Storm clouds gather over dealer markups

The dealer markup on indirect auto loans is the subject of intense debate among auto lenders, dealers, consumer advocates and government regulators.

Some experts, including even some auto lenders, say a time may come when one-size-fits-all flat fees could replace the dealer markup, which can vary from customer to customer within certain limits, depending on what the market can bear.

"The dealer markup model and the regulatory pressures we are facing, that's really my concern as you look at increased bank regulation. It's stuff we are all concerned about," says Andrew Stuart, CEO of VW Credit Inc.

The markup model "can kind of be a target," he adds. Dealer markup, also called dealer reserve or finance reserve, is the practice whereby dealerships mark up the interest rates on loans they arrange for customers as a source of income for the dealership.

The markup is a mainstay of a dealership's profits in the finance and insurance department and for the store as a whole.

Most dealership groups don't disclose how much they make on dealer reserve. However, publicly traded Lithia Motors Inc. of Medford, Ore., reported its average was $406 per car in the fourth quarter of 2011, up from $361 in 2010. As of the first quarter of 2012, Lithia stopped reporting that specific number, although it still reports total F&I revenue per vehicle.

In 2011, Lithia sold 44,537 new vehicles at retail, ranking it No. 9 on Automotive News' list of the top 125 dealership groups.

VW Credit's Stuart is also chairman of the Vehicle Finance Division of the American Financial Services Association in Washington. At an association conference in San Francisco earlier this year, Stuart said he sees the auto lending industry slowly moving toward flat fees.

The big question is whether government regulators, including the new Consumer Financial Protection Bureau or the Federal Trade Commission, could speed that up by taking another look at dealer markup. The practice has been controversial in the past.

Potential interest from the Consumer Financial Protection Bureau could also come as more consumers apply for loans online, instead of having a dealership F&I manager do it for them. That could lead to more direct-to-consumer loans, in which the dealership doesn't get paid for acting as a middleman.

In addition, some shoppers -- especially younger ones -- distrust the dealership F&I process and want more transparency, research by Northwood University in Midland, Mich., shows.

"At the dealership, there is no transparency,'' says Tom Alexander, Northwood's finance department chairman. "It's not transparent and never has been. The dealers don't want it to be, and that's not a good thing anymore."

Legally, the fact that the dealership can set the final interest rate on an auto loan is a big part of what made dealer markup controversial in the past. Dealer discretion raises the possibility that two customers with similar credit histories, representing similar levels of risk, can be charged two different rates.

That's OK unless the price difference has what's called a disparate effect on customers. That is, a statistically disproportionate effect on a legally protected class of consumers -- for example, minorities. If that can be proved, it amounts to discrimination even if lenders or dealers didn't intend to discriminate.

The disparate-effect argument was central to court cases in the late 1990s and early 2000s that led to settlements in which several auto lenders agreed to put caps on dealer markups.

Michael Benoit, a partner with the law firm Hudson Cook in Hanover, Md., says he doesn't think the Consumer Financial Protection Bureau or the FTC is likely to tackle dealer markups directly. However, he wrote in an e-mail that it's possible regulators again could promote caps on dealer markups. Benoit is counsel for the AFSA Law Vehicle Finance Subcommittee.

Benoit said dealers shouldn't have to disclose their markups on auto loans any more than retailers in other industries should have to disclose their markups.

The Consumer Financial Protection Bureau has been careful to avoid saying much about its plans to regulate auto lenders. But without singling out the auto industry, the bureau put out a statement in April that specifically said it intends to use disparate impact as a "legal avenue ... to pursue lenders whose practices discriminate against consumers."

Tom Lazenby, senior vice president for Regions Financial in Birmingham, Ala., says that within reason, auto lenders would do whatever it takes to comply with the rules, but there is way too much uncertainty about what the rules will be. "Just give us a roadmap, and we will comply," he said, at the Auto Finance Risk Summit in Dallas last month.

But what if lenders are forced to switch to flat fees?

"I would take that deal," Lazenby said. "Just give us the road map."