September 21, 2015

Are CFPB charges of racial bias in the auto loan market overblown?

Regulators are worried not only that the auto loan market could be overheating - they've also sounded the alarm about alleged racial bias in the booming sector.

'Disparate impact'
Two big operators in the car loan business, Ally Bank and American Honda Finance Corp., have both settled with the government over the past two years. The Consumer Financial Protection Bureau concluded that Ally Bank loan holders who happened to be black or Hispanic paid up to $300 more over the life of their loans than white borrowers. It's not that these companies and others, which the government has fined $200 million total so far, are accused of being racist on purpose. It's that regulators found that policies had the result - whether intentional or not - of squeezing borrowers of color. The name for this dynamic is the "disparate impact" doctrine.

An investigation by American Banker found that the CFPB's own documents acknowledge that the agency's methods could result in overestimating the amount of racial bias built in to loan ecosystems. A memo from Patrice Ficklin, assistant director of the watchdog agency's Office of Fair Lending, describes the CFPB's formula as "valid and reasonable under the circumstances here, and although there may be some risk of overestimating disparities, the alternative presents an equal (and perhaps greater) risk of underestimating disparities and thus consumer harm."

Dealerships get a pass
Part of what has some auto loan companies crying foul is that dealers are, thus far at least, exempted from the bias probes. That's because Congress wrote the law empowering the CFPB so as to include lenders but not dealers, according to the Wall Street Journal. At the heart of the issue is the "reserve" charged by dealers when a lender handles a given car loan. Some dealers add as much as 2.5 percent to loans as markup for themselves, pointed out. Regulators are pushing lenders to cap those markups at lower levels or adopt flat-fee structures.

The regulatory vigilance may be socking all consumers with higher loan payments, according to numbers crunched by the Wall Street Journal. The publication looked in detail at American Honda Finance Corp. loans. As a result of the company's settlement with the feds, it agreed to alter aspects of their loans. A pricing sheet from Texas showed that someone with a credit score of 760 is paying 1.1 percent more in base interest than before the settlement. Assuming a dealer markup of 0.5 percent, that would add $586 to interest payments over the life of a 48-month, $25,000 loan.

Methods criticized
Targeted lenders argue the government isn't using the most accurate methods to determine the race of borrowers. Some type of proxy must be used, since law prohibits loan writers from asking the race and gender of borrowers. Regulators made educated guesses by comparing borrowers' last names and places of residence with Census data. The method used by the CFPB deduced that, in the case of Ally, 235,000 borrowers of color paid more than their white counterparts. Left out of the calculus were variables such as the borrowers' credit scores.

Critics also point to the slowness of lenders allegedly harmed under the policies to collect their money as proof the government overstated the extent of discrimination. Ally has $80 million earmarked for victims still sitting in escrow. The upshot of all this criticism: House Republicans are pushing a bill that would rein in the CFPB's power over auto loan markets. The bill's prospects are unclear in the Senate and, should it even get that far, American Banker doesn't see much chance of that bill surviving an expected presidential veto.

Uncertainties like these are a part of any banks' analysis of which parts of their loan portfolios to keep and which to sell. Loan sale advisory firm Garnet Capital Advisors has decades of experience helping banks navigate the fast-changing regulatory environment.