The US Congress enacted the Wall Street Reform and Consumer Protection Act of 2010 (or the "Dodd-Frank Act" as it is more commonly known, named after its two principal Democratic Party sponsors, former senator Christopher Dodd of Connecticut and former representative Barney Frank of Massachusetts) in response to the financial meltdown of 2008 that had devastating effects across the global economy.
Like most lawmaking in the US, the Dodd-Frank Act was a reaction to an unpleasant situation, in this case the failure of Lehman Brothers and the government’s bailout of AIG and some of our largest banks due to the fraud and mismanagement in our asset-backed securities (ABS) markets. The Dodd-Frank Act, and particularly Title X which created the Consumer Financial Protection Bureau (CFPB), is a creature of populist political pressure to punish banks for their bad behaviour.
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Congress’s fix
Notably, other ABS markets – like auto finance – performed well during the crisis. But as is so often the case, Congress decided to do a big and untested fix. Ergo, the CFPB, an agency designed to oversee the nation’s consumer financial services providers and their compliance with US consumer financial protection laws.
With a few significant exceptions, the CFPB has statutory enforcement authority (i.e. the ability to conduct investigations and sue companies and persons within its jurisdiction) over virtually all consumer financial products and services and their providers. It was given statutory supervisory authority (i.e. the ability to conduct periodic examinations of a provider) for the mortgage, payday lending and student loan markets, as well as "larger participants" of other markets by writing a rule defining those markets and participants.
As far as auto finance is concerned, the CFPB has always had statutory enforcement authority, but it must write a rule to define the auto finance market and the "larger participants" it will supervise before it can examine these entities. On 16 September, CFPB director Richard Cordray signed off on a proposed rule to do just that.
The proposed "Defining Larger Participants of the Automobile Financing Market and Defining Certain Automobile Leasing Activity as a Financial Product or Service" rule (quite a mouthful, so from here on, just the "Proposed Rule") is significant in many ways. It proposes to define a larger participant as an entity that originates (or purchases or otherwise acquires) 10,000 or more automobile financings (including refinancing) or leases in a calendar year. By the CFPB’s count, this definition would allow it to supervise and examine the 38 largest non-bank auto finance companies representing about 91% of the non-bank auto finance market.
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By GlobalDataThe CFPB is considering whether 5,000 or 50,000 annual originations might be a better number. It calculates that 50,000 annual originations would capture the top 17 non-bank auto finance companies representing 86% of the market. Doing the maths, that means that 21 companies represent just 6% of the market, shining a light on how competitive and fragmented the US auto finance market is.
Conversely, the CFPB calculates that lowering the threshold to 5,000 annual originations would capture 55 companies representing 93% of the non-bank market. The maths here indicates that 17 companies make up the additional 2% of market coverage, further reinforcing the idea of a fragmented market.
Also significant is the CFPB’s focus on auto leasing. Few practitioners dispute that Congress made a mistake when it defined leasing to be the "functional equivalent of a purchase arrangement" in the Dodd-Frank Act. We have those kinds of leases in the US, but they are not at all similar to the leases auto finance companies enter into with consumers.
No ownership
In fact, few, if any, consumers would characterise an auto lease as the functional equivalent of a purchase arrangement, primarily because they never take ownership of the vehicle, and there’s usually a significant residual – up to 60% of the original value – remaining at the end of the lease term. Yet the CFPB winds its way through a tortured analysis to explain why the opposite is true.
While we expect the CFPB to dig in its heels and stick to its contention that leases are purchase equivalent (why be inconvenienced by facts?), it’s clear that it has serious doubts about its analysis. So much so, that it went to the trouble to include a second definition of leasing that is identical to the definition Congress wrote back in 1987 so that national banks could engage in garden-variety auto leasing.
There’s no doubt that auto leasing will be included in the calculation of annual originations, but disingenuously characterising a typical lease as the equivalent of a purchase arrangement can lead to problems down the road should regulators not clued in to its fanciful analysis try to apply it substantively in other scenarios.
Probably the most careless thing the CFPB did in the Proposed Rule was its failed attempt to carve securitisation trusts out of the larger participant definition. While it declared its intention that securitisations not be covered in its explanatory material, the actual proposal only carves out "investments" in ABS – not the actual entities that hold the assets and in which the investors invest. That error, if not fixed, will cause significant disruption in the ABS markets that would be devastating to non-banks that rely on ABS for capital.
The industry has been preparing for federal supervision for a while, but most have never been examined to the extent they will soon experience.
Whether one agrees with the idea of federal supervision or not (non-banks are regulated at the state level), the significant costs associated with supervision will result in less access to, and higher cost of, credit. Who will pay? The very consumers the CFPB seeks to protect, of course. Some may see it as a small price for consumers to pay. Others may see it as a further disregard for the least among us.
Michael Benoit is a partner in the Washington, D.C. office of Hudson Cook LLP.
