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November 19, 2014

American Financial Services Association

Fair Lending:

Implications for the Indirect Auto Finance Market

Prepared by: Arthur P. Baines and Dr. Marsha J. Courchane

For: American Financial Services Association

Charles River Associates 1201 F Street, NW Suite 700 Washington DC 20004

Date: November 19, 2014

The conclusions set forth herein are based on independent research and publicly available material. The views expressed herein are the views and opinions of the authors and do not reflect or represent the views of Charles River Associates or any of the organizations with which the authors are affiliated. Any opinion expressed herein shall not amount to any form of guarantee that the authors or Charles River Associates has determined or predicted future events or circumstances and no such reliance may be inferred or implied. The authors and Charles River Associates accept no duty of care or liability of any kind whatsoever to any party, and no responsibility for damages, if any, suffered by any party as a result of decisions made, or not made, or actions taken, or not taken, based on this paper. Detailed information about Charles River Associates, a registered trade name of CRA International, Inc., is available at .

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American Financial Services Association

Table of Contents

1. BACKGROUND........................................................................................................................... 8

2. APPROACH AND METHODOLOGY....................................................................................... 8 2.1. DATA ................................................................................................................................. 9

3. THE RETAIL AUTOMOTIVE FINANCE MARKET ................................................................ 9 3.1. MARKET SIZE ................................................................................................................. 10 3.2. MARKET SEGMENTS ...................................................................................................... 11

3.2.1. Direct and Indirect Channels...................................................................................................... 11 3.2.2. New and Used Vehicles.............................................................................................................. 12 3.2.3. Prime, Non-Prime or Subprime Consumers ............................................................................ 13 3.2.4. Lease or Purchase ...................................................................................................................... 14

3.3. MARKET PARTICIPANTS ................................................................................................. 15

3.3.1. Consumers ................................................................................................................................... 15 3.3.2. Types of Financial Institutions.................................................................................................... 17

3.4. MARKET CONCENTRATION............................................................................................. 17 3.5. SEGMENT SPECIALIZATION ............................................................................................ 20 3.6. SOURCES OF CAPITAL.................................................................................................... 20 3.7. COMPETITIVE FACTORS ................................................................................................. 22

3.7.1. Online Credit Application Networks ? the efficient auction .................................................... 24 3.7.2. Dealers .......................................................................................................................................... 25 3.7.3. Vehicle Manufacturers ................................................................................................................ 31 3.7.4. Bringing it all together ? transactions........................................................................................ 32

4. FAIR LENDING COMPLIANCE FOR INDIRECT AUTOMOTIVE FINANCE .................. 34

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American Financial Services Association

4.1. BACKGROUND ................................................................................................................ 34 4.2. ECOA ? DISPARATE IMPACT AND TREATMENT.............................................................. 38 4.3. FAIR LENDING AND DEALER RESERVE ........................................................................... 41 4.4. IDENTIFYING RACE AND ETHNICITY FOR VEHICLE PURCHASES................................... 45

4.4.1. Vehicle purchases by Race/Ethnicity Shares .......................................................................... 48 4.4.2. Specific Proxy Methods .............................................................................................................. 51 4.4.3. Testing of Specific Proxy Methods ............................................................................................ 54

4.5. MEASUREMENT OF DEALER RESERVE ......................................................................... 63 4.6. COMPLEXITY OF THE TRANSACTION.............................................................................. 64

4.6.1. Unknown consumer-specific factors ......................................................................................... 65 4.6.2. Unknown dealer-specific factors................................................................................................ 67

4.7. PRICING DIFFERENCES ACROSS DEALERS ................................................................... 70 4.8. OBSERVABILITY OF DEALER CONTRACTS .................................................................... 71

5. OBSERVED PRICES IN THE CURRENT MARKET........................................................... 72 5.1. OBSERVED CONTRACT RATES AND BUY RATES.......................................................... 73 5.2. SIMILARLY SITUATED CONSUMERS AND CONTROLS ................................................... 76

5.2.1. Adjusting for proxy bias............................................................................................................... 77 5.2.2. Deal Specific Controls................................................................................................................. 79 5.2.3. Unknown Factors ......................................................................................................................... 80

6. ALTERNATIVE DEALER COMPENSATION MODELS ..................................................... 81 6.1. CFPB AND DOJ PREFERENCES ................................................................................... 82 6.2. TESTING.......................................................................................................................... 82

6.2.1. Scenario 1..................................................................................................................................... 83 6.2.2. Scenario 2..................................................................................................................................... 83

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6.2.3. Scenario 3..................................................................................................................................... 84 6.2.4. Scenario 4..................................................................................................................................... 84

7. CONCLUSIONS AND RECOMMENDATIONS.................................................................... 85 8. APPENDIX A. PROJECT TEAM ............................................................................................ 88 9. APPENDIX B. GLOSSARY OF TERMS AND ACRONYMS............................................. 90 10. APPENDIX C. HOUSEHOLD VEHICLE OWNERSHIP BY STATE AND

RACE/ETHNICITY, 2010-2012............................................................................................... 94 11. APPENDIX D. BISG ASSUMPTIONS USED BY CHARLES RIVER ASSOCIATES FOR

THIS STUDY ........................................................................................................................... 100 12. APPENDIX E. RACE/ETHNICITY PROXIES: DIFFERENCES BETWEEN BISG

CALCULATIONS: CRA V. CFPB ........................................................................................ 101 13. APPENDIX F. BISG 2-WAY TABLES, "HEAT-MAPS" ..................................................... 105 14. APPENDIX G. BISG FALSE POSITIVES AND NEGATIVES BY TRACT, FICO,

INCOME, AND LMI ................................................................................................................. 107 15. APPENDIX H. CRA CONTRACT DATA VARIABLES ...................................................... 111 16. APPENDIX I. CRA CONTRACT DATA DESCRIPTIVE STATISTICS ........................... 112 17. APPENDIX J. DEALER RESERVE REGRESSION RESULTS ...................................... 128 18. APPENDIX K. COST/BENEFIT SCENARIO RESULTS................................................... 132 19. APPENDIX L. CHARTS AND TABLES ............................................................................... 140 20. APPENDIX M. REFERENCES ............................................................................................. 141

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INTRODUCTION

Over the past few years, regulatory focus on fair lending examination of the indirect automotive finance market has increased significantly. Recent regulatory developments that impact the indirect auto finance market include the issuance on March 21, 2013 of the Consumer Financial Protection Bureau (CFPB) Bulletin 201302,1 "Indirect Auto Lending and Compliance with the Equal Credit Opportunity Act" (Bulletin) which details the manner in which certain policies related to dealer discretion have the potential to create significant fair lending risks for financial institutions that participate in this important consumer market.2 At the same time, methodologies used by regulatory agencies for fair lending examinations have changed significantly. For example, the CFPB issued "Using Publicly Available Information to Proxy for Unidentified Race and Ethnicity" (White Paper) on September 17, 2014 which presents its methodology for using a proxy to assign race/ethnicity to consumers obtaining auto financing.

In this research, we illustrate the complexities of indirect automobile financing and evaluate current regulatory fair lending practices observed in the industry. The research uses data collected from a number of market participants and aggregated in order to inform the discussions concerning dealer compensation, prices observed in the market, and the costs and benefits to consumers of alternative dealer compensation methods.

Highlights of the study include demonstrating that:

? The markets for purchasing automobiles (the retail automotive market) and for financing automobiles (the automotive finance market) are complex, highly interconnected and highly competitive.

? Accurately analyzing dealer reserve is difficult for a number of reasons, and failure to consider these challenges increases the potential for drawing erroneous conclusions.

? The methods commonly used by regulators to proxy race and ethnicity, including the recently applied Bayesian Improved Surname Geocoding

1 CFPB Bulletin 2013-02, March 21, 2013. 2 In this paper we use the term `financial institution' to refer to any company that finances new or used vehicle sales. Financial institutions include banks, non-banks, credit unions, captive and non-captive companies, direct lenders and indirect finance companies, and buyhere pay-here dealers.

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