This guest post was contributed by Raj Date, head of the Cambridge Winter Center for Financial Institutions Policy and a former McKinsey consultant, bank senior executive, and Wall Street managing director. For further information on the auto dealer exemption, see the recent study by the Cambridge Winter Center.
Over the past several months, Congress has debated ways to strengthen and rationalize consumer protection in financial services. Central to that debate is the proposed creation of a new agency focused exclusively on this issue, the Consumer Financial Protection Agency (the “CFPA”).
Even among proponents, however, there are varying conceptions of the scope and function of the CFPA. For example, the CFPA as envisioned by the House Financial Services Committee would exclude auto dealers from the CFPA’s coverage. The Administration’s original proposal would have included them. Starting this week, the Senate Banking Committee will have to wrestle with the same question.
They shouldn’t have to wrestle long: Even by the low analytical standards applied to hastily arranged, crisis-driven corporate welfare initiatives, the exemption of auto dealers from the CFPA appears profoundly ill conceived. Exempting auto dealers would simultaneously be bad for consumers, bad for industry stability, and bad for what remaining sense of free-market integrity we still have.
First, and most obviously, exempting auto dealers from the CFPA would be a big step in exactly the wrong direction on consumer protection.
One the central premises of the CFPA is that it would provide comprehensive rule-making — that is, regardless of what a firm chooses to call itself (bank, thrift, finance company, ILC, investment bank, broker — whatever), if it sells financial products, then it should be subject to the same rules of the road as every other competitor. Absent the same rules applying to all players, the marketplace becomes a “race to the bottom”: all participants migrate to the most permissive system of rules, and customer practices degrade to the lowest common denominator. (And then one day you wake up, and everyone is marketing teaser-rate option-ARMs).
So by that logic, if auto dealers are selling loans, then they should be subject to the same rules as everyone else.
And auto dealers are certainly selling loans.
Dealers are not a niche part of some obscure and immaterial market; they are the single largest channel (with 79% market share) in the origination of auto loans and leases, a business that (at more than $850 billion in outstandings) is larger than the entire U.S. credit card industry.
Not only are dealers a giant part of auto lending, but auto lending is a giant part of dealer economics. Over the past ten years, gross profit per new car has plummeted by a third. That would seem catastrophic in what was, even a decade ago, the brutally thin-margin business of selling cars. But dealers, somehow, still were profitable in 2008. The main reason: Over this same period, dealers were able to double their amount of higher-margin finance and insurance income.
Moreover, auto finance is demonstrably susceptible to unfair and deceptive practices, and those practices are demonstrably not held in check by private market forces alone. Just like mortgage brokers during the bubble, auto dealers have the opportunity to mark up interest rates; they routinely and confusingly cross-subsidize finance pricing and vehicle pricing; they can and do add “garbage” fees and add-ons of questionable provenance and dubious value. (Can I interest you in undercarriage coating? How about paint protection?).
So auto dealers are in the business of selling loans — a lot of loans — and their business model is susceptible to abuse. This is not a close call; they should be subject to the same rules as other players.
But this problem goes beyond consumer protection; it goes to the stability of the system.
The auto finance market consists of two basic distribution channels: the dealer (or “indirect”) channel, which is generally funded by a handful of large national banks and Wall Street capital markets platforms; and the retail (or “direct”) channel, which generally consists of credit unions and community banks. By artificially distorting the auto finance market in favor of the dealers’ distribution channel, the exemption encourages the primacy of Wall Street funding sources over traditional bank deposit funding. As evidenced by the crisis, intentionally chasing businesses from traditional banks and credit unions into Wall Street funding models creates the real potential for disruptive volatility over time.
Finally, the exemption also offends even the most basic principles of regulatory fairness. Free-market adherents should be dismayed by the notion of specially permissive regulatory treatment for some classes of politically powerful market participants. We should not be stacking the deck in favor of the already-dominant players with the most dubious customer practices (auto dealers and the captive finance companies and Wall Street houses that fund them), and thereby discriminating against competitors with more transparent, customer-friendly business models (community banks and credit unions chief among them).
By Raj Date