The Inside Story of the CFPB's Battle Over Auto Lending

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Second in a series about CFPB's use of disparate impact. Part one is here, and part three is here.

WASHINGTON — The Consumer Financial Protection Bureau has struggled internally with how to end potential discrimination in auto lending, including debating whether it should cite a large lender in the hope of effectively ending the ability of partnering dealers to mark up loans with all lenders.

In a series of internal documents reviewed by American Banker, agency officials wrestle with the practice of dealer markup, in which the dealership typically keeps the difference between the rate set by the lender and the one agreed to by the borrower as its compensation. On multiple occasions, CFPB officials suggested to forgo rulemaking and instead use a few high-profile enforcement actions against large auto lenders to do away with dealer discretion, thereby significantly curbing potential discrimination.

"The purpose of this meeting is to continue our discussion around a market-tipping settlement that would resolve the discriminatory disparities caused by dealer markup by eliminating markup at many major auto lenders," said a memo from officials in preparation for a briefing with CFPB Director Richard Cordray and 19 senior officials on May 20, 2013.

Such a plan of attack lends support to what the industry has long feared: that the CFPB's efforts to cite auto lenders for unintentional discrimination was really a means to control competitive price negotiations between lenders and dealers.

Auto lenders and dealerships argue that the CFPB's acute focus on dealer markup, a common facet in the industry, won't end discrimination and will likely raise overall auto financing costs for consumers.

The markup amount "is only a small picture of the deal for the borrower. … The consumer can get what looks like a terrible deal on the markup but do really well on the rest of the factors" like the price of the vehicle or the trade-in value, said Nicholas Smyth, a former CFPB enforcement attorney now at Reed Smith. "The CFPB has only focused on the markup of the loan because that's the safest to look at from within its jurisdiction."

The CFPB continues to argue that it is not seeking to eliminate dealer discretion. Rather, it is just trying to root out discrimination within the auto lending industry.

"As we have stated consistently and repeatedly, we recognize that auto dealers play a valuable role in facilitating auto finance transactions, and they deserve to be compensated fairly for the work they do," said Sam Gilford, a CFPB spokesman. "It is not the CFPB's position that auto dealers should receive less compensation, but rather that consumers should not be subjected to illegal and discriminatory pricing."

Yet the CFPB clearly views enforcement actions as a key to its strategy, and the dealer markup remains a top target based on recent moves.

American Honda Finance Corp. agreed in July to lower the amount dealers could mark up a loan as part of a settlement with the CFPB and the Justice Department. As American Banker previously reported based on confidential documents, that settlement included forgoing charging Honda civil money penalties because it agreed to limit dealer discretion. According to memos, the CFPB attempted similar discussions with Toyota and Nissan's financing arms, though those cases have not been resolved yet.

To understand the CFPB's actions, American Banker reviewed three years' worth of internal documents about the agency's decision-making process. Following is a deeper look at the CFPB's use of disparate impact — a legal theory that cites lenders for unintentional discrimination based on statistical analysis of the loan portfolios — against the auto industry, and the agency's internal debate over how best to curb bias.

The CFPB targets auto lenders
The 2010 Dodd-Frank Act created the CFPB, giving it wide powers over a range of players in the financial marketplace. But there was one area that Congress expressly carved out of the agency's jurisdiction — auto dealers.

That has always been a sore spot for the agency, particularly since auto lending is a huge part of the overall credit marketplace and dealers play a significant role in shaping costs to consumers, former staff said. To address the issue, the CFPB has chosen to target lenders that partner with dealerships.

In March 2013, the agency released a controversial bulletin that warned lenders they would be responsible for any statistical bias in the rates charged by the partnering dealer, even if the lender was not aware of it before the loan closed. The CFPB said it would use disparate impact analysis to determine if minority borrowers were being charged more for car loans. Since auto loans do not show the race or gender of the borrower, the CFPB crafted its own proxy method to estimate borrower demographics and use that to cite lenders for unintentional discrimination. Such estimates inevitably created complications between the industry and the CFPB.

"With indirect auto financing, potential discrimination literally takes place in backrooms on dealer lots, so direct evidence is just not available. It's not like you have dealer finance managers talking to customers on recorded lines or anything," said Raj Date, managing partner at the venture investment firm Fenway Summer and the former No. 2 at the CFPB. "So unless the CFPB was just going to ignore discrimination in the second-largest lending market in the country, it was always going to have to use inference and analytics, and apply disparate impact doctrine to the lenders who are within its jurisdiction."

Before it issued the bulletin, the CFPB created an auto finance working group. According to internal documents reviewed by American Banker, officials cited the prevalence of auto lending, and concluded "most" consumers seek auto financing at the dealership even though they know little about how those transactions work.

"Seventy-nine percent of consumers who finance with the dealership are unaware that the interest rate on their auto loan is able to be marked up by the dealer," CFPB officials wrote in a 2012 charter setting up the working group, citing figures from a study by the Center for Responsible Lending. "Each annual cohort of auto finance consumers pays an estimated $25.8 billion in interest rate markup over the lives of their loans."

Unlike other products the CFPB targets, the agency did not say that its pursuit of dealer markup was motivated by consumer or referred complaints, or that its own statistical evidence showed widespread disparities in auto lending (the agency later performed samplings of lender portfolios). Instead, officials relied on outside analysis by consumer groups and their own concerns about the auto lending model, according to the charter.

Rulemaking vs. enforcement
Almost from the beginning, documents show, officials zeroed in on the ability of dealers to mark up the interest rate of a loan as a key cause of discrimination.

In mid-2012, the agency's internal working group discussed whether it could push the industry away from dealer discretion and toward a flat-fee structure in which dealers are paid a set amount as compensation for helping make the loan. But the auto industry strongly opposed that system once the CFPB publicly suggested it in 2013, arguing that other costs would have to increase for consumers.

Gilford said the CFPB is focused on all aspects of the auto financing, but that this kind of discretion is open to potential abuse.

"Our supervisory and enforcement experience has found that when lenders' policies provide this type of discretion and incentives they create significant risk of illegal pricing disparities based on factors like race or national origin," he said. "Our supervision of the auto finance market is focused on ensuring that consumers are treated fairly throughout the life of a loan."

By April 4, 2013, CFPB officials had a meeting with Cordray to discuss how best to eliminate discrimination. One option on the table was to "affirmatively pursue the eliminating" of dealer price discretion. Other options were to continue to encourage lenders to boost compliance management or move to a flat-fee system or an alternate compensation structure. In that memo, officials clarified internally that they were not necessarily trying to end dealer markup.

"We are not seeking the elimination of markup per se, but rather the elimination of discrimination resulting from markup," the memo said.

But later that same month, CFPB officials once again target the dealer markup, suggesting to use a "market-tipping settlement that would resolve the discriminatory disparities caused by dealer markup by eliminating markup at many major auto lenders," said an April 24, 2013, memo.

Still, officials were aware that using enforcement actions might not be enough to change dealer markup nationwide. The other option was to write a rule banning or restricting dealer discretion. But there were two problems with that approach. The first is that it would "necessitate a change in other rulemaking priorities" at that time, officials wrote in the memo.

But officials also worried they did not have the legal justification to write a rule and would face a backlash from the politically powerful auto dealers.

"First, the legal authority for all of the potential rulemakings is unclear given our lack of authority over dealers," the memo said. "Second, the bureau would face considerable pressure from external groups if it sought to regulate or ban the practice of markup itself — pressure that should not be underestimated. The rule could be perceived as an attempt to circumvent our lack of regulatory authority over auto dealers, and that presents both legal and political risks that our rule could be overturned by a court or by Congress."

Still, some former CFPB officials argue it would have been more transparent for the agency to pursue the issue via rulemaking, but claim it feared disclosing its proxy method used to determine a disparate impact on minorities.

"The auto finance industry is such a fragmented marketplace that to believe these one-off enforcement actions would change the entire industry's market pricing is an interesting theory," said Gerald S. Sachs, former senior counsel at the CFPB's Enforcement Office who is now with Paul Hastings. "In this case, a rulemaking would be more evenhanded and fair across the marketplace. It would necessitate that the CFPB disclose its proxy methodology — in its entirety — to the public for comment, criticism and debate, which would bring transparency to the CFPB's indirect auto initiative."

The bureau released a white paper last year about its method. But many in the industry argue it was not detailed enough, particularly in how lenders should structure their compliance management systems to avoid being cited for discrimination. A rulemaking, however, could clarify that.

The CFPB white paper is "really broad. While market participants typically appreciate broad guidance that allow them to find the best way to apply it to their business, in this case, the lack of specificity is causing a huge amount of duplicative work because every lender has to come up with its own methods to prevent and remedy potential disparities," Smyth said. "Instead the CFPB is forcing the lenders to police the dealers. But at least if CFPB were to issue a rule, it would make really clear what the expectations are to lenders in compliance and answering all the questions the public has."

No silver bullet
Throughout the debate, CFPB officials recognized there was no simple solution to curbing discrimination in the auto lending industry. Internally, at least, they acknowledged that eliminating dealer discretion could have unintended consequences.

"It is possible that disclosing or eliminating dealer markup would create more transparent pricing, and thereby improve competition," officials said in an April 4, 2013, memo. "It is worth noting, however, that if markup were eliminated, it is not entirely clear how the market would respond. Dealers would undoubtedly seek to replace the revenue stream, and the ultimate impact to consumers is unknown."

Moreover, although Cordray publicly promoted the flat-fee structure as a potential solution, the CFPB said in a 2012 presentation that it too had flaws. They noted it could create some "alignment issues" between the dealer and consumer.

During that time, CFPB officials also considered doing a push to educate consumers to at least check their interest rate or promote a "robust refinance market" or more innovative direct loan deliveries.

The battle over pricing
Another issue raised by the industry and some lawmakers is how much power the CFPB has over the auto industry — and whether it is trying to improperly control what lenders and auto dealers charge. CFPB officials are adamant that they are just trying to crack down on discrimination in the industry, not trying to dictate market pricing or force the adoption of flat fees.

A "flat fee is not the only approach. I think there is a number of possible approaches and we have talked to lenders extensively about this," Cordray told the House Financial Services Committee on March 3. "That's not the only means by which this can be addressed."

But some Republican lawmakers believe the CFPB is going too far. "I find it incredible myself that an agency which under federal law has no supervisory, enforcement or regulatory authority over auto dealers is still attempting, I believe, to dictate the manner in which auto dealers are compensated and how much they should be compensated for facilitating an auto loan for their customers," said Republican Rep. Roger Williams from Texas, during the March hearing with Cordray.

Cordray maintained that the CFPB remains within its jurisdiction. Congress gave the CFPB oversight over auto lenders, and that is going to naturally have an effect on dealers as well, he said. "That's how I have to enforce the law," he said in March.

The issue is likely to come up again when Cordray testifies before the Financial Services Committee on Tuesday.

Because of the CFPB's limited jurisdiction, some observers said that going after the lender for dealer markup is one of the few ways that the bureau can stay within its bounds.

"Apart from 'buy-here-pay-here' auto dealers, the CFPB doesn't have jurisdiction over dealerships. But it can, at its disposal, tell the lenders, 'We're holding you responsible because ultimately, it's your loan,' " said Ed Kramer, executive vice president of regulatory affairs at Wolters Kluwer, and New York's former deputy superintendent of banks. "I did the same thing as deputy superintendent. This isn't new. Whatever methodology you use as a regulator, the goal is to make sure that there is no discrimination."

Other observers, however, questioned why the CFPB voluntarily chose to tackle dealer markups so soon after it opened its doors in 2011. Even facing mandatory deadlines in other areas such as mortgages and pressing enforcement issues like add-on products, the agency put considerable emphasis on auto lending.

In one memo, CFPB officials recommended pulling enforcement resources from student loan refund cards in order to have enough resources to pursue auto dealer markups. "Enforcement's auto finance allocation is already maxed out with existing investigations and it seems unwise to abandon those promising investigations midstream," several officials said in a drafted memo to Cordray. "Thus, we propose adding auto finance discrimination as an enforcement resource allocation priority, replacing student loan refund cards."

The CFPB's early pursuit of markups is also perplexing since most of the industry had already set a 2.5% cap on the dealer's price discretion as part of settlements in the mid-2000s after allegations of discrimination. Those settlements have since expired, but the cap has become a common practice.

Still, only a few lenders have moved to a flat-fee structure or lowered their dealer price caps since the CFPB started its efforts over the past three years.

"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," said Bill Himpler, executive vice president of legislative affairs at the American Financial Services Association.

A former CFPB staffer who is familiar with the matter agreed.

"The years have proven that the CFPB's hope to tip the market was misplaced," the former staffer said. "They've managed to get a few changes through – for example, most indirect lenders have implemented dealer monitoring programs to prevent disparate impact – and some lenders have switched to a flat-fee structure, but there's been broad resistance to any fundamental changes to how auto loans are priced."

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