Crowds gathered at the September P&A Leadership Summit and Industry Summit in Las Vegas to hear attorney, Rick Hackett’s forecast of the future direction of the Consumer Financial Protection Bureau (CFPB). Hackett is the former assistant director of installment and liquidity lending markets for the bureau’s division of research, and has been considered the point man for the auto finance industry.
Hackett addressed the current state of the industry and predicted what he referred to as “headwinds that may further develop in the future.” He likened his predictions to climatology or meteorology, with the caveat that though he could offer predictions, those predictions would be more like a weather forecast based on available information. And, he added humorously, “Most people abide by the rule ‘If you don’t like the weather, you don’t shoot the weather man.’”
Auto Finance Discrimination
First on Hackett’s agenda was the topic of auto finance discrimination. He explained the legal theory behind BSIG - Bayesian Improved Surname Geocoding. “There was a statistician and economist named Thomas Bayes who figured out how you could combine geocoding (the practice of using location to predict ethnicity and race) and surname in a secret formula to come up with a probability to predict race and ethnicity.”
For the sake of argument, Hackett asked the audience to “assume someone has a magic wand that can tell you the race and ethnicity of a name on a piece of paper with an address.”
The bureau, Hackett pointed out, identifies the buy rate as the true risk based price for credit because it takes into account the value of collateral and the borrower’s credit worthiness. It’s a baseline. The retail mark up (participation) is a matter of pure discretion. According to Hackett, the bureau says there is no business justification for a difference in dealer mark up based on credit risk. The dealer mark up should be set at a standard amount for all customers. Any difference in the final price should only result from a customer’s credit worthiness.
Despite this, Hackett explained that everyone knows there is a “rest of the deal” going on. He cited an example of a dealership car purchase where the consumer had “squeezed the price out of the middle as much as possible.” Once the consumer enters the F&I office, other factors might be needed to make the transaction come together. Hackett reported that the bureau’s current stance is, “Variables which affect the profitability of the overall deal, are not a business justification for credit pricing differences. “If there is a difference between whites and minorities with the same credit, you can’t look at anything other than credit reasons for that difference. Obviously, that is going to lead to some interesting difficulties.”
Disparate Impact or Disparate Treatment?
Hackett recalled meeting numerous individuals with significant seniority at various auto dealerships during his stint at the CFPB. Though the CFPB does not regulate dealerships, these individuals were concerned about the CFPB’s March 2013 bulletin on auto finance discrimination. Hackett recounted a conversation with one of these dealers/managers. The individual referred to the short period of time and limited information available to the finance manager to best put together a package including the vehicle, financing, F&I products, and enough profit for the business to survive. When it comes to things like pricing, the individual stated that F&I managers rely on certain known generalities such as “Asians are better credit risks,” illustrating the typical assumptions made in the marketplace.
The bureau, however, says this is not the statistical strangeness they refer to as disparate impact; rather, it is an example of disparate treatment. Hackett recounted an explanation he was given, “Folks [in the F&I office] are having to make decisions really quickly based on a lot of moving parts, some of which are subconscious assumptions about who knows what and who can negotiate better, and may include some parameters which happen to be illegal.”
Even though the Supreme Court could decide that disparate impact is not a valid legal theory, Hackett said disparate treatment is clearly a legal theory that works. Historically, disparate treatment occurs when the originator of a credit transaction has the freedom to price it, within bounds, wherever he or she wants, and gets paid more if the price is higher. Hackett said this happened frequently in the mortgage market, resulting in hundreds of millions of dollars in fines for large financial institutions.
Hackett explained that disparate treatment stems from the subconscious assumptions individuals make about customers that include race or ethnicity. The results may cause a dealership’s numbers to be skewed with regards to race and ethnicity. For a dealership to ensure everything that comes out of their portfolio is perfectly equalized and free from disparate treatment, their entire portfolio would have to pass this type of statistical test. Hackett described this as “pure disparate impact, and pure BISG.” He concluded that if you have a genuine business reason for treating customer “A” differently from customer “B,” then it’s not disparate treatment.
In their 2013 guidance, the CFPB mentioned flats and called for fair lending compliance management from dealers. However, Hackett said absent the inclusion of mechanics to follow, it’s difficult to interpret the bureau’s meaning.
Hackett pointed out that the NADA says flats are ordinarily reflected in the price of the credit. “So if I am going to pay 300 or 500 basis points in a flat, my retail credit charge is going to be higher,” explained Hackett, “Dealer Track and Route One are going to tell me, the dealer, who’s going to pay the most money. So whenever I can, I will push things toward the person who is paying the most to me, thus charging the most I can to the consumer.” Because of the typical subconscious assumptions occurring, discrimination occurs. However, it won’t be visible in a single lender’s portfolio. Hackett said from the CFPB’s perspective, this type of discrimination just goes away – only the Department of Justice (DOJ) and the Federal Trade Commission (FTC) can see it at the dealer level. In these instances, Hackett agrees with the NADA. He stated, “It’s not a good idea to swap out one system of ‘discrimination’ for another that puts the entire onus on the dealerships.”
Coming Soon from the CFPB Near You . . .
Hackett said a white paper focusing on economics could be expected soon from the CFPB. He expects it to address the bureau’s use of BISG and the allowance of controls. A control could be set for new versus used vehicle transactions. The white paper may also address dealer level monitoring and portfolio level monitoring. “It’s going to talk about the important technicalities, such as whether there is a minimum probability to trigger the analysis. “Is 51% African American enough to trigger it, or should it be 90%? And just maybe, if they are smart, the bureau will take this statistical thing they have created and test it against the tens of millions of known transactions in the national mortgage database; because mortgage loans collect both race and ethnicity data.”
While the CFPB is not going to broadcast what percentages they consider triggers, Hackett said the lawyers he works with estimate it to be around ten basis points. Reminding the audience again that he was only “the weatherman,” Hackett forecast an 80% likelihood for this scenario’s occurrence.
In March 2013, the CFPB issued a supervisory bulletin addressing indirect auto lending and compliance with the Equal Credit Opportunity Act (ECOA). With all the larger financial institutions in automotive already regularly examined by the bureau, Hackett said it would be rather disingenuous to assume that only a financial institution that has been publically flogged has had to deal with and resolve this situation. “Generally, when a resolution takes place with a large financial institution,” explained Hackett, “it’s nonpublic. It’s dealt with through an MOU (memorandum of understanding). Institutions will often concede many issues and be willing to concede a lot of things in order to do it in a supervisory, nonfinancial manner to avoid being publically flogged.”
Hackett said it is typical for the CFPB to make “supervisory highlights” around 18-24 months after a program or process starts in a supervisory area. He suggested that the CFPB’s intent could be expressed this way: “Hi. We’ve been out there working quietly and confidentially and we’d like to share – without naming names – what we’ve found and what people have decided to do.”
Ancillary Products and the CFPB
Hackett said the CFPB’s stance on vehicle service contracts (VSC) and ancillary products boils down to concern over consumers’ lack of knowledge of the products, their quality and their value. “Consumers know a lot about the quality and value of motor vehicles . . . They have many sources of information available to them. They know which vehicles work well and which don’t. They also know a ton about vehicle price. You all know these people – they go to a dealership, test drive a car, go home, and for a $12 dollar payment to TrueCar, they get a bid that they can take back into the dealership with all the profits stripped out of it. It seems easy, except, you can’t run a business that way – not if you are selling cars.”
To illustrate the bureau’s perspective on variable pricing of VSCs and ancillary products, Hackett described a hypothetical scenario at Wal-Mart: If Wal-Mart sold and advertised three VSCs priced side-by-side at $797, $1295, and $2095 a consumer would naturally want to know if the various products’ benefits justified the differences in price. They would probably seek out an expert in the store to provide them with product information. If the consumer learned Wal-Mart actually set the price, but in reality the VSCs were all the same product, the consumer would not be happy.
This translates into the CFPB’s argument that the difference in price goes back to the dealership – there is a possibility of unfair or deceptive sales practices going on because consumers don’t understand what they are being sold and they don’t understand that they are being sold a product that may have a variable price based on different coverages.
Despite their concerns with different pricing for the same product, Hackett said the CFPB could ultimately do little to address them. “The story is about unfairness or deception. That is a point of sale question and there is an invisible plastic bubble over the point of sale. If an auto dealership that sells or leases vehicles also has service facilities, and ordinarily sells most of its contracts to an unrelated third party, then they are not subject to enforcement or supervision. They are not subject to rule making [by the CFPB]; even the rules under truth in lending are still governed by the Federal Reserve Board when it comes to auto dealerships.”
Buy Here Pay Here (BHPH) dealerships are open for regulation because their business model is typically set up to keep contracts. But with BHPH customers, typically there is limited payment room for ancillary products and/or variable pricing. For this reason, Hackett doesn’t expect to see a lot of action from the CFPB on VSC and ancillary products in the BHPH space. Though Hackett said there are not a lot of smoking guns in the larger publically traded companies in the BHPH space, public filings show there are a few which have been under investigation for around two years but a resolution has not yet been reached.
Finance Companies Policing Dealers?
Hackett questioned the possibility of the CFPB’s potential attempt to make finance companies police dealer pricing on VSC and ancillary products in the future. “The bureau now has data on tens of millions of auto finance transactions and some of them have data with ancillary products. Therefore, they were able to pull out the information on dealer participation.”
The CFPB recently settled a case with a finance company whose business model Hackett described this way: “Go to Best Buy, buy a TV, put it in a small retail outlet at three times the price and then finance it at 18%. The bureau actually got them to sign a consent decree that said it was a scheme that artificially inflated the prices of consumer goods in order to hide finance charges. In this model, you can almost argue that it is obvious.” But Hackett said the problem with “it’s obvious” is determining where on the slippery slope the standard lies. At what point does the regulator say, “This is the real price.” The bureau looks at the final cost of a product and determines how much of that cost is finance charge, and how much is the actual price of the product. “If everything above $795 for the service contract is finance charge, they have a ‘hook’ into the whole transaction for the finance company.” Obviously, if this occurred, it would have the potential to change the entire landscape of vehicle transactions in F&I. Hackett likened the severity of impact to a mega tsunami creating beachfront property in Iowa.