Wall Street is beginning to worry that subprime lending, currently unraveling in the mortgage industry, will deliver a double whammy to the economy as more and more consumers, who financed their cars with subprime loans, default. If it happens, consumer activists say banks and car dealers only have themselves to blame.
"Car dealers are destroying their market, with phony loan documents and hidden charges that are driving their subprime customers into default," said Duane Overholt, founder of StopAutoFraud.com.
Overholt is a shady car dealer's worst nightmare. In the business for 25 years, Overholt stood up and blew the whistle in 1997. At the time, by his calculation, he had swindled consumers out of $33 million. Today, he says, abuses at auto dealerships are even worse.
"In 1997, the average rip-off that I could identify, because I did it, was about $1,200 a car. Today it's over $4,000 per automobile."
The rip-offs don't just come on the price of the car, but on the financing. And Overholt says the subprime customer has provided an easy mark for the unscrupulous dealer.
The customer who has little money and poor credit gets saddled with a very high interest rate. In addition, the consumer is charged for things that aren't really there, inflating the price of the car and -- more critically -- the amount the consumer must finance.
They're doing it, he says, by falsifying documents. On the credit application, income is inflated and length of employment is increased to make the subprime borrower look more credit worthy, so they can afford a more expensive car, with those higher than necessary monthly payments.
"They're taking other documents the bank requires, such as a book-out sheet, showing the equipment on the car, and falsifying that," Overholt charged. "Now, that's a very key document because it establishes the value of the car. These two documents they falsify consistently."
For example, a consumer may want to purchase a used SUV that is actually worth $12,000. But as chrome wheels, alarm systems and premium sound systems are added on paper -- but not installed -- the price of the car rises to $15,000. As a result, the bank lends more money on the car than it's actually worth.
"The customer is not only upside down because of the interest rate, there's equipment on the car that doesn't really exist, and they've been put into an automobile they know they really can't afford," Overholt said. "The consumer always believes that the bank is the good guy, that it's not going to lend them money they can't afford to repay. But that's not the case."
How many car dealerships engage in these fraudulent practices?
Overholt admits that it's hard to know for sure, but he believes it could be as many as 60 percent, with more succumbing to the pressure all the time. One rule of thumb, he says, is the bigger the car dealer, the more likely it is to be ripping off its subprime customers. Recently, automotive site Edmunds.com hired an undercover reporter to expose fraud in the showroom.
Overholt says there was very little subprime lending on cars until about 1992. Prior to that time, when a person wanted to buy a car but didn't have credit, they depended on their parents to co-sign for them, or they saved up more money for a down payment, so they could get a decent interest rate.
Car dealers embraced subprime lending because it opened up a vast new market of previously unqualified consumers, allowing Detroit to turn out more cars and fueling dealership growth, turning many into publicly-traded chains selling cars nationwide. With that growth came increasing pressure to bend the rules.
"What the financial institutions have decided to do in order to get some of that revenue is to defraud customers," said William Cunningham, an investment advisor at Washington, D.C.-based Creative Investment Research. "The hard way to go about maximizing shareholder value is to provide absolutely excellent value to customers, but that's hard to do. It's easier to defraud a customer by adding $5,000 to the cost of a new vehicle, or by charging a higher interest rate than you should."
Cunningham, whose expertise is mortgage lending, has closely followed the implosion of the subprime mortgage market. He traces the problems to the very concerns Overholt has expressed.
"A lot of these predatory lending practices that are now showing up in the housing industry started out in the auto industry. When they weren't caught adding thousands of dollars to the cost of a car loan, those practices bled over to the housing sector," Cunningham said.
"A lot of these predatory practices were first put onto people in communities of color; in Hispanic communities, where there are language issues, and in African-American communities, where there is a problem just from a net-wealth standpoint. We've seen these practices that started out in communities of color now move into the broader community."
In fact, Cunningham charges the subprime category has an inherent gender and racial bias, with women and minorities making up the bulk of subprime borrowers.
"Fifty years ago there weren't many women and minorities in that group of prime borrowers so you didn't really have a solid database that you could use to estimate the probability of repayment," Cunningham said. "And remember, that's what all these credit rating systems are supposed to do. They're supposed to evaluate your ability to repay a certain loan. Strangely enough, your ability to repay a loan goes down as the cost of the loan goes up."
It's also young people who tend to make up the bulk of the subprime market. A young person just out of college with a decent job may have to settle for a subprime loan on that first car.
"You start off at a higher rate, so you're behind the eight ball from the beginning," Overholt said.
After the young person gets married, buys another car and then a house, the couple are firmly entrenched as subprime customers. As a result, they're paying double-digit interest rates on both vehicles and their home mortgage payment may be adjusted upward by $240 a month. Suddenly the young couple has a credit problem.
"Now, did they create that credit problem, or did the lenders and the dealers create that problem?" Overholt asks.
It's these kinds of consumers Overholt says he is trying to help. When consumers contact him with a complaint, he studies their documents, looking for signs of predatory lending. If he sees the signs, he sends in undercover "secret shoppers," sometimes wired with microphones and hidden cameras if state law allows. He has helped consumers bring lawsuits against a number of dealers. He's helping, he says, because no one else will.
"The American public should realize the federal government is not protecting them anymore," he said. "Most states have abandoned, abolished or modified their deceptive trade practices laws."
But lawmakers may have gotten the message, not so much from consumers as from Wall Street. When a major subprime lender like New Century Financial goes from making a $60 billion profit in 2006 to declaring bankruptcy in 2007, Washington and Wall Street take notice.
The director of the Federal Deposit Insurance Corp. joined lawmakers recently in calling for a national standard to crack down on predatory lending. Meanwhile, Democrats in Congress have scheduled a number of hearings on predatory lending as a prelude to promised legislation. Overholt, however, remains highly skeptical.
"There are laws on the books now to protect the consumer from predatory lending," he said. "Nobody is enforcing them."