CFPB Releases Report on Fair Credit Exams and White Paper on Proxy Methodology

Along with its proposed larger participant rule for the auto financing market, the Consumer Financial Protection Bureau issued a special edition of Supervisory Highlights (the “report”) describing its fair credit supervisory activity in what it characterizes as “the indirect automobile lending market.” Its auto finance supervisory activity to date would relate to insured depository institutions and credit unions with total assets greater than $10 billion, and their affiliates, which Dodd-Frank subjected to CFPB supervisory authority on the designated transfer date of July 21, 2011.

The report indicates that CFPB supervisory examination teams have been conducting targeted Equal Credit Opportunity Act (ECOA) compliance reviews of “indirect auto lenders.” (The CFPB uses the term “indirect auto lenders” to refer to persons who engage in the sales finance business of purchasing retail installment sale contracts from motor vehicle dealerships.) These targeted reviews have included examinations of credit approvals and denials, wholesale buy rates quoted to dealers and what the Bureau characterizes as “any discretionary markup or adjustments to the buy rate.”

The report’s focal point is the last item—fair credit examinations of the difference (the “rate spread”) between the wholesale buy rate and the retail contract APR. It indicates that “[e]xamination teams found that indirect auto lending policies that allow discretionary markups affecting dealer compensation often resulted in disparities in dealer markup based on race and/or national origin.” After observing that the CFPB is required to make a referral to the U.S. Department of Justice (DOJ) whenever it has identified a pattern or practice of discrimination on a prohibited basis, the Report notes that a referral does not affect the Bureau’s authority to take independent corrective action.

This is the segue into the surprising news that multiple targeted ECOA reviews conducted during the last two years have resulted in non-public, supervisory resolutions with several auto “lenders” involving approximately $56 million in redress for approximately 190,000 consumers. According to the report, these institutions had not been “adequately monitoring and controlling the fair [credit] risk associated with their policies.”

Consistent with the one public enforcement resolution to date, the non-public “supervisory resolutions have not required institutions to adopt a single compliance alternative.” Instead, the report indicates that “institutions have the choice to adopt compliance mechanisms that suit their particular business structure, provided that the institution addresses the policies and practices that resulted in the disparities in dealer markup.”

When examination teams have determined that corrective action is necessary, the report indicates that the institutions involved were “directed to pay remediation sufficient to address direct and indirect consumer harm from the examination period through the date of the resolution addressing the discrimination.” It further indicates that the institutions were directed to “remunerate consumers on a prospective basis if compliance mechanisms do not eliminate disparities in dealer markup in the future.”

Significantly, however, the report does not specify how these direct and indirect damages were measured and calculated. It merely notes that, in addition to performing an annual analysis of their portfolios, some creditors are remunerating as often as monthly “by adjusting interest rates to address emerging disparities” and refers to a directive to use “a regression model and proxy method that are appropriately designed to identify harmed consumers.”

The report notes that additional supervisory reviews have identified ECOA violations at other auto finance institutions, and “examination and enforcement teams are actively working toward resolutions for the harmed consumers in each of these matters.” It further indicates that “[t]he Bureau is currently engaged in additional enforcement investigations involving other indirect auto lenders.”

The report includes numerous other assertions and observations drawn from supervisory examinations:

  • The CFPB expresses its belief that controls appropriate to a statistical analysis of wholesale buy rates “may not be appropriate to a dealer markup analysis because, when the dealer considers applying a discretionary markup, the [assignee’s] underwriting and pricing systems often have already considered risk-based factors related to creditworthiness, the characteristics of the collateral, and the terms of the transaction.” The Bureau takes the position that, “[a]bsent a showing of legitimate business need, it is generally not appropriate to consider… factors [used by the assignee’s underwriting and buy rate pricing systems] for a second time in conducting an analysis of dealer markup to identify disparities on a prohibited basis.”
  • Supervisory activity identified some auto finance “products” that, as a matter of policy, significantly limit “discretionary dealer pricing adjustments” to a level as low as 100 basis points. While the report does not specify the “products” involved, it asserts that significant limits on “markup, such as a limit of 100 basis points, may reduce fair lending risk and significantly reduce the need for certain compliance management activities.” The implication is that that the CFPB believes that the more common limitations of 250 and 200 basis points are insufficient. Instead of supporting that claim, however, the Bureau simply criticizes assignees of retail installment sale contracts for failing to engage in significant monitoring and other compliance management activities.
  • Supervisory resolutions have included a direction to adopt policies and practices that effectively mitigate fair credit risk. The report mentions three possible methods of mitigating the fair credit risk: (1) monitor and correct disparities through a strong compliance management system; (2) further limit “the maximum discretionary pricing adjustment to an amount that significantly reduces or eliminates disparities and fair [credit] risk”; and (3) “eliminate discretionary dealer adjustments to risk-based buy rates altogether and fairly compensate dealers using a non-discretionary mechanism that does not result in discrimination.”
  • A list of corrective actions that the CFPB has directed be taken by “[i]nstitutions that choose to permit discretionary pricing affecting dealer compensation after an examination revealing discrimination” on a prohibited basis. This includes some discussion concerning the establishment of a reasonable minimum volume requirement for dealer monitoring. The report does not discuss the potential impact of a dealership’s adoption of the NADA Fair Credit Compliance Policy & Program, which is an optional compliance program that the National Automobile Dealers Association (NADA) released to its members in January 2014. (The NADA Program is modeled on the fair credit compliance program contained in DOJ consent orders that two dealerships entered into in 2007 to resolve credit discrimination claims..
  • A brief discussion of three potential alternatives to “discretionary” finance charge rate spreads: flat fees; a fixed percentage of the amount financed; and a multiple-criteria approach predicated upon both the amount financed and the duration of the contract. The report notes that “several indirect auto lenders have chosen to fully implement or pilot policies that do not rely on discretionary markup to compensate dealers.” However, it offers only one example—an institution that publicly announced it would pay dealers 3 percent of the amount financed subject to a dollar limit. The Report does not indicate whether auto sales finance was a significant line of business for that institution or what effect this change had on the volume of retail installment sale contracts that dealers assigned to that institution.

“The Fallacy of Flats,” an article by the NADA representative who spoke at the CFPB auto finance field hearing on September 18, 2014, explains that, “far from eliminating dealer discretion, flat fees would merely shift the primary exercise of that discretion from intra-finance source discretion (that is, the discretion a dealer exercises in determining how many basis points to add to the wholesale buy rate offered by a single finance source) to inter-finance source discretion (that is, the discretion a dealer would exercise in determining which flat fee amount to choose from among the competing offers it received from multiple finance sources).” This also would be true of the other alternative suggested by the Bureau—a fixed percentage of the amount financed.

Finally, the report explains the CFPB’s use of the hybrid Bayesian Improved Surname Geocoding (BISG) methodology to proxy for unidentified race and ethnicity in the non-mortgage context. The report was accompanied by a white paper explaining this proxy methodology in further detail and reporting that a study conducted by the Bureau had concluded that this “integrated approach to building a proxy is more accurate than either surname or geographic data individually.” 

An American Financial Services Association (AFSA) representative who spoke at the field hearing observed that “[t]he white paper confirms that BISG overestimates the number of minorities in a lender’s portfolio, but did not mention how the CFPB plans to address that.” Indeed, with respect to the composition of a portfolio, the report acknowledges that the BISG method is not as effective as geographic proxies for the Non-Hispanic Asian/Pacific Islander and the Non-Hispanic Multiracial categories. Referring to a fair credit study commissioned by AFSA, the AFSA representative asserted that that “our extensive study will show that the CFPB’s overreliance on the BISG methodology skews the results….” Finally, the AFSA representative noted that the proxy white paper “did not describe how [the Bureau] estimates disparities – leaving more to be said.”

The timing of the report’s release suggests that it is intended to emphasize the importance of supervisory examinations of auto finance operations and the continued focus on ECOA reviews of finance charge rate spreads. The report expressly acknowledges as much, stating that “indirect auto lending remains a significant focus of supervisory reviews, especially for indirect auto lenders that maintain discretionary markup policies and have not yet been subject to a fair lending review.”