Why the DOJ won’t back down on auto lenders

(Nam Y. Huh/AP) (Nam Y. Huh/AP)

Buying a car is expensive, but the government wants to make sure that you're not paying more than the next guy just because the dealer has that discretion.

For that reason, Ally Financial, one of the nation's largest auto lenders, handed the government $98 million in December to settle allegations that it allowed dealers to charge minorities more for car loans than whites.

Since then, dealers have rallied around new industry recommendations to end discriminatory pricing. But the government is not backing down on its investigations.

"There will probably be more actions like Ally in the coming year because [discretionary pricing] is an industry," said Jon Seward, deputy chief of housing and civil enforcement at the Justice Department, during a panel discussion at the National Community Reinvestment Coalition conference on Wednesday. "I don't think Ally is very different from any lender doing business across the country." 

At issue, as Seward said, is an industry practice that too few consumers even know exists. Car dealers have the discretion to mark up the interest rate on car loans they arrange through lenders, a practice that can boost the profit on a sale of a car by hundreds of dollars.

Say you've got your eyes on a mint condition '65 Mustang (only in my dreams). You go to your local dealer, who offers to get you a quote on a loan for the classic car. The dealer calls up a banker, who says, "I can do the loan at 6 percent interest."

That "buy rate" is based on such criteria as your credit history and down payment. The banker gives the dealer the discretion to tack on an additional percentage point or two on your "contract rate." Why? Because the banker pays the dealer a fee based on the difference between the two rates, hence the dealer's incentive to charge you more.

So the rate the dealer brings you for the '65 Mustang could be as high as 8 percent, even though you may qualify for a better deal.

2011 study by the Center for Responsible Lending found that the average dealer markup on a car loan was about 2.5 percentage points, or $714 in additional interest payments on a average 60-month loan. Researchers at the National Automobile Dealers Association (NADA), a trade group, contend that the rate is closer to 1 percentage point for new cars and 0.7 for used vehicles.

No one disputes that dealers should be compensated for the one-stop-shop service they offer. But at whose expense?

Advocacy groups have long warned of disparities in the number of black and Latino borrowers hit with higher interest rates and questioned whether markups breed fair-lending violations. Folks at Justice and the Consumer Financial Protection Bureau believe it does.

That's why they went after Ally, whose network of 12,000 dealers allegedly charged 235,000 minority borrowers higher rates than whites from April 2011 to March 2012. Black, Hispanic and Asian American customers paid up to $300 more for car loans than whites with the same credit histories, according to federal officials.  The rate disparity was often over a quarter of a percentage point.

Ally said it never had any information about the borrowers' race or ethnicity (it's illegal to collect that kind of data in auto lending), so how could it discriminate? The government investigation involved a statistical analysis of the last names of 800,000 customers. Regulators contended that despite being an indirect lender, Ally should have done more to make sure the dealers did not discriminate.

Whether dealers are discriminating has become a source of debate. Dealers argue that they often start out with a markup, but come down on the rate in negotiation. If you come in with a quote from your credit union on that Mustang at 6.5 percent interest, the dealer could counter at 6.4 percent to get your business.

But that argument doesn't fly with consumer groups or regulators. The CFPB, which has jurisdiction over the largest lenders, has suggested three alternative pricing models to compensate dealers without discriminating against customers. Bankers could pay dealers a flat fee on each transaction or a fixed percentage of the loan. Another approach calls for a hybrid system in which compensation would be tied to the amount of the loan and the duration of the contract.

Dealers aren't too keen on the flat-fee model, which they say would eliminate competitive pricing and, consequently, cost consumers more money in the long run.

In January, NADA recommended that dealers establish a markup ceiling, never exceed it and document a legitimate reason when they offer a discount below that ceiling. A legitimate reason could be, for instance, to beat a competing offer like the one your credit union gave for the Mustang.

It's a commendable approach to addressing fair lending concerns, but it may not be enough to satisfy the Feds. And consumer groups say that's a good thing because a large part of the pricing problem is the lack of transparency. Dealers should have to disclose the rate rationale to consumers in all cases.

It's notable that Ally has not changed its pricing model despite paying the hefty fine. The reason: The company has said it doesn't want to run the risk of losing dealer business. In other word, Ally needs a few more lenders to make the change before the company puts its neck on the line.

Danielle Douglas-Gabriel covers student debt. Before that, she wrote about the banking industry.
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