Inside Santander Consumer USA, alarm bells were ringing over a list of auto dealers that were sending rapidly souring car loans to the subprime lender.
The speedy defaults were seen internally as a warning sign that the dealerships might be inflating customers’ incomes in order to qualify them for loans, Massachusetts authorities later alleged.
Santander Consumer conducted audits of high-risk auto dealers. At one particular Bay State dealer, the company looked at 11 loans and found seven that inflated borrowers' incomes by $45,000 or more per year, according to the authorities. Nonetheless, the Fort Worth, Texas-based lender allegedly made hundreds more loans through the dealer.
These accusations, which date from 2009 to 2014, were detailed last month in a $26 million settlement agreement that the U.S. auto-lending unit of the Spanish banking giant Banco Santander reached with the Massachusetts attorney general’s office. Santander Consumer neither admitted to nor denied the allegations.
The settlement’s eye-popping charges are shining a light on the hard-to-measure problem of auto dealer fraud, while also raising questions about the adequacy of lenders’ efforts to combat bad behavior.
Such fraud often involves fitting unqualified subprime loan applicants into the underwriting standards established by lenders. That can be accomplished either by inflating the borrower’s income, which makes the loan appear easier to pay off than it actually is, or by overstating the value of the consumer’s purchase, which leads lenders to approve larger loan amounts.
Industry critics allege that subprime auto lenders have little incentive to police the malfeasance aggressively because — in a parallel to the subprime mortgage bubble of a decade ago — they often package the loans into bonds and offload them quickly.
More than 78% of the loans that Santander Consumer originated through Massachusetts auto dealers were sold to third parties, according to the March 28 settlement agreement. The lender allegedly told state authorities that requiring borrowers’ proof of income often put it at a competitive disadvantage in the market.
“That was the exact excuse that lenders were making about why they had to look the other way when mortgage brokers were sending them increasingly risky and increasingly fraudulent loans,” said Chris Kukla, executive vice president at the Center for Responsible Lending.
“The one who’s going to be hurt the most is the person who bought the car and then can’t hold onto it,” he added.
There is no comprehensive data on the extent of loan fraud perpetrated by auto dealers, in part because much of it goes undetected.
“Most of the fraud is slipping through,” said Frank McKenna, chief strategist at PointPredictive, a San Diego firm that sells fraud-prevention services to auto lenders.
Of course, dishonest car dealers are not a new phenomenon. But at a time when car sales are leveling off, dealers may be tempted to go further to close sales than they did in the recent past. Meanwhile, underwriting standards have loosened substantially in a market that is showing signs of overheating.
PointPredictive estimates that $4.2 billion to $6 billion in fraudulent U.S. auto loans will be originated in 2017, which is twice as high as the firm’s estimate from two years earlier. The estimate, which amounts to slightly more than 1% of the car loans made annually, includes fraud perpetrated by auto dealers as well as cases of identity theft and other illegal schemes by car buyers.
Today’s subprime auto lending industry today is much smaller than the subprime mortgage market was 10 years ago, and the more recent spate of fraud seems unlikely to impact the nation’s financial stability. Still, there are a number of ways in which the situations are similar.
Auto dealers play an analogous role to mortgage brokers, profiting from loans without shouldering the risk of default. Lenders frequently fail to require that borrowers’ income be verified, which makes it easier for the dealers to perpetrate fraud.
And securitization deals are structured so that losses must hit high thresholds before bond investors take a financial hit, so the investors do not have a strong incentive to demand effective fraud-prevention measures.
“It is not unlike what the mortgage industry experienced between 2003 and 2008,” PointPredictive argued in a recent report.
In a March administrative case brought by New York City’s department of consumer affairs, a Queens-based car dealership chain was accused of inflating borrowers' incomes and car values.
The city’s complaint described the experience of one woman who visited the chain, Major World, and bought a 2013 Nissan Quest. The woman earned $41,600 per year in salary and paid 46% of that amount in rent. But the loan application stated that her annual income was $76,000, and her rent was $0, according to the complaint. The loan, which carried an annual percentage rate of 23.12%, was approved.
Major World did not respond to requests for comment. New York City’s complaint did not identify the lender.
Some observers said that auto lenders should be doing more to ferret out patterns of misconduct in the dealerships. “It does seem that opportunities to connect the dots are not being taken,” said Peter Lane, a consumer protection lawyer in Northampton, Mass.
Quote'It does seem that opportunities to connect the dots are not being taken,' said Peter Lane, a consumer protection lawyer in Northampton, Mass.
But others said that allegations against Santander Consumer are not representative of the auto lending industry as a whole.
“I think that the good operators, of which there are many, don’t have any significant problem with fraud,” said Christopher Gillock, managing director at Colonnade Advisors LLC, which advises auto finance companies.
Some auto lenders monitor not only the dealerships with which they do business, but also individual employees who have a track record of bad behavior and have moved from one dealership to another, Gillock said.
Nonetheless, he said that cases of fraud appear to be on the rise. “As auto sales flatten out, and dealers are trying to move the metal, they try to figure out: How can I put the customer into the car?” he said.
In the Massachusetts case, Santander Consumer did take some action after flagging certain dealers as suspicious, according to the settlement agreement. For example, the lender demanded that the suspicious dealers repurchase certain loans that had gone into early default.
But Massachusetts authorities say that the lender’s response was inadequate. The settlement states that Santander Consumer only counted loans as having income inflation if the borrower’s pay was boosted by $500 or $1,000 per month.
The company also waived proof-of-income requirements for some dealers that had been flagged as representing a high risk, according to the document.
Santander Consumer expects that roughly 42% of all subprime loans originated at Massachusetts dealers on the high-risk list between 2009 and 2014 will eventually default, according to authorities. The predicted default rate is the same in Delaware, which was also a party to the settlement.
In a statement to American Banker, Santander Consumer noted that it has a new management team, and said that it has taken steps over the last 18 months to strengthen its business practices and controls. Those steps include the creation of two new groups inside the company that are focused on dealer oversight.
At Santander Consumer’s investor day in February, Chief Operating Officer Richard Morrin said that the company is working to determine which dealer relationships should be ended.
“We need to separate out those relationships, identify ways to grow relationships from the right dealers and look for ways to frankly discontinue relationships with dealers that don’t do things the right way,” he said.
Santander Consumer still has considerable legal exposure. The publicly traded company has disclosed that it received subpoenas related to its underwriting and securitization practices from the Department of Justice and the Securities and Exchange Commission. The firm also has received requests for information from a group representing 27 state attorneys general.
And in January, the Mississippi attorney general’s office sued Santander Consumer for allegedly inducing consumers to apply for loans they could not afford.
Analysts at Moody’s Investors Service said in a recent research note that the allegations outlined in the Massachusetts case further expose Santander Consumer to future settlements.
Other subprime auto lenders could also come into the authorities’ crosshairs. Credit Acceptance Corp., a subprime auto lender based in Southfield, Mich., has disclosed receiving demands for information from the Massachusetts attorney general’s office and from other state and federal agencies.
Joseph Cioffi, a lawyer at Davis & Gilbert LLP, said that other lenders should heed the Santander Consumer settlement.
“The lesson is that audits and controls in place are not enough,” he said in an email. “You can’t just monitor a problem. You have to take action.”