After suffering a sharp downturn in the recession and following credit-crunch, auto lending in the U.S. has been on the rise for five years, and growing explosively for the last year-and-a-half to two years. As of 2014, 80 percent of all car purchases were financed – and as of 2013 the average car loan was around $27,000.
All in, there are roughly 30 million auto loan transactions per year in the U.S., which adds up to a market with a total worth of around $900 billion. That means car loans are America’s third largest source of debt for consumers – following mortgage loans and student loans.
With consumer interest come those concerned with protecting consumers’ interests – and with auto lending on the rise it is really not much of a surprise everyone’s favorite unregulated regulator — The Consumer Financial Protection Bureau — showed up to get a better look at just what was going on. Nor did it come as any great shock that they didn’t much like what they saw, since they almost never do.
And, as if often the case, the CFPB’s ire is expensive. In December 2013, auto lender Ally Bank got slapped with $98 million in fines and restitution, in 2014 the American Honda Finance Corp. was ordered to pay $24 million in penalties in restitution.
This week, a new auto lender has joined the party in progress. Fifth Third Bank has been ordered to pay $18 million to borrowers, for the same the reason Ally and Honda were ordered to pay “discriminatory auto loan pricing” as part of a joint enforcement action by the CFPB and the Department of Justice (DOJ). The order further orders the bank to restructure its pricing and compensation system to minimize the risks of discriminatory action on the part of its dealer partners.
“Consumers deserve a level playing field when they enter the marketplace, especially when financing an automobile,” said U.S. Attorney Carter M. Stewart of the Southern District of Ohio. “This settlement prevents discrimination in setting the price for auto loans.”
So what happened exactly?
While it sounds like something that should be part of a Texas Hold ‘Em game, a dealer reserve comes into play when a consumer allows the auto dealer they are purchasing a car from to negotiate the term of a loan with a lender on their behalf.
When a consumer finances a car, they essentially have two options: They can apply for financing directly through a bank, or they can use the auto dealer as a loan broker.
Once the auto dealers/loan broker get the loan back with a proposed interest rate, they have a choice to make. They can either pass that rate, as is, on to the potential buyer, or they can mark that rate up further. That mark-up, which most consumers don’t know exists, is called a dealer reserve.
The dealer then keeps the difference between what the bank offered and what the consumer paid. The amount of a dealer reserve varies — some cases show dealers adding as much as 2.5 percent to the loan.
Dealer reserves, while not widely known, are not new or actually uncommon. Nor are they, by themselves, ostensibly a practice that the CFPB and Justice Department are trying to stamp out. The issue in Fifth Third’s case (and in Honda and Ally’s cases) is how those reserves were applied — particularly to African American and Hispanic borrowers.
“Over the time period under review, Fifth Third permitted dealers to mark up consumers’ interest rates as much as 2.5 percent,” the CFPB noted in a release on the settlement.
According to the DOJ and CFPB, an examination of Fifth Third’s indirect auto-lending program, for compliance with the Equal Credit Opportunity Act, determined that minority borrowers were on the whole paying higher dealer mark-ups that were apparently unrelated to the borrower’s actual creditworthiness. The investigation further determined that damage was not minor or incidental.
“During the time period covered by the analyses, on average, African-American borrowers were charged approximately thirty-five (35) basis points more in dealer markup than similarly-situated non-Hispanic whites for retail installment contracts,” the CFPB wrote. “These disparities are statistically significant, and these differences are based on race and not based on creditworthiness or other objective criteria related to borrower risk.
“These disparities mean that thousands of African-American borrowers paid higher markups than the average non-Hispanic white markup and were obligated to pay, on average, over $200 more each in interest than similarly-situated non-Hispanic white borrowers assuming they held their loans for the full term of the contract,” the CFPB added.
Going forward, Fifth Third will pay $18 million in damages for consumer harm – $12 million of which will flow into a settlement fund that will go to harmed African-American and Hispanic borrowers whose auto loans were financed by Fifth Third between January 2010 and September 2015.
The bank has also been ordered to either reduce or eliminate entirely dealer discretion.
Fifth Third will reduce dealer discretion to mark up the interest rate to only 1.25 percent above the buy rate for auto loans with terms of five years or less, and 1 percent for auto loans with longer terms.
“We are committed to promoting fair and equal access to credit in the auto finance marketplace,” said CFPB Director Richard Cordray noted. “Fifth Third’s move to a new pricing and compensation system represents a significant step toward protecting consumers from discrimination. We are also obtaining millions of dollars in relief today for consumers affected by deceptive marketing of credit add-on products.”
“We commend Fifth Third for its commitment to treating all of its customers fairly without regard to race or national origin and its leadership in agreeing to impose lower caps on discretionary markups,” said Principal Deputy Assistant Attorney General Vanita Gupta, head of the Civil Rights Division. “This agreement shows that the indirect auto lending industry is moving toward a model of dealer compensation that fairly compensates dealers for their work related to loans, while limiting the dealer markup that leads to discriminatory pricing.”
Fifth Third did not face further penalties over the $500K assessed because the bank has been proactive in changing its policies.
The bank was additionally fined $3 million in a different settlement relating to credit card policies – particularly around signing consumers up for paid services without their consent.
While the CFPB and DOJ are happy with Fifth Third’s willingness to comply, there is still some concern about how exactly guilt is being established and fines are being netted out — given that it is impossible to know for sure the racial status of those taking out car loans. Applicants for auto loans do not disclose their race or ethnicity because it is, in fact, illegal to ask for it under the provisions of the 1974 Equal Credit Opportunity Act (ECOA).
So how does the CFPB know that dealer reserves are being charged to minorities at a greater rate than non-minorities?
Smart forensics (if you’re a fan).
They guessed (if you’re not).
“To proxy for race and national origin, exam teams rel[ied] on data associated with consumers’ last names and places of residence. Census Bureau Data is first used to calculate the probability that an individual belongs to a specific race and ethnicity based on their last name. Exam teams then update[d] that probability based on the demographics of the area in which the person resides again using Census Bureau data,” the agency noted in a late fall 2014 release.
Short form: Legally barred from gathering hard demographic data on auto loans takers, the CFPB used last names and region of origin to make an educated guesses about the races of borrowers.
Those educated guesses have been the basis of tens of millions of dollars in fines to lenders.
This is not to say that discriminatory lending doesn’t exist or that dealer reserves have always, or even usually, been correctly applied — but it does at least bear mentioning that the evidence for it as gathered by the CFPB is more inductive reasoning-based than actually observational. A long way of saying that $18 million is a lot of money to pay for something that possibly happened that one potentially knew about.
Fifth Third for its part will comply with the rule change, as Honda and Ally did before it, and limit dealer discretion in setting a reserve going forward.
We’re always on the lookout for opportunities to partner with innovators and disruptors.
Learn More