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The Next Subprime Crisis Will Ride on Four Wheels—Unless the Government Stops It

Daniel Acker/Bloomberg via Getty Images

Having failed to act on the subprime mortgage crisis, federal regulators now have a shot at redemption. This week, a top official at the Justice Department vowed to fully investigate subprime auto lending, which has in recent years become a major way to make a buck by targeting low-income communities.

Subprime auto loans don’t represent an existential threat to the U.S. economy: With $21.8 billion in subprime securitizations last year, the market is roughly 1/50th the size of mortgage-backed securities at the height of the bubble. But low-income borrowers are still being swindled by unscrupulous dealers, or forced into giving up their cars because of a loan they could never afford. And though auto dealers, active in every local community, carry tremendous political power, nobody in this industry is too big to jail. If law enforcement cannot take down small-time frauds, there’s no hope for the big ones. 

The proliferation of subprime auto loans results from two post-financial crisis factors. First, investors lost interest in mortgage-backed securities, but still sought out investments with enough risk to bring decent yields. So they migrated to subprime auto securities. The market has grown every year since 2009.

The second boost for subprime auto lending was the auto dealer carve-out from Consumer Financial Protection Bureau oversight in the 2010 Dodd-Frank Act. Former Congressman John Campbell, a former car dealer who received $7 million a year from renting out six dealerships and one repair shop while in office, pushed through the giveaway. Like escaped prisoners running away from a klieg light, financiers moved into the one market where regulators weren’t allowed to look. 

The Federal Trade Commission has primary jurisdiction over auto dealers. “Historically they have not taken an aggressive approach,” said Chris Kukla of the Center for Responsible Lending. The CFPB, meanwhile, has jurisdiction over the financial companies buying the loans, while the Securities and Exchange Commission regulates the securitizations and the prudential banking regulators also monitor some of the key players. This allows the industry to play regulators off one another for maximum leniency. “It’s hard enough to convince one regulator of the problem,” said Kukla. “It’s good that you have lots of cops on the beat, but the bifurcation can be problematic.”

These factors have super-charged the market. Subprime customers took out $129.5 billion in auto loans in the first eleven months of 2014, over one-quarter of total auto sales, according to credit-reporting bureau Equifax. And just like in the subprime mortgage days, increased investor appetite has pressured financiers and dealers to weaken underwriting standards. Regulators are probing numerous instances of falsified loan applications and inflated incomes.

Just as troubling are the ways dealers gouge borrowers that may be more unethical than illegal. The average term on a subprime auto loan is now 66 months, according to CRL’s Chris Kukla. Dealers stretch out the terms to make the monthly payment look smaller, but over time the borrower pays more. They also make a lot of money selling add-ons like extended warranties and service contracts, some of which have questionable value. Subprime borrowers often trade in cars worth less than they owe, rolling the debt onto the back of the new loan in an eerie recall of the bubble-era mortgage refinancing boom. Interest rates can be as high as 30 percent in some states, even though lenders can repossess the car if the borrower defaults. And defaults are rising: Missed payments on car loans are at a post-financial crisis high, according to Moody’s Analytics.

Increased defaults make sense when you consider the layers of risk placed on borrowers. The average loan-to-value ratio on a subprime car loan is as high as 150 percent. Buyers are deeply “underwater” on their loan the moment they drive off the lot. And that’s before auto dealers charge their “dealer markup,” points on the interest rate dealers add as compensation for matching the borrower and lender. Dealers often shop for financial institutions that allow them to issue the biggest markup. When borrowers are told the final interest rate, they have no idea how much of that goes to the dealer as pure profit. 

These dealer markups disproportionately affect people of color. Studies show that African-Americans and Hispanics pay higher interest rates than white people, even when they try to negotiate the loan. “People of color who tried to negotiate got worse interest rates than whites who didn’t,” said Kukla.

The Justice Department is probing this raw material to bring cases, which fall into two parallel categories. First, as JPMorgan Chase has admitted in regulatory filings, they are in discussions with Justice over racial disparities on their dealer markups. The investigation grew out of a CFPB partnership, enforcing the Equal Credit Opportunity Act. Ally Bank has already paid $98 million in fines over the same practices, and both Honda and Toyota’s financing arms have acknowledged their potential exposure.

But Sally Quillian Yates, acting number two at the Justice Department, named a variety of other potential offenses in her speech to the National Association of Attorneys General on Tuesday. She included securities fraud, origination fraud and deceptive consumer practices. That could include faking borrower incomes, knowingly making false promises to investors about the quality of subprime auto loan securitizations, or selling worthless warranties to customers. Several companies, like Ally Financial and Santander Consumer USA, have already received subpoenas for information on underwriting and securitization.

Kukla credits aggressive media investigations of subprime auto loans, including an ongoing New York Times series, for finally calling attention to the industry’s problems. It could spur additional regulations to weed out still-legal practices, like usurious interest rates, excessive loan terms or “starter interrupts,” where lenders can shut off delinquent borrowers’ vehicles remotely, without any due process affirming the default. “There’s a severe lack of regulation in auto lending,” Kukla said. “The good result here is that people are starting to pay attention.”

Will these federal investigations yield results? The Justice Department has been criticized repeatedly for its inability to prosecute individuals responsible for the financial crisis. But the auto lending space seems like a classic environment for flipping the smaller players (the loan officers/brokers) to get to the decision-makers at the top (the dealers/lender executives). The industry will whine about preventing access to credit, but preventing fraudulent conduct is actually federal prosecutors’ job description. In a relatively small market, without the threat of extreme collateral consequences for cracking down, DOJ should have the freedom to go wherever the investigations take them.

Early signs have not been promising. That settlement with Ally Financial over dealer markup discrimination implicated no individuals, and Ally didn’t have to admit to wrongdoing. In these investigations, the government appears to be using a statute, the Financial Institutions Reform, Recovery, and Enforcement Act (FIRREA), which has a lower burden of proof but only allows for civil and not criminal penalties. In her speech Tuesday, Yates stressed that financial penalties are “not a substitute for holding individuals within those institutions personally accountable for their actions.” But talk is cheap.

Without an aggressive push on auto lending fraud, the Justice Department will signal that it is just as unserious as it was about mortgages, content to impose one-off financial settlements that do nothing to deter misconduct. As Sally Yates said this week, “We shouldn’t wait until there is a crisis to pay attention.”