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Friday, March 7, 2014

The Consumer Financial Protection Bureau (CFPB) threatens Small Business

Ruggles/Banks 14 Feb 2014
AFSA 2014 Working Paper

The CFPB, created as a part of the sweeping Dodd - Frank Act, recently entered into a “consent agreement” with ALLY Bank. Penalty and restitution amounts to $98 million, plus ongoing costs mandated by the CFPB to ensure continued compliance with the “agreement.” According to the CFPB’s “methodology,” it was alleged that ALLY Bank was guilty of facilitating discriminatory lending practices that led to marginally higher interest rate markups by car dealers to certain “protected classes.”

Don’t assume that the CFPB has any direct method to identify who is a member of a “protected class.” The “methodology” used by the CFPB to determine who is and isn’t a member of a “protected class,” which is a narrow legal definition, is discussed later in this article. To call their methodology “imaginative” is an understatement. The CFPB finds fault in ALLY’s business practice of charging dealers a “Wholesale Interest Rate” and allowing them to mark it up on a case by case basis based on what can be negotiated with each borrower. This is common practice in the auto industry and lenders are referred to as a "finance source-assignees". According to the CFPB, this creates a system that imposes a “disparate impact” on certain protected classes even though there is absolutely no demonstrable intent to discriminate.

...The CFPB affects auto finance in ways hard to predict...

The theory of “disparate impact” holds that actions by business may be considered discriminatory and illegal if they have a disproportionate "adverse impact" on members of a minority group, or "protected class." It makes no difference if there was intent to discriminate under this theory. Discriminating against credit applicants is prohibited pursuant to the Equal Credit Opportunity Act (ECOA) and its corresponding regulation, Regulation B, on the bases of race, color, religion, national origin, and other factors that determine a “protected class.” “Reg B,” as it is usually called, states that this prohibition applies not just to intentional discrimination, but also to credit practices that result in a negative “disparate impact” on consumers based on one of these prohibited factors.

So what does any of this have to do with small business? Isn’t ALLY Bank a large financial institution, not a small business? Despite the fact that the damages and penalties are levied against ALLY Bank, it is auto dealers who are the CFPB’s real target. ALLY Bank didn’t originate any of the Retail Installment Sale Contracts the CFPB calls “discriminatory.” Auto dealers ALLY Bank has a relationship with and reassigned loans to ALLY originated the Retail Installment Contracts did. According to the CFPB, ALLY’s alleged transgression is facilitating that “discrimination.”

The CFPB has been rattling its sabre in the direction of auto dealers since its inception despite the fact that Congress was specific in NOT giving the CFPB authority over them. The CFPB was, however, granted authority over Buy Here Pay Here (BHPH) auto dealers, who are finance companies as much as car dealers, based on a very narrow legal definition. The exception to direct CFPB authority applies to auto dealers who sell or assign their Retail Installment Sale Contracts and Lease Contracts plus maintain repair facilities. If those two conditions aren’t met the dealer is subject to the CFPB. That leaves the BHPH dealers. But that’s not what this is about. CFPB is clearly making an “end run” around Congressional intent in its pursuit of the auto dealers over which it was denied authority.

So how does the CFPB regulate businesses over which it has no direct authority? They do so by prosecuting the finance sources with whom auto dealers do business, such as ALLY Bank. After the recent ALLY Bank consent agreement, there are now a host of other finance sources preparing for a costly CFPB assault. Auto dealers “buy” or “obtain” the loan money from finance sources at a discounted “Wholesale Rate,” then “resell” it at a “Retail Rate after adding in a “Retail Margin.” This occurs on a deal by deal basis. Auto dealers try to maintain an average “Retail Margin” to fund their origination operation and provide a return. Dealers are able to obtain the “Wholesale Rate,” which consumers typically do not have access to, because of the large volume of auto loans they control as well as the loan origination costs they save for lenders. The Retail Rates charged to consumers aren’t rigid or set from finance source to finance source. To do so would involve illegal collusion and collaboration prohibited by federal antitrust law and enforced by the Federal Trade Commission (FTC) and the U.S. Department of Justice (DOJ). The basic federal law prohibiting "price fixing" is the Sherman Antitrust Act. “Price fixing” is generally defined as any combination, contract, agreement or arrangement, express or implied, the purpose and effect of which is the fixing, raising, depressing, pegging, or stabilizing the price of a product or service.

The current finance source/auto dealer financing system is referred to as “Indirect Lending.” Finance sources compete for business based on a variety of issues which include interest rate, amount advanced, term allowed, the option of payroll deduction, and automatic bill payment and other conveniences. After being quoted an interest rate for auto financing, prospective borrowers can decline, make a lower offer, a higher offer, arrange for their own loan, or pay cash. Consumers are free to leave and shop for a financing deal they prefer. To presume that consumer financing decisions are based solely on interest rate is inaccurate and uninformed. Consumers frequently opt for a higher interest rate deal if they have a strong affinity for a particular lender, often based on previous relationship. Sometimes that consumer choice results in a higher or lower “Retail Margin.” None of this has anything nothing to do with gender, race, country of origin, etc. Consumers are not “charged” an interest rate by auto dealers. There is frequently negotiation involved as well as options presented that consumers select from.

Auto dealers are often able to arrange financing for borrowers the borrowers couldn’t arrange for themselves. Dealers are often able to accomplish this by “packaging” less palatable deals with “gold plated” deals and shrewdly shopping the “package” to various finance sources. Sometimes this results in an approval the consumer might not have been able to find for themselves. It can also result in the consumer obtaining a better credit tier than they could get on their own, resulting in a lower interest rate. Dealer financing provides convenience to vehicle buyers, saves lenders time and money, allows more vehicles to be sold, and a host of other benefits.

To be clear, no consumer is forced to take advantage of dealership financing. Each deal stands on its own. Some dealer financing deals are more expensive for consumers than they might find on their own. Many are less. Dealers sometimes use their “wholesale rate” for negotiating purposes when the negotiation is particularly rate sensitive. An interest rate close to or equal to the wholesale rate might be used to secure a particular deal in a highly competitive market.

According to the CFPB, ALLY Bank dealers charged certain protected classes more “Retail Margin” than others. According to CFPB methodology used to identify members of “protected classes,” “Blacks” were charged 29 basis points more “Retail Rate Margin,” Hispanics 21 basis, and Pacific Islanders 20 basis points more Rate Margin than the market overall. To put this into actual interest rates, 29 basis points equates to .29%, less than a third of a percent. On a 60- month auto loan of $18K, this amounts to about $2.25 per month. For the transgression of allowing their dealers to negotiate “Retail Margin” from their “Wholesale Rate" at the dealers’ discretion, ALLY Bank has been levied a total of $98 million in damages and penalties, plus ongoing compliance costs going forward. Had all of ALLY Bank’s dealers charged the same “Retail Rate Margin” to ensure everyone would have paid the same margin, the Federal Trade Commission would have had them all for collusion, collaboration, and price fixing. The only way this wouldn’t hold true would be if auto dealers charged no margin at all. Perhaps that is the CFPB’s objective?

In addition to the damages and penalties charged, ALLY Bank has been branded a “discriminator.” CFPB Director Richard Cordray’s remarks on the matter are at the link on the CFPB web site: http://www.consumerfinance.gov/newsroom/prepared-remarks-of-directorrichard- cordray-on-the-ally-enforcement-action-press-call/

Those familiar with the issue of auto dealer indirect lending will note that Director Cordray referenced ALLY Bank “sharing in the profit” of auto dealer “Retail Margin.” This is just not true. There IS a program available to auto dealers where they can give up a percentage of their “Retail Margin” to ALLY Bank and in return be indemnified against unearned interest charge back in the case of an early payoff. This is NOT “sharing the profit,” despite Director Cordrays's incorrect characterization. Most Retail Installment Contracts are paid off early, resulting in a return to the consumer of unearned interest (unearned by the finance source) which is calculated into the payoff. Any dealer "Rate Margin" margin is also unearned in this case and is charged back to the dealer. Through the indemnification agreement, the auto dealer receives the discounted interest reserve upfront without having to wait until the contract "earns out" to full term.

Many believe ALLY Bank was targeted because the government still holds a substantial stake in the company. ALLY needed to be granted bank holding company status to allow them to float an Initial Public Offering (IPO) to raise capital to buy out U.S. Government ownership, making them a rather easy target for the CFPB. ALLY acquiesced to CFPB pressure, providing CFPB a precedent to use to hammer its next targets. Some might read this as “extortion.” If you are engaged in small business or lending and you aren’t getting alarmed yet, read on.

Some borrowers aren’t as sophisticated as others, and the best negotiators tend to get the best deals. Financially astute White borrowers get better interest rate deals than less financially astute White borrowers. For examples, informal observation indicates that uneducated “White” farmers and ranchers do particularly well versus educated White factory workers because barter and negotiation is baked into their culture. The same is true of “Black” borrowers. I use the term “Black,” because “African American” isn’t even accurate in this case. The CFPB doesn’t seem to be concerned if one is an actual “American” or U.S. Citizen. In fact, the CFPB’s “methodology” in determining who is what in regard to “protected classes” is so nebulous as to have incited pointed questions from Congress on the matter. What IS clear is that one could slice and dice the general population and find “discrimination” anywhere, even among those in the “protected classes” themselves or the control group.

The CFPB says it wants all borrowers to be treated the same as it pertains to “Retail Margin.” They freely acknowledge that the indirect dealer lending model provides value to consumers. But to treat all borrowers the same would require collusion and collaboration. And that attracts FTC attracts FTC scrutiny unless auto dealers’ option to mark up rate or make fees is completely eliminated. If dealers weren’t able to finance their indirect loan operations through "Retail Margin", it could lead to consumers being on their own when financing a vehicle. That would most certainly harm consumers. Even if it were legally possible to charge all borrowers the same, to do so would punish those who put in the time to do the work and research to became financially astute while rewarding those who don’t.

Allowing finance sources to offer “flat fees” has been discussed by some at the CFPB in open forum, including at the recent American Financial Services Conference held in New Orleans in January 2014. But if all lenders charge the same “flat fee,” at either the lender or dealer level, the same problem with collaboration and collusion arises. If it could be shown that dealers placed financing with lenders paying a higher flat fee than others, the same possibility for unintended “disparate impact” still exists. This is the very definition of “conundrum.”

About the CFPB’s methodology to determine who is a “protected class:” The following is taken from the CFPB website and was authored by Patrice Ficklin, Assistant Director for Fair Lending, who addressed the recent AFSA conference:

“Let’s say a responsible auto lender wanted to make sure that their female customers are not paying more for a loan than similarly-situated men. Before analyzing the pricing patterns, the lender needs to calculate the likelihood that a borrower is male or female. Without actually recording the gender of each borrower, to substitute, or “proxy,” for gender, responsible lenders often rely on a first name database from the Social Security Administration. The public database contains counts of individuals by gender and birth year for first names occurring at least five times for a particular gender in a birth year. Using statistics, they can determine a probability that a particular applicant is male or female based on the distribution of the population across gender categories for the applicant’s first name.

There are a greater variety of methods to proxy for race and national origin. One method used by lenders to check the probability that an applicant is Hispanic or Asian is to use the last name database published by the Census Bureau, in which the Census Bureau reports, by race and national origin, the percentage of individuals with a given surname. Another method to proxy for race and national origin uses the demographics of the census geography (e.g., census tract or block group) in which an individual’s residence is located, and assigns probabilities about the individual’s race or national origin based on the demographics of that area as reported by Census. This method is also used to proxy the probability that an applicant is African American, and it can be used to proxy for other racial and ethnic groups as well.”

As a matter of record, census questionnaires allow respondents to “self identify.” Many respondents simply decline to respond to the census questionnaire, preferring to take the chance of paying a fine than to answer questions they deem inappropriate. Some recall Japanese Americans being interred in camps during World War II as a result of how they answered census questions. Others have their own motivations. In short, there is a huge margin of error in the CFPB’s “proxy methodology.” Do reasonable people think CFPB’s methodology is accurate enough to determine that an additional third of a percent of interest rate was charged to a protected group resulting in a $98 million assessment? Shouldn’t the consumers’ remedy to perception of “unfair interest rate pricing” be to not do business with the establishment, and to take their business elsewhere?

Two letters have been sent to CFPB by members of Congress on the issue of CFPB using this so called “proxy methodology” for determining who is and isn’t a member of a “protected class.” One letter was from 35 Republican members of Congress. Another letter was sent on the same issue by 13 Democratic members of Congress. According to Buckley and Sandler LLC, “The Republican letter takes issue with the CFPB “initiating a process without a public hearing, without public comment, and without releasing the data, methodology, or analysis it relied upon to support such an important change in policy. The letter notes that “allegations of disparate impact do not involve intentional conduct, but instead consist solely of “statistical analysis of past transactions” and that any model assessing such impact must be reliable and accurate. Because the guidance fails to disclose the model for assessing fair lending violations, Congress requested the CFPB provide all pertinent details regarding its methodology to evaluate whether the statistical model supports its supervision and examination of financial institutions.” The firm describes the CFPB response to the Democrats' letter as, “short on the specifics behind the methodology used.”

Take the case of one of the authors if this piece, whose wife is Japanese but her last name is Ruggles. How does the CFPB know she is Japanese from that? Ruggles is the last name of a famous African American. Is he regarded as Black by CFPB "proxy methodolgy" as if his last name was Jefferson or Washington? He has many relatives who are of mixed race. Some look “White” with Hispanic last names. Some look Hispanic and have “White” last names. Some are Native American mixed with other races. There is just too much at stake and too much margin of error for a powerfulgovernment agency to use “voodoo methodology” to label a legitimate businesses as a “facilitator of discrimination” and assess penalty and damages, especially when the alleged misdeeds weren’t even committed by them in the first place?

The CFPB, created by Congress under the Dodd- Frank Act and signed into law by President Obama, who touts the benefits of "transparency," is anything but. They refuse to give more than very general explanations of the so called “proxy methodology” they use in determining who is a member of a “protected class.” This enables them institute witch hunts at will. They claim they will accept solutions to the perceived problem as long as those solutions are “data driven.” But they have themselves proven an uncanny ability to parse data in such a way as to prove discrimination where none exists.

If you have followed us this far, please follow us further into the “tall grass.” As mentioned previously, the CFPB is not empowered to regulate auto dealers, with the previously mentioned exception for Buy Here Pay Here auto dealers. Other than that, the CFPB can only directly regulate lenders, in this case "finance source-assignees." Imagine, if you will, two auto dealers. One is in Iowa, a low cost market with mostly “White” consumers. The other is in Los Angeles, a high cost market made up primarily of “protected class” consumers Each dealer holds their own “financing paper” in house, advancing his/her own money to make auto loans. The dealer approves the credit, takes the risk, advances the money, holds the Retail installment Sale contract and collects the monthly payments. No "finance source-assignee" is involved at this point. The dealer in Iowa charges his/her borrowers 5% per loan. The Los Angeles dealer charges 7%. No law has been broken even though the LA dealer is charging “protected classes” an extra 2%. After a couple of years, the dealer in LA finds a need for additional working capital and sells off some of his/her retail installment contracts to a finance source. At that point a law has been broken as the finance source has now become complicit with the dealer for “facilitating discrimination” under “disparate impact.” The CFPB can get at the auto dealer by penalizing the lender.

Noted auto industry analyst and columnist Jim Henry points out in a recent Automotive News article that ALLY Bank contends that it is not discrimination for a dealership in a high-cost metro area to charge a higher rate than a dealer in a low-cost area. Yet when those loans are analyzed side by side, it could look like the high-cost dealer is practicing discrimination. The CFPB analyzes lenders' loans on a dealership-by-dealership and portfolio wide basis. A logical question might be to ask if a higher concentration of “protected class” consumers live in high cost markets and if CFPB methodology takes this into account? It doesn't appear they have.

At some point, I am hoping that some readers have figured out that it just isn’t small business auto dealers being threatened. If the CFPB remains unrestrained, where will it stop? Boat, RV, mobile home, water sports, and motorcycle dealers may all come under the same scrutiny, as may new home sellers and their finance sources. Even if there are no financing issues the CFPB, can take action against any business where pricing is negotiated and the product is financed using the theory of “disparate impact.”

Terrence O’Loughlin, J.D., MBA, and Director of Compliance and Integrated Document Solutions for Reynolds and Reynolds Company makes the following observation: “The theory of Disparate Impact, a lame legal concept to be sure, won’t be limited to only auto dealer interest rate reserve but will be applied to other products and services where merchants have leeway as to pricing their goods. Ancillary products of all sorts will be scrutinized and perhaps prosecuted by the CFPB.”

There are many who expect both the theory of “disparate impact” and CFPB's “proxy methodology” to fail in a legitimate court of law. The CFPB seems to be going out of their way to avoid such a court test. Imagine ALLY Bank being required to pay out millions in restitution, then a court makes the reasonable ruling that “legal intent” has to be proven before penalties can be assessed and damages can be awarded. Does ALLY Bank get its money back? Reasonable people might think a court should weigh in BEFORE the CFPB gathers any more steam. The CFPB has been quite nimble in avoiding court by entering into negotiated “consent agreements” with targeted finance sources who don’t want the cost and hassle of going to court.

Thomas B. Hudson is a partner at the Hudson Cook law firm, specializing in CFPB and automotive compliance issues. He observes that the potential heavy costs of compliance with such a nebulous piece of regulation will most certainly be passed onto consumers.

No one we know in the business of selling and financing motor vehicles is interested in discriminating against anyone. There ARE credit and finance abuses that need to be scrutinized. There is a lot of very worthwhile work to be done by the CFPB. For example, any mistreatment of military personal is not to be tolerated. But the business model of indirect lending among finance sources, auto dealers, and consumers isn’t “broken” and doesn’t need “fixing.” It works well the way it is. What is taking place is a CFPB witch hunt that begins with a preconceived notion and parses data backwards to “prove” that conclusion.

There are legitimate market forces at work in the auto financing space that negate the need for government regulatory over reach to fix a “problem” that doesn’t exist. There are numerous companies using available technology to identify consumers who might have agreed to a higher than market interest rate on an auto loan. In some cases, the consumer’s credit score has improved since they signed their original loan, qualifying them for a better current interest rate. These independent companies identify these consumers, contact them, and refinance their loan to lower the borrower’s interest rate and monthly payments as the market permits.

In the case of any financing, the “deal” isn’t complete until the loan is paid off. Consumers are free to pay off and/or refinance auto loans at any time whether or not they are contacted by a refinancing company. No consumer is forced to agree to a deal he/she doesn’t want. Knowledge of these market driven facts keeps competitive pressure on dealers without unnecessary and frivolous regulation.

In summary, auto dealers and their finance sources are under attack by a government bureau with immense authority and no Congressional oversight. The CFPB’s funding doesn’t come from Congress; it comes from the Federal Reserve Bank. There aren’t a lot of people ready to jump to the defense of auto dealers, but there might be when it comes to other types of lending and small business. The current CFPB initiative is destructive and wrong. They have auto dealers and their finance sources in an impossible situation with little recourse. CFPB over reach isn’t likely to end here.

Additional Notes:

Another situation arises when an aggressive dealer meets a consumer with good credit and a severe negative equity situation in their trade in. They have been approved for financing by lenders but lack the cash to get the deal bought based on lender advance calls. They consumer has usually visited a host of dealers and lenders trying to get a deal approved. The aggressive dealer might alter the trade allowance and actually lose money on the front end of the deal, while making it up on the back end. In some cases, the borrower might pay off early and the dealer eats his loss when the back end is charged back. But on balance, the dealer will do deals other dealers won't and most will "stick." An ardent practitioner of this approach is Larry van Tuyl. His group does a lot of these kinds of deals. The consumers love them for getting their deal done when everyone else passed, while their competitors hate them. Larry's approach penetrates the market, gets the trade, still makes money, and gets the additional service and warranty business. These are usually high CSI score deals. I wonder if CFPB has measured the incidence of extreme negative equity of consumers at large versus negative equity of protected class members? I doubt it.