtrade.com.