The Role of Predatory Lending in the Collapse of Detroit

by Laura MacCleery

After listening to a stirring speech by Professor Elizabeth Warren of the Senate Congressional Oversight Committee on the bailout last Saturday at the American Constitution Society convention, I was struck by the many similarities between credit card company practices in moving the profitability of financial products towards the “back end” penalties and fees, and those I uncovered several years ago in the automobile lending context.

The coverage of the auto bailout and the collapse of the domestic auto industry has lacked real understanding of how risk was fed into the auto purchase marketplace. The same full range of predatory practices affecting home mortgages were widely used – and perhaps even to a greater extent – by the automobile industry to sell vehicles. 

In general, Detroit has been inattentive to the serious problem of oil dependency for its profitability model, pushing far larger SUVs and pickups on consumers than was justified by transportation needs. It has also been hostile to safety advances, and managerially backwards. These problems are well known. Less well understood is that, through predatory lending practices, they’ve been taking their customers to the poorhouse with them.

When I was at Public Citizen, we wrote a report in 2003, entitled Rip-Off Nation, detailing many of the fraudulent and misleading aspects of auto purchases. We worked closely with a whistleblower who had been an auto dealership employee and was familiar with many of the tricks and traps then being used to saddle consumers with overpriced auto loans, and published real examples of actual auto lending documents demonstrating the scams. Without the mortgage lending example to illustrate the problem and its potential economic costs, our work to raise the issues largely fell on deaf ears.

Yet the situation has only worsened since, and the number of consumers who are underwater in their loans continues to climb. In December 2008, as The Denver Post reported, both the number of “upside-down” new vehicle purchases and the amount that consumers owe on auto loans have ballooned:

"About one-fourth of new auto sales this year left consumers upside down, according to Edmunds.com, an auto shopping service, with them owing an average of $4,421 on their loans over their car's value. The percentage of negative equity sales has hovered around that mark since 2003, although the negative balance on those loans is about 25 percent higher." 

In summary, a usury-based profit model took hold in the auto industry over the past decade, replacing a reasonable exchange of value for a predatory lending relationship – and its consequences for both the industry and consumers have been disastrous. Our 2003 report documented how dealerships profit from arrangements with banks that allow them to get a markup on loans – taking 2 or 3 percent on top of the costs for consumers, and driving dealers towards the most profitable loans rather than those that were best for the buyer. Dealers used backroom negotiations to eke out profits from needless add-on products, increasing the cost of a loan without adding value. Moreover, so-called “yo-yo” sales tactics would deceive purchasers who drove a new vehicle off of the lot into accepting a subsequently altered loan contract containing dealers’ most favorable terms. 

It is no overstatement to say that, in burdening consumers with loans that were immediately – upon the point of purchase – deep underwater, and that would never recover any substantial value, the auto industry rapidly dried up demand for its new vehicles and preyed upon its most valuable asset: its customers. While the deteriorating economy and high price of oil no doubt both played a role, it is very difficult to explain the near-cataclysmic drop in demand for new vehicles, from 17 million in 2005 to only 11 million sold last year, without referencing the staggering climb in the number of consumers who became upside down on their vehicle loans, which increased by hundreds of percent between 2000 and 2008. Below I describe the relationships between these trends and describe their impact on consumers.

Because the auto industry’s production models require returning customers to trade in 3 or 4 year-old vehicles for new ones, vehicles, while a depreciating asset, thus play a crucial role for consumers as a kind of usable “credit container.” Yet over this period, a combination of low-quality domestic vehicles (reflected in a low, “residual,” or resale price) and overpriced loans widened the cost gap enormously between new vehicles and older ones, making it virtually impossible for consumers to affordably return to buy a new car.  As Stephanie Mencimer put it in Mother Jones in a rare story connecting the dots in December 2008:

"In 2004, major auto analysts noted that the lengthening loan terms and the increasing number of potential car buyers who were upside down on loans would lead to no good end for the auto industry, and GM in particular. Deutsche Bank analyst Rod Lache was prescient when he told Automotive News that the negative equity problem would only get worse if the automakers didn't address it. Observing that the average amount of money owed by someone trading in a car with negative equity had jumped from $2,900 to $4,000 in just a five-month period, he wrote, 'The impact on US demand, price and mix from this phenomenon could be devastating, particularly if the impact is compounded by rising rates.'" 

The collapse of the auto industry is directly connected to the fact that profitability for dealerships, starting in the late 1990s, became disconnected to vehicle sticker prices, due to increasing consumer price savvy as a result of the Internet and also to a tremendous squeeze on vehicle profitability by the manufacturers. Deep discounts in the up-front price of vehicles were also a major part of the strategy to move vehicles by the domestic manufacturers starting in 2000 and 2001, a choice that in turn eroded resale values for entire model years and made it difficult to raise prices again in subsequent years. 

Detroit’s downward industry spiral can be attributed in part to changes in how these shifts in vehicle pricing impacted consumers and the debt-to-value ratio for vehicles. When the domestics dropped prices and pushed other kinds of sales promotions starting in 2000, the rapid depreciation in their vehicle fleet for those model years drove consumers underwater even faster than before. Given the lower quality of their products and higher prices for vehicle loans, these choices in turn cut deeply into both consumers’ wallets and the domestics’ competitive positions in the larger marketplace. 

The reductions also merely accelerated background trends in the profit model for dealerships. Profitability increasingly became a function of the tricks and traps in the “back room” of dealerships in inscrutable consumer contracts loaded with extras that were padded into loans, often without consumers’ knowledge or consent. The extras were even part of dealerships’ software programs, which would prompt salespeople to extract the maximum possible price for loans.

Illusory products such as “gap insurance” or “etch” were sometimes used as tax shelters for dealerships, which would run them as no-profit paper subsidiaries in which all of the monies paid for by consumers – and financed by lenders – would be passed along, as bonuses and “sales incentives” to dealership staff. This cycle predictably led to very high numbers of loan contracts that were inflated in ways that added nothing to the resale or use value of vehicles, but burdened purchasers with thousands of dollars per vehicle in extra interest and debt.

Moreover, the major creditors – captive funding arms such as Ford Motor Credit as well as outside banks – knew of these widespread practices and even incentivized them by compensating the financing and insurance, or “F and I,” staff at dealerships on a percentage basis: the larger the loan, the larger the payoff for a dealership’s employees. In fact, by 2003, profitability for the auto industry as a whole was concentrated almost entirely in the lending arms of the major manufacturers, creating an incentive cycle that required complicity between dealers and the captive lenders to provide operating capital for the manufacturing side of giants like Ford and General Motors.

As the above quote from a Deutsche Bank analyst shows, Wall Street also knew about these practices. The rating agencies over the same period were reacting to this hollowing-out of the industry by downgrading the domestic auto companies to junk bond status. Yet packages of these toxic auto loans were simultaneously being bundled and sold as derivatives by banks, spreading the damage throughout the financial services and wider economy.

In some ways, the harm in the vehicle marketplace may outstrip that in the mortgage lending area, despite the remarkable lack of attention to this aspect of the auto industry’s woes. Many low-income or financially vulnerable consumers who are not able to afford a home mortgage may nonetheless need one or more vehicles, and a vehicle is by far the most significant expenditure beyond housing for most families.  Loss of a ready means of transportation can lead to loss of employment, loss of access to health care and numerous other serious difficulties for working families. Moreover, these types of losses, like losing a home, are sinkholes for families that can keep them in hock to creditors for years. 

And while realtors may assist with some aspects of home purchases, no one is there to help consumers in the intimidating showrooms of dealerships. As we explained in our 2003 report, most consumers shop the sticker price of vehicles. Because consumers do not have a compound interest calculator with them, the translation of that sticker price into monthly payments that include interest on the loan is obscure at the moment of purchase.

Dealers widely exploited this fact, pushing payments of, for example, “only $70 more per month” on consumers, which added up to thousands in interest and payments over the life of a loan. And loan terms kept expanding, augmenting the profit from a monthly-term negotiation, and lowering the equity of the vehicle, first to 60 months, then to 72 months, and finally to an astonishing 96 months, accompanied by higher interest rates that would similarly drive up profits.

Consumers were often not told or were misinformed about competing loan products that would have saved them money, as dealerships chose the loan that maximized their profits. Yet misrepresentations that consumers had received the “best deal” were common, and consumers were frequently and infamously bullied by long waits, intense negotiations and other high-pressure sales tactics into taking the loan product on offer by the dealer.

Dealers would conceal the differential between the negotiated sticker price and the profit thus padded into loans by creating meaningless categories for “extra” products that they recorded consumers as purchasing. As the original loan documents published with our report showed, in one contract a product such as “etch” would cost $400, and in another contract it would cost $750 from the same dealership (see Appendix 12A and 12C).  The truth was that it was valueless – it was merely a container for the “leg” – or extra profit – a salesperson had created by imposing a higher monthly payment. Scams called “yo-yo” sales were also used to entice consumers to drive off the lot with new vehicles, enabling dealers to subsequently alter loan terms to their benefit and the purchasers’ loss.

Other tricks common to the mortgage marketplace were used. An award-winning 2003 hidden camera investigation by Dateline actually caught a dealership employee fraudulently inflating the purchaser’s income on the loan documents, to puff up the purchaser’s eligibility for a more expensive vehicle.  As in the home mortgage marketplace, requirements for documents showing income and loan eligibility rapidly eroded, and subprime loans became more common. Some consumers surveyed by us or interviewed on the Dateline program even reported that dealerships had forged their signatures on multiple loan documents, or that they had deliberately sabotaged their credit by repeatedly running credit reports to disable their ability to comparison shop on favorable terms at other dealers.  

There was an interaction between the artificially low price of interest rates and secondary mortgages as well: many families took advantage of very low interest rates to take out home equity loans and plowed that money into new vehicle purchases, trading more home debt for far worse vehicle debt. Such boom-fueled purchases left the auto industry even more addicted to predatory credit practices and vulnerable to the subsequent profound drop in demand. As a consequence of that and the credit squeeze, auto-loan delinquencies have risen alongside those in the mortgage market.

In 2003, I also investigated whether there was any federal – or even state – oversight of these practices. Yet there was only a gaggle of weak consumer credit and lending statutes administered by an alphabet soup of agencies. In fact, just a bare skeleton of consumer credit statutes addressed any of the auto lending issues. State insurance commissions also showed little interest in investigating the unlicensed, and potentially unlawful, sale of shadowy insurance products, such as “gap insurance,” by dealerships.

On the Public Citizen Web site, we hosted a survey which produced compelling, albeit anecdotal, evidence of harm to purchasers from these kinds of dealer sales abuses. More than 400 people filled out the survey, providing detailed information.  We subsequently sent the information to state Attorneys General, with little response. A few state Attorneys General were pursuing similar claims, such as North Carolina’s against Sonic Automotive Group.

While a group of class actions successfully addressed lender discrimination against vehicle purchasers over the course of several years, individual claims regarding these other types of financial abuses, if brought on behalf of particular consumers, are very expensive relative to the damages incurred. Repossession – and pursuit by collections agencies and creditors who would collect on loan liabilities even when the vehicle was no longer in possession of the purchaser – were far more common resolutions.

Consumer suits, even when pursued, also faced high legal barriers, including stiff resistance by dealers and the auto industry. Only a few consumer attorneys nationally make a practice of the issues, given their low dollar value and the prevalence of forced arbitration clauses in the sales papers. A much-noted change to bankruptcy law in 2005 concerning the aptly named “cramdown provision” also made it far harder for destitute consumers to escape these loan obligations. Given these gaping holes in the safety net for consumers, it would be ideal for federal regulatory investigation and action to address the industry-wide predatory practices.

In view of such need, it was truly a pleasure to hear Professor Warren make the case for a new Consumer Financial Protection Agency. Strengthening protections for consumers is an economic imperative. With perseverance and a comprehensive approach, the hope is that we can avoid the devastating boom-and-bust cycles that have infected consumer lending for all kinds of lending products, address the misleading system of short-term profit incentives that led to the collapse, and prevent such cataclysmic outcomes in the future for both consumers and industry.

Comments

[Salma01]

Hi,

We have just added your latest post "The Role of Predatory Lending in the Collapse of Detroit" to our http://www.au-toloan.info. You can check the inclusion of the post, Visit http://www.au-toloan.info/story.php?title=the-role-of-predatory-lending-in-the-collapse-of-detroit/ We are delighted to invite you to submit all your future posts to the directory for getting a huge base of visitors to your website and gaining a valuable backlink to your site.

Warm Regards

Au-toloan.info Team

http://www.au-toloan.info