First of two parts.

When Congress passed the Dodd-Frank Act in 2010, one of its provisions banned outright bounties that that mortgage lenders had formerly paid to brokers for steering borrowers toward high-interest rate loans. These so-called yield-spread premiums were "an outrage" that were "driving people into more expensive loans than they actually qualified for," Richard Cordray, director of the Consumer Financial Protection Bureau said shortly afterward.

Three years after Dodd-Frank's passage, Cordray's CFPB is confronting virtually identical markups in the auto loan market—but this time it's taking a very different approach.

Instead of an outright ban, the bureau is seeking to lay the groundwork for enforcement actions against lenders on the grounds that the markups are higher for minorities than for whites and therefore racially discriminatory.

The CFPB's decision to abstain from banning dealer markups appears based on a very different political reality. Unlike with mortgages, Dodd-Frank did not establish any prohibition on markup compensation under the law, and as a matter of practice the CFPB has shied away from the politically divisive practice of forbidding industry practice outright via bureaucratic fiat. Equally important, in auto lending the agency must contend with a vast network of car dealers, who carry great clout with Congress, and over which it has no direct authority.

Targeting alleged discrimination is simply the safer bet than pushing an outright ban, says Deepak Gupta, a former senior counsel for enforcement strategy at the CFPB who is now in private law practice.

"There's going to be some obvious wariness about using that authority [to ban longstanding but abusive industry practices], taking it out for a spin for the first time," he says.

At the crux of the controversy are practices that date back decades. Traditionally, auto dealers underwrite loans and sell them at a "wholesale" rate to lenders. If dealership employees convince borrowers to pay more than the wholesale interest rate, the dealer and the bank split the extra profit, which is referred to as a "dealer markup" or "dealer participation."

It's a big business. Federal Deposit Insurance Corp.-insured banks alone hold more than $300 billion in auto loans, with dealers originating nearly 80% of the new credit. Some of these indirect loans are written at the wholesale rate alone, but the markups also earn dealers billions of dollars in additional annual income.

In opting to bring enforcement actions against lenders for discriminatory practices instead of a ban, the CFPB is avoiding a politically charged and risky fight in favor of a relatively straightforward strategy, consumer advocates and industry observers say.

Enforcement actions based on allegations of discrimination would mirror a strategy that the National Consumer Law Center employed successfully a decade ago.

"Given the litigation we did years back, [the CFPB] wouldn't have to go too far out on the limb," says John Van Alst, an NCLC attorney.

Given its authority over lenders, the CFPB would likely be able to extract a number of settlements from the banks it targets, industry sources and outside analysts agree. Much less certain is whether such actions would merely result in isolated victories or pave the way for the sort of new industry standard that the CFPB would ultimately like to create.

Another risk is that settlements with large banks would let smaller banks and other lenders not party to them gain an advantage. Enforcement actions also run the risk of alienating lenders at a time when many are believed to be quietly in favor of phasing out the dealer markups and thus putting an end to the legal and reputational risks they entail.

The CFPB says it can manage these potential pitfalls.

"If action is needed, we want to act in a way that promotes a level playing field for all lenders, both banks and nonbanks," the bureau wrote in response to questions from American Banker.

Balancing Act

The CFPB appears to be aware that it's on delicate ground. In recent weeks, it has counseled consumer groups to show patience. Agency officials have cited the fact that banks have limited access to borrower data and at most play an indirect role in any discriminatory practices. They have also shown an aversion to penalizing a handful of lenders for practices that are common throughout the industry.

For the time being, however, the CFPB is simply demanding lenders try to comply with its public statements urging them to be on guard against anything that smacks of discrimination.

"Over the long term, we believe that any changes that auto lenders make in response to our recent guidance will bring greater transparency to the market about the costs of financing, and therefore greater competition," the CFPB wrote in a response to questions.

When the National Consumer Law Center first filed class actions accusing auto finance companies of discrimination early in the last decade, it was picking a very big fight. The challenges of proving the cases stemmed from the nature of indirect auto lending in which dealers underwrite car loans and then sell them to lenders. The banks and automakers' captive finance companies that provided the financing never met the consumers who took out the loans and were not informed of the borrowers' races or other characteristics.

"The banks said 'How can you bring this against us? We can't know the race, gender or age of the person we're lending to,'" Stuart Rossman, one of the NCLC's attorneys, recalled during an interview last year.

The NCLC took the position that banks were guilty of willful blindness. Although the dealers were setting the discriminatory rates, the lenders were facilitating the misconduct. NCLC's lawyers eventually gained access to the banks' records. They then analyzed loan, census and motor vehicle ownership data.

Their conclusions were stark: Among the more than 30 states studied, African-American and Latino car buyers paid higher interest rates than equally creditworthy white buyers, the NCLC declared. For white borrowers, the average markup above wholesale interest rates on GMAC loans was $245. For African-Americans it was $656, or 2.7 times higher.

The industry disputed the validity of the NCLC's statistical methods but eventually agreed to pay about $100 million to settle the claims. It also agreed to temporarily cap the size of markups.

With the last of the restrictions having expired last year, discrimination remains and is part of a larger problem, argues the NCLC's Van Alst. Auto dealers continue to reap markup premiums for foisting higher rates on less sophisticated auto buyers—a practice that's objectionable even in the absence of racial disparities, he argues.

"We'd rather see an outright prohibition on dealer compensation based on an increase in interest rates, and many lenders would like that, too," says Van Alst.

Limited Powers

Lenders may be on the same side as the CFPB in seeking to abolish dealer markups, but under Dodd-Frank the agency's authority goes only so far. At the time that Dodd-Frank Act was drafted, its authors' concerns about auto dealer markups went beyond the discriminatory implications.

The Senate Banking Committee wrote in March 2010 that "borrowers are simply unaware of the incentives pushing the auto dealers to charge buyers higher interest rates" and that "auto dealers have a significant incentive to steer borrowers to the highest rate loans they can, without borrowers ever being aware of the backdoor transaction."

Auto dealers were quick to perceive a threat, recalls former Rep. Barney Frank, who pushed for them to come under the CFPB's jurisdiction.

"The most influential networks in America are natural grassroots networks," Frank says in reference to auto dealerships. "And it's particularly the case when they come from a business culture that is outgoing. Auto dealers are among the most outgoing people. And they're generally pretty well known and popular."

Further complicating the politics at the time was the fact that successful African-Americans car dealers pushed their local Congressional representatives for an exemption from the agency's watch.

In the end, Frank's bid to include auto dealers under the CFPB's auspices failed to gain a majority of support in the House Financial Services Committee that he oversaw.

"It was the biggest loss I had," Frank said in a recent interview.

Although car dealers won the battle to exempt themselves from CFPB regulation, authority over auto lenders remained with the bureau. Consumer advocates have pressed the bureau to ban lenders outright from paying dealer markups.

"Dealer compensation should be divorced from the ability to increase interest rates from one consumer to another," the Center for Responsible Lending, Consumer Federation of America, National Consumer Law Center and other consumer groups wrote in a 2012 comment letter for a car lending roundtable hosted by the Federal Trade Commission.

The CFPB says publicly that it's keeping its options open. It could pursue non-public supervisory actions, rulemaking, or enforcement.

"In the context of indirect auto lending in general, and the practice of dealer markups in particular, we have considered and will continue to consider all our available tools," the bureau wrote in response to questions.
While it decides on an approach, the bureau resorted to a combination of public haranguing and enforcement activity. Last year it requested documents from at least four lenders and released a bulletin warning that indirect auto loans were ripe for discrimination enforcement actions.

One benefit of this approach is speed. By highlighting the potentially discriminatory aspects of markups, the CFPB can make the case that the lenders have fallen short of pre-existing standards and must alter their behavior immediately.

Focusing on bank's internal monitoring of discrimination also enables the CFPB to avoid a head-on confrontation with the auto dealers. In contrast, if it launches a rulemaking process, the legally required public comment period would likely result in a strong backlash among auto dealers' Capitol Hill allies, says Christopher Willis, a lawyer at Ballard Spahr, who defends banks in fair lending cases.

"I believe [the CFPB] is worried about that," he says.

"They're paying some attention to Capitol Hill developments, probably on this issue more than all others," adds another banking industry source.

As long as the CFPB frames the debate as involving racial discrimination, it's very hard for anyone to take the other side, industry observers note. The question for Richard Cordray and his staff is how, and how hard, to press the issue.

Next: The road ahead for auto financing.

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