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The CFPB Auto Dealer Exemption--A Reminder of the Why We Should be Worried

posted by Adam Levitin

It looks like auto dealers are going to get their carve out from the CFPB.  I can't think of a policy argument for exempting auto dealers; maybe someone will provide one in the comments.  The used car dealer has long been the poster child for sharp dealing.  But it's worth reviewing the consumer protection problems with auto dealers, so that we realize what practices are being exempted from potential future regulatory oversight.  

Auto dealers sell a variety of products to consumers.  They sell cars.  They buy cars (trade-ins).  They sell insurance products (warranties, rust proofing, GAP insurance, credit life,  etc.).  And they sell financing.   They're not the only merchants that do a brisk business in both selling goods and financial products (electronics and furniture retailers do a fair amount of financing, for example, as do some retailers with private-label credit cards, like Target), but auto dealers are definitely combining sales and credit on a larger scale than any other type of merchant.  

Auto loans themselves tend to be fairly simple--short terms, amortizing loans.  While rates can be quite high (for example, the 21% APR in Till v. SCS Credit Corp.), loan structures aren't the problem; interest only and payment option haven't caught on in this market, but they don't need to because there's lots of other ways to make money off of consumers.  

Two features of the auto purchase market facilitate sharp practices:   

First, there are high transaction costs in purchasing a car.  The consumer has to figure out the type of car they want and then locate a dealer, and then physically go to the dealer and haggle over price (yes, I know there are some Internet options now, and maybe that will improve things).  By the time the deal is closed, the consumer has spent a fair amount of effort.  This makes consumers reluctant to walk away when confronted with an abusive practice, not least because they fear that the next dealership will be even worse.  

Second, a typical auto purchase transaction involves multiple components (sale, trade-in, warranties, financing, and add-ons).  These components are all governed by different regulatory regimes, and the consumer cannot know the total cost of the purchase until at the very end of the deal.  Meaningful comparison shopping--on the total cost--is therefore frustrated, and that allows lots of predatory, rent-seeking practices.  (Sound familiar?  It should be.  The fundamental move of frustrating total cost comparison shopping is the same as in credit cards and lots of areas of consumer finance.) 

So what are the problems in the auto lending world?  Here are some.  I'm guessing I'll learn of some new ones in the comments.  I'm also guessing that auto leasing has its own bag of tricks.  

Bait and Switch.   There are lots of variations on bait-and-switch with auto dealers.  Here's one: the dealer gives the consumer a quote on a particular model and says that it is in stock.  The consumer comes in and guess what--that model is still in stock, but only with a bunch of dealer-added features (hubcap locks, pinstripe, fog lights, etc.) that raise the cost of the car by more than the value given.  Want to guess why I'm driving a Honda Odyssey with a "racing pinstripe" on it?   

Hidden Fees.  This is sort of self-explanatory, and is another bait-and-switch variation.  The consumer bargains with the dealer over the price of the car and the financing and thinks that a deal has been reached.  Then the consumer gets the final bill for the car and it has a bunch of previously unmentioned fees.  The dealer says don't worry, we'll just increase the amount financed.  

Dealer reserve kickbacks.  These are the yield spread premiums of the auto world. The dealer often acts as a broker for a financing company that will finance the car purchase.  The dealer is compensated for this service by getting a slice of the interest on the loan.  The higher the loan rate, the larger the kickback.  So the consumer qualifies for a loan at 10%, but the dealer steers the consumer into a 14% loan in order to get a larger dealer reserve payment.  (One way to avoid being steered due to dealer reserve is to go in with a direct financing offer lined-up from an independent finance company; I wonder how many consumers do this, though.)  

Loan packing.  Overpriced and underused or frankly unnecessary products like credit life insurance and GAP insurance and rust-proofing get bundled in to the deal.  

Overselling.  Dealer's cuts on loans can give them an incentive to steer consumers into larger loans.  One way to do that is to sell the consumer a more expensive car, which requires more financing.  Of course the consumer still has to be qualified for the loan, and there have been problems in auto lending, just as with mortgages, of dealers (and borrowers) fudging the numbers on the paperwork to make borrowers look more creditworthy.  

Spot delivery yo-yos.  This is one of the sleaziest moves.  The consumer buys a car with financing arranged through the dealer.  The financing includes a nonrefundable deposit.  The consumer takes the car home thinking that everything is in order.  The dealer then calls the consumer the next day to say that the financing was denied in the end and the consumer has to return the car.  And the dealer keeps the deposit. 

Binding mandatory arbitration.  This is a generic consumer finance problem.  

Two concluding questions:    

1.  What explains the persistence of the auto dealer business model, which combines car sales with the sale of various financial products?  Is this just a matter of path dependence?   I don't see any inherent efficiency in this bundling.  But there might be a very obvious answer I'm missing.

2. Why do these sharp practices persist in auto dealers?  Why hasn't inter-dealer competition, reputational sanctions from consumers, and OEM reputational concerns gotten rid of sharp-practices?  

I'd love to hear readers thoughts on these questions and on abusive practices at auto dealers in general.  Comments are open.  


Thank you for outlining the various pitfalls.

I've posted a small comment about how this affects North Carolina's many military families:


Thank you for digging into this loophole.

I've been employed as a finance manager in the auto industry for over twenty five years. I've probably placed over 15,000 auto loans or leases for consumers over that time. I cringe when I hear people make statements regarding regulation. Yes auto dealers are in the business to make money. Yes we may earn income from placing loans for our customers. For some reason you believe this is evil. Have you ever spent any time in a automobile agency and walked through the sales process? I pride myself on offering more competitive loan rates then my clients can obtain through their own financial institutions. I do it on a daily basis. I may save them money. I definitely save them time and make the sales process easier.

What scares me is when "experts" make statements like "we don't know what type of regulations to instill, but we know the industry needs regulation", or your take that subsidized low interest rates lead to dumb choices by consumers. Your twisted way of thinking and proposed solutions will eventuality lead us to bigger government, less choices, and higher costs to consumers. You state that consumers may obtain their own loan, but doubt that many do. So am I to believe that your opinion is factual? Why didn't you back up your spiel with some data?

The examples you used as the dealers way of doing business are probably illegal. Loan packing, already illegal. Hidden fees? The only fee I've ever charged is a dealer document fee which is already capped by regulation at $55. Every client pays the same document fee. Bait and switch? Never happens in the agency I work for. That type of behavior is unethical. Shame on anyone guilty of that practice. Consumers should walk away if they find themselves exposed to that situation. You want to regulate the practice. I know of no dealers that offer credit life insurance. I doubt that many offer rustproofing. I work and live in California. Rust isn't an issue for most people.

Why didn't you mention the current Regulation Z. This "truth in lending" regulation requires the complete disclosure of every penny spent on an automobile purchases? All loan contracts already are under this regulation. Did you conveniently overlook the regulation or intentionally fail to explain it on the radio broadcast.

I could go on further but I have to sign up a client for his new .9 APR auto loan.

I just got a new car and the document fee was $300. We caught it but only because my wife, who is a lawyer, read every word of the sales contract.

Around 2000, we got a loan for a new car in the dealership, but the math didn't work out. After we tried to explain to the finance person literally 10 times how the numbers didn't add up, he finally admitted that we were signed up for credit life insurance. The dealership said he was not supposed to put us in that product without telling us, but I bet the next person in his office was signed up without knowing it.

Let me be clear about the point of my post. I am certainly not alleging that every auto lender engages in sharp practices. Rather, I am merely noting that sharp practices do exist in the auto lending industry, which calls into question whether auto dealers should be exempt from the CFPB's regulatory authority, or whether they should be covered, just like an auto finance company.

Jon Klippel suggests that most of the shady practices I detailed are "probably illegal." But are they? There might be specific state statutes I don't know, but there's little in the way of protection on the federal level. Some states cap, like California, things like dealer document fees, but that's not uniform, and there are plenty of unregulated fees; a creative lender can easily come up with new junk fees. And just because something is illegal doesn't mean it doesn't happen. There are laws against murder, after all.

Mr. Klippel also mentions Reg Z as if it is some talismanic proof of industry good behavior. Let's recall that Reg Z covers credit card and mortgage and payday lending too. How much good does that do? Reg Z requires disclosure of the finance charges, the sales amount (itemized), and who besides the lender is getting paid on the deal. There are a few problems with this.

First, the consumer only sees this disclosure right at the end of the negotiations, after the consumer has put in considerable transaction costs. Are you really going to walk away at that point over an extra $100, when you know the next dealer will do just the same thing and might not give you as good of a price? It's hard to walk away once you've sunk in major transaction costs. (This is also a problem with mortgage lending, when additional fees get added on at closing.)

Second, the disclosure isn't necessarily very meaningful. How many consumers have any idea what it means if they see a "dealer reserve fee" disclosed? How many are going to ask or realize that it could be negotiated?

And third, there isn't very much enforcement of Reg Z for non-banks. The FTC is the agency responsible for Reg Z enforcement for non-banks, but the FTC does not conduct regular examinations of auto dealers, the way banks are examined. And private enforcement--just not worthwhile. How often is a consumer going to bring suit over a few hundred or few thousand dollars? Not worth it. And for a single dealership, it's probably not even worth a class action.

This all goes to the Klippel's "show me the data" point. I would love to show some data on the auto lending industry. Unfortunately, I don't know of any data sources, and would be very happy if someone could point me to some data. The Fed tracks auto lending rates, but that's just the APR, and doesn't tell you much of anything. The absence of data is itself a problem--there's plenty of anecdotal evidence of abuses in auto credit sales, but because no one keeps track of the terms of the transactions, it's hard to make an informed policy judgment.

Mr. Klippel launches a generally salvo against "experts" who think they know better than industry and big government. Did he sleep through the mortgage crisis? It seems we know pretty well what happens when consumers are given artificially low teaser rates--a lot (but not all) get in over their heads. As for the silly big government is bad meme, consider quality of life in countries with lots of government (US, Europe, Canada, Japan, e.g.) vs. countries with minimal government (Iraq, Afghanistan, Haiti, e.g.). Where would you rather live? The issue can't be a matter of "big" government. It's really a question of effective government. And let's not make the foolish assumption that more regulation leads to higher prices and less choice. The impact of increased regulation is, in the abstract, indeterminate. The issue isn't the amount of regulation, but whether it is smart regulation. Smart regulation should enhance competition by eliminating rent-seeking opportunities. The result should be lower prices and increased pressure to innovate products (not just pricing), which means more (meaningful) choices for consumers.

Mr. Klippel challenges me on a factual assertion, that consumers may obtain their own direct auto loan. Check out Capital One's Auto Finance website: http://www.capitalone.com/autoloans/. I don't know how many consumers get this sort of direct loan; I suspect it is a small minority, but I know it helped me get a much better rate out of my dealer.

Finally, how is Mr. Klippel going to make money on a .9% APR loan? It sure isn't on the interest. If he's willing to lose money on the loan, he's got to be making it up elsewhere.

Isn't he making it up in the price of the car?

The captive lender pays a flat fee between $150 and $250 to the dealership for placing a subsidized loan (.9apr) with them. Lenders realize that dealerships must earn income to survive, something big government advocates rarely acknowledge.

You state: " I don't know how many consumers get this sort of direct loan; I suspect it is a small minority, but I know it helped me get a much better rate out of my dealer."
That's a great example of how it works! Could you give me an example how big government could make it any easier?
The internet has made it very easy to compare pricing on automobiles and interest rates. All of the popular websites (Yahoo, MSN, AOL, Google, etc..) have links that provide a ton of information about purchasing a automobile. Everything from the dealers invoice cost to links were you can get pre-qualified for an auto loan and take a blank check into the agency. Credit unions and other organizations have buying services that offer to take care of the consumers, save them money and take the hassle out of buying a car. In what other industry does the consumer have that much information and choices? Yet you want smart regulation a (misnomer as far as I'm concerned) Don't get me going on the unintended consequences that pop up after regulation becomes effective. Yes government should protect us from fraud, not dictate the process of buying a car.
Bottom line is the issues that you are concerned about are so yesterday! You should be promoting the auto dealerships who do things right, not supporting more burdensome government regulations on small business. Sounds to me you may be lobbying for the "Auto Loan Czar" appointment!

Jon Klippel: Obviously dealers have to make money to stay in business. The question is whether dealers or anyone else should be able to make a profit. Of course they should. But the rules of the game of capitalism require that the profit be made _fairly_. If you can't make a profit fairly, you should be out of business. That's the free market--compete, fairly.

So let's take your own case. You get paid a fee for steering the consumer to a subsidized loan from the OEM's lending arm. The only way the OEM is going to make money then, is by having a higher mark-up on the car, which means that the OEM's captive is financing an unnecessarily large loan, albeit at a below-market rate. The consumer is borrowing more than necessary, which offsets the savings from the low rate. I can borrow $15,000 at .9% for 4 years or $14,000 at 5.0% for 4 years and end up with virtually the same monthly payments. The OEM and the dealer like this because they can book larger sales now (and benefit more from the hanging paragraph). THe low rate is just part of a thimberlig game between cost components. The big question is the _total_ cost of car and financing and extras, and nothing you have written suggests that consumers are able to comparison shop on total cost. Consumers don't really care about the allocation of the fees to different components; they care about the total cost.

Many of the problems I outlined in the post fall clearly in the ambit of fraud: bait-and-switch, hidden fees, dealer reserve kickbacks for steering consumers to higher cost loans, yo-yos, loan packing. I'm glad to hear these problems are "so yesterday" at your dealership (I'm sure you would never add on features like pin stripping to models delivered by the OEM in order to charge an extra fee for the worthless decoration...), but they continue to be real problems in many places.

If you're willing to call these problems fraud, then there is obviously a role for the government. But even if you don't think they rise to the level of fraud, you're argument that the market works depends on disclosure working and consumers having access to adequate information when they are making their purchasing decisions. The problem is they don't. There's shockingly little evidence disclosure actually works with complex financial transactions, and even if it did, the relevant disclosure--that of the _total_ cost---is not disclosed until the very end of the transaction, after the consumer has sunk in a lot of time and effort and is reluctant to walk away over a few hundred dollars. So yes, while I can get lots of info on the different price components of buying a car, that does me no good when I go into a dealer because those price components are always dependent on each other. Low financing rate if the car price is higher or if there's rust proofing. Free rust proofing if the financing rate is higher, etc. I got a better rate out of my dealer by having an alternative financing source in hand, but that doesn't mean that my total cost was actually lower.

And yes, regulation has unintended consequences, but so too does lack of regulation. Unless you think the financial crisis was the intended outcome of lack of regulation.

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