Dealers urged to replace loan reserve profit

Auto dealers are saying it's urgent to sell more F&I products, such as extended-service contracts, now that the Consumer Financial Protection Bureau seems ready to put stricter limits on how much dealers can earn on customer interest rates, also known as the dealer reserve.

"We've been de-emphasizing dealer reserve for several years," says Tyler Corder, CEO of Findlay Automotive Group in Henderson, Nev. "My guess has been that it would be more highly regulated, and now it looks like that's going to happen."

Corder and other dealers have been warning for months that the Consumer Financial Protection Bureau had dealer reserve in its sights and that it was time to start pursuing other profit streams to compensate.

Last fall, Corder called the bureau effort a train bearing down on dealership F&I sales.

Corder says he has been boosting F&I product sales at Findlay's 27 dealerships as a way to reduce reliance on dealer reserve. His goal is to cut dealer reserve for the group to less than 20 percent of total F&I revenue, down from about 30 percent in 2012 and 40 percent in 2009.

Larry Dorfman, CEO of F&I administrator EasyCare, said last month that reducing dependence on finance reserve is a strong industry trend.

"We tell dealers shame on them if they get more than 50 percent of their F&I from dealer reserve," Dorfman said.

EasyCare is the trade name for Automobile Protection Corp. of Norcross, Ga., which offers extended service contracts; Guaranteed Asset Protection, or GAP; and other F&I products, as well as dealership training.

Recent events make Corder's early warnings sound prophetic.

According to the American Financial Services Association, the Consumer Financial Protection Bureau sent letters to some banks in February warning them that bank examinations had turned up what the bureau considers discrimination.

Specifically, the association says, the Consumer Financial Protection Bureau told the banks that bank pricing policies might have had a disparate impact on legally protected classes of consumers.

Under the Consumer Financial Protection Bureau's legal theory, if statistical analysis shows that a protected class, such as minorities or women, pays more than similarly qualified customers who are not members of a protected class, that's a disparate impact. Only the end result matters; it doesn't matter whether the discrimination is intentional.

Dealer reserve is the crux of the argument. The disparate impact theory is that by allowing dealers to set the customer's final interest rate -- by adding dealer reserve, which can vary from customer to customer -- lenders potentially allow a disparate impact.

Lenders strongly deny they discriminate or allow discrimination, said Chris Stinebert, CEO of the American Financial Services Association, a Washington-based trade group that lobbies for banks, captive finance companies and independent auto lenders.

Dealers also deny they discriminate, according to the National Automobile Dealers Association.

"We take any accusation, charge, or even any hint of discrimination against our customers -- that is still our No. 1 goal, is to satisfy and meet the needs of that borrower -- any charge, we take every seriously," Stinebert said at the American Financial Services Association's Vehicle Finance Conference last month.

After the Consumer Financial Protection Bureau's letters became known, Stinebert said his group disagrees that the letters were necessary. It also questions the methodology the Consumer Financial Protection Bureau used for determining whether discrimination took place, he said.

Nevertheless, the Consumer Financial Protection Bureau expects lenders to monitor dealerships and take "remedial action" if disparate impact is detected, said Richard Hackett, the bureau's assistant director for installment and liquidity lending markets, at the vehicle finance conference in Orlando.

If the bureau makes its case stick, the result could be an even lower ceiling on dealer reserve. Under the terms of earlier class-action lawsuits alleging disparate impact, most auto lenders joined a series of settlements in the mid-2000s that imposed voluntary ceilings on dealer reserve of up to 3 percentage points, depending on loan terms.

In practice, dealer reserve rarely reaches the ceiling and often averages less than 1 percentage point, according to NADA.

Another possible outcome if the bureau is successful is that lenders could switch from dealer reserve to flat fees to reward dealerships for acting as a middleman on loans.

Chris Willis, an Atlanta lawyer whose clients include banks involved in auto lending, says it's probably a good idea for dealers to look for other ways to make up for dealer reserve.

"They're smart to consider that," he says. "Unless something happens to prevent what happened in mortgages, I think the same thing will ultimately happen in autos."

Willis says the Consumer Financial Protection Bureau apparently sees dealerships playing a similar role to some mortgage brokers who could add an additional spread to a customer's interest rate, a practice the bureau stopped.

Willis says that in autos, the bureau would probably prefer flat fees for dealers rather than any form of interest-rate participation.

That would be more acceptable to some dealership groups than others. Ralph Larson, finance director for Dick Hannah Dealerships in Vancouver, Wash., says his 13-store group already earns mostly flat fees, since most of its sales are financed by credit unions.

"We don't count on a lot of dealer reserve. Don't get me wrong; we love to do it if we get the opportunity. We just don't get many opportunities," because most of his customers are loyal credit union members, he says.

Dealer reserve can represent hundreds of dollars per vehicle for dealerships.

Public retailer Lithia Motors Inc., which stopped providing a detailed breakout of its F&I revenues per vehicle last year, reported that in the fourth quarter of 2011, dealer reserve averaged $406 per vehicle.

Last fall, Don Forman, dealer principal at United Nissan in Las Vegas, said that in his case, dealer reserve could be as much as $600 per vehicle.

"The fact is, as dealers, we want to protect our profits in these transactions," he said. "In today's market the front-end profit can be little or nothing -- in some cases less than nothing. We are very dependent on those back-end products. We need to make sure we can still sell the service contract, GAP or other warranties.

"The question I would ask is: Is that an unreasonable profit for us to make? The profit we make this way is what we use to take care of the customers. It's not a dirty word. It's crucial that we protect this."