Auto Lenders Charged with Racial Bias

The U.S. Justice Department has intervened on the plaintiffs' side in a class-action suit filed under seal two years ago against Nissan Motor Acceptance Corp. It is expected that Justice will also intervene in a similar case filed against General Motors Acceptance Corp. (GMAC). The cases were filed in the U.S. District Court for Middle Tennessee in Nashville by three black residents of Nashville. The filings were "unsealed" in mid-September as a result of a motion by the New York Times and the ABC program, 20/20. The plaintiffs allege racial bias in their automobile loans because their contracts carried higher interest rates than those of white borrowers. Their contracts had been purchased from the dealers by the lenders named in the suit. They are seeking $100 million in damages from GMAC. Both firms have denied the allegations. Two Nashville lawyers, backed by the National Consumer Law Center in Boston, represent the plaintiffs.

At the outset, it is important to track the lending process. Initially, the dealer negotiates the selling price of the car, the value of any trade-in and the rate of interest that the consumer has agreed to pay; that is, the "buy rate" of the finance contract between the consumer and dealer. When the dealer sells the contract to a bank or finance company, the lender may set a rate that is lower than the contract rate on the auto loan. If the "sell rate" is lower than the "buy rate," the dealer receives an extra payment reflecting the difference between these rates. To illustrate, one of the plaintiffs in the case, Ms. Coleman, agreed to finance the purchase of her car by paying the disclosed contract rate of 20.75 percent. (According to court files, Ms. Coleman had a "rocky credit history.") Then, in an entirely separate transaction, the dealer sold the contract to GMAC at a rate of 18.25 percent. This difference between the two interest rates resulted in an increase in the proceeds from the contract that the dealer received, which is known in the industry as dealer participation, dealer markup or finance commission.

The cases raise three basic issues:

1. Did the differences in the rates charged whites and blacks reflect racial discrimination?
2. Were the lenders, Nissan and GMAC, responsible or liable for any possible racial discrimination by the automobile dealers from whom they purchased paper?
3. What would be the economic consequences of holding banks and finance companies liable for any discriminatory practices of the automobile dealers who are selling them the installment loans?

Did the rate differences reflect racial discrimination?

As we have seen in the various instances of alleged racial discrimination in mortgage lending, it is extremely difficult to "prove" discrimination, in large part because race may be correlated with other variables that are associated with credit risk. (See Spotlight, October 2000 "Loan Performance and Race.) For example, following the release of a study by economists at the Federal Reserve Bank of Boston which claimed to find racial discrimination in residential mortgage financing, numerous academic studies challenged both the reliability of the data used and the failure of the statistical analysis to consider fully the credit risk of the applicants for mortgage loans.

The plaintiffs' lawyers retained Dr. Debby A. Lindsey, a professor at Howard University, to test for discrimination. In the case of Nissan Motor Acceptance, for example, she found that the average "markup" on installment contracts of white customers had a cash value of $507.94, while that on contracts of black customers was $969.91, a difference of $461.97. However, the mere existence of a black-white pricing differential tells us nothing about whether it was warranted on the basis of creditworthiness, and articles about the case make no mention of Dr. Lindsey's having adjusted for differences in the credit risk of the two sets of borrowers. Both Nissan and GMAC have sophisticated credit scoring systems that Dr. Lindsey evidently failed to consider in her analysis. Further, while residential mortgage loans show the race or national origin of the borrowers, this is not the case on consumers' auto loans. How did Professor Lindsey determine the race of the borrower for a sample large enough to draw statistical inferences? In other words, how can "racial discrimination" be proved without knowing the risk, race or national origin of the borrowers?

Were the lenders responsible for discrimination by the auto dealers from whom they purchased loans?

The second issue is whether finance companies and banks that purchase dealers' auto loans should be held liable for illegal discriminatory practices of those dealers. (By the same token are banks that purchase credit card paper from retailers, hotels, restaurants, etc. liable for any of their discriminatory practices?) The Federal Reserve Board's staff has concluded that lenders that purchase loans from others will not be held liable for any violations of credit laws, including the Equal Credit Opportunity Act. A telling argument for this conclusion is that the lenders do not know the race of the consumers whose automobile loans they purchase.

What would be the consequences for consumers if lenders were held responsible for illegal discrimination by the auto dealers from whom they purchased loans?

In explaining the "unintended consequences" of holding finance companies and banks liable for illegal discrimination by their automobile dealers, attorneys for the American Financial Services Association pointed out that "Competition among dealers would be reduced, as would competition among banks and finance companies for the financing business that a dealer controls." As in any market, reduced competition would drive up financing costs to consumers and reduce the availability of credit. Further, in their competitive marketplace, dealers must either replace the income from dealer participation or drop out of the business. Replacing the income would require lowering trade-in values or raising the financing and selling prices. It is hard to see how these responses would help consumers. In any case, dealers with "a taste for discrimination" would go undetected.

The bottom line is that consumers' best defense against price gouging (race-based or otherwise) is to shop for the best deal. At present, consumers must shop for the best car at the best price, net of the trade-in allowance. They must also seek the most favorable maturity and rate of interest on their auto loans. Admittedly, this is a difficult decision, with interrelated prices and values. But, even if the government passed a law requiring that a contract with a buy rate of 18 percent must have a sell rate of 18 percent, a consumer must still shop for the most desirable "package" comprised of the automobile selected, its price net of the trade-in allowance and the terms of the auto loan.