The Consumer Financial Protection Bureau is preparing to crack down on interest rate markups that automobile dealers add onto the cost of car loans, potentially threatening one of the few bright spots for bank lending of late.
When banks provide financing for loans through auto dealers, the lender typically sets an interest rate that serves as a price floor, while allowing the dealer to charge a markup to the car buyer that often ranges from 2 to 2.5 percentage points.
The dealer usually gets to keep much of the markup — a practice known as dealer participation. Consumer advocates compare the markups to the yield-spread premiums that mortgage brokers received during the house bubble, and have since been banned.
American Banker was first to report last summer that the consumer agency was investigating whether those rate markups are being imposed by auto dealers in a discriminatory way. That probe has since progressed, with Bloomberg reporting last month that the bureau has warned four banks of potential lawsuits.
"The bureau has made it clear that nonmortgage lending and, in particular, auto finance are going to be major focuses of enforcement in 2013," says Anand Raman, a banking lawyer at Skadden Arps.
In early March, Ally Financial, one of the nation's top auto lenders, disclosed in a regulatory filing that the CFPB is investigating some of its "retail financing practices." The company declined further comment.
The regulatory scrutiny comes at a time when banks including Wells Fargo (WFC) and JPMorgan Chase (JPM) have ramped up their lending through auto dealers, a business known as indirect auto lending. Auto sales have rebounded in recent years and many banks have capitalized by partnering with more dealers.
At the Consumer Bankers Association's annual conference this week in Phoenix, the legal risks that banks face in auto lending was one of the hottest topics of conversation. Among the speakers was Patrice Ficklin, the consumer agency's assistant director of fair lending and equal opportunity.
Ficklin made two statements during her remarks in Phoenix that sharpened the concerns of bank lawyers.
First, she said that when the consumer agency investigates whether the markups are being imposed in a discriminatory way, it looks at certain factors, including the car buyer's surname and home address, that it uses as proxies for the borrower's race.
Unlike in mortgage lending, no one collects data on the race of auto loan borrowers, which is why regulators turn to proxies. But those proxies are imperfect, as bank representatives point out.
"The available name and geography proxies are ineffective in identifying the race of the borrower," argues Andrew Sandler, a bank lawyer with BuckleySandler.
Second, when Ficklin was asked whether there is a numerical threshold below which the CFPB will not pursue fair-lending cases in indirect auto lending, she declined to specify any such number.
That comment left bank attorneys wondering if even a small gap between the average interest rates charged to minority borrowers and those charged to non-minority borrowers — perhaps no more than 15 to 20 basis points — could be enough to trigger a fair-lending lawsuit.
The bigger-picture problem for banks is that the regulatory scrutiny requires them to monitor the loans being made by all of the auto dealers they work with. That's sometimes more than 1,000 dealers.
"If they're done in a discriminatory manner, then you, the bank or the credit union, are responsible for that," says Edward Kramer, the executive vice president of regulatory programs at Wolters Kluwer Financial Services.
Ficklin added that the CFPB does not consider interest rate markups by auto dealers to be intrinsically unlawful, a comment that drew mixed reaction from bank lawyers.
"I think that was a very positive development," says Kenneth Rojc, managing partner of the auto finance group at Nisen & Elliott LLC.
"Everyone thought there was going to be a complete outlawing of dealer rate participations," he adds. "I don't see the CFPB going there."
Other bank industry lawyers were less happy about the CFPB's assertion. Banks might actually benefit from rules banning discretionary markups and replacing them with a flat-fee structure.
But if the consumer bureau were to enact an outright ban on markups, it would antagonize the nation's auto dealers — a powerful interest group that Congress exempted from the agency's jurisdiction.
Unless regulators impose industrywide rules banning the dealer markups, banks fear that if they alter their own pricing structures, they will lose business to competitors, Wolters Kluwer's Kramer says.
"If you have 1,000 auto dealers, and you say, 'OK, I'm going to get rid of markups,' they're going to leave and go somewhere else," he says.
The CFPB denied a request for an interview with Ficklin. In a written statement about auto dealer markups, the agency said, "We know the practice has historically been found to affect people of color more than others. There are also concerns about the costs to consumers and the transparency of the practice."