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Special Finance Under Fire

June 2009, F&I and Showroom - Feature

by Tariq Kamal

Sen. Dick Durbin of Illinois has a leading voice in the U.S. Senate and the Democratic party. He was first elected to his current seat in 1996 after seven terms in the House of Representatives. He was made Democratic Whip in 2004, assuming the title of Majority Whip after his party won the majority in 2006. He currently chairs two key subcommittees: the Senate Subcommittee on Financial Services and General Government and the Senate Subcommittee on Human Rights and the Law.

It was in the former that Durbin introduced Senate Bill 500 and, with a co-sponsor, SB 257. Together, the bills are designed to discourage predatory lending practices such as payday and title loans, but they also have the potential to put an end to subprime lending altogether. Will the new legislation serve as a legacy for an esteemed lawmaker or an epitaph for the special finance industry?

Breaking down the bills

Let's take a quick look at the new rules proposed by each bill:

SB 500, also known as the Consumer Credit Fairness Act, seeks to establish a new national standard for usury laws by providing that "no creditor may make an extension of credit to a consumer with respect to which the fee and interest rate ... exceeds 36 percent." It would also allow states to set their own cap even lower. The bill would modify the standards set forth by the Truth in Lending Act by including expenses such as ancillary products, credit insurance, late fees, NSF fees and others in any calculation of the "fee and interest rate" (dubbed "FAIR" by the author).

SB 257 would prohibit creditors from collecting debts from customers who enter bankruptcy proceedings if the interest rate exceeds 15 percent plus the yield on 30-year Treasury bills; currently, about 19 percent. To the extent the debt is secured, SB 257 would effectively void the security interest. It would also exempt debtors from the "means test" set forth by a 2005 revision to the U.S. Bankruptcy Code. The means test was designed to measure a debtor's income against the state median to determine if they should file for Chapter 7, under which some debts can be discharged, or set up a plan to repay their creditors under the terms of a Chapter 13 filing.

SB 257's co-sponsor, Sen. Sheldon Whitehouse (D-R.I.), told fellow Senators that successful passage of that bill would aid families trapped in cycles of high credit balances and late fees.

"If you can't pay the balance off, then they have you," he said. "A payment delayed, a minimum not met, and now your interest rate doubles, and fees and penalties pile on. You can't escape and they sweat you."

So what's the catch? For lenders and dealers who serve credit-challenged customers, as a March 16 memo from attorneys at Washington, D.C.-based law firm Hudson Cook LLP stated, "The devil is in the details."

All opposed?

In an interview picked up by CNN and other national news outlets, Baltimore-based Friendly Finance Corp.'s president, Steven Pittler, warned that successful passage of SB 257 would impair the ability of finance companies to lend to subprime buyers and serve as an incentive for cash-strapped drivers to file for bankruptcy.

Under the current U.S. Bankruptcy Code, a buyer has an incentive to continue to make their car payments after filing for bankruptcy in order to keep their vehicle. If SB 257 were to pass, according to Pittler, that incentive would no longer exist.

"You can imagine the losses the lender would incur if he can't reduce the borrower's balance by selling the repossessed car," Pittler said. "This bill encourages people to file for bankruptcy; essentially, they get rewarded with a free car."

Michael Benoit, a partner at Hudco, agrees. "I'm not sure Sen. Whitehouse realizes that SB 257 retroactively jeopardizes lenders who have entered into appropriately underwritten credit agreements and prospectively provides a windfall for debtors who get to keep their collateral without paying for it," Benoit says. "It's one thing to provide relief for distressed borrowers. It's quite another to treat legitimate lenders as punitively as SB 257 does in the process."

As we discussed, under the terms of SB 257, a debtor would also be excused from the means test if he or she has any debt with an interest rate that exceeds the threshold.

"That means if you have an auto loan at zero percent interest but a credit card bill or any other debt that exceeds the threshold, you get to skip the means test completely," Pittler told Special Finance.

In submitting SB 500 for consideration, Sen. Durbin built in severe civil and criminal penalties for creditors who exceed the interest rate cap. But that cap is a moving target, calculated by adding such expenses as ancillary products, credit insurance and even certain late fees to the FAIR calculation.

To determine whether it's in violation of the bill, should it become law, a lender would have to recalculate the FAIR whenever a late fee or NSF fee is paid, if it exceeds a certain amount. Given their inflationary effect on the FAIR calculation, credit insurance, property insurance and ancillary products such as vehicle service contracts could, in practice, become a thing of the past.

"An original APR of 10 percent could quickly exceed the 36 percent cap when such expenses are added to the calculation," Pittler says. "You would find special finance lenders, who know how expensive it is to originate and collect these loans, telling people they simply can't get financing."

"And it's not just special finance lenders that need to be concerned," Benoit says. "It's easy to see how a prime loan calculated under Senator Durbin's formula could quickly become usurious."

If it passes, lenders that do continue to originate such loans under the terms of the new legislation may be in for another surprise in the event of default. As the Hudson Cook memo pointed out, the 36 percent threshold could also be exceeded in the course of a repossession. Repo fees, attorneys' fees and court costs charged to a debtor could all be factored into the FAIR calculation.

An uncertain future

SB 500 and SB 257 are still in committee, and there is much work and debate to be undertaken before they can be voted into law. Nevertheless, the timing could hardly be worse for dealers. New-car sales are at historic lows. General Motors and Chrysler are dissolving franchise agreements by the hundreds. Stores and dealer groups of every stripe are struggling to keep their doors open. Many banks and finance companies, bitten by poorly performing portfolios and a difficult securitization market, continue to restrict their programs or abandon the special finance market altogether.

"These bills would be devastating to lenders, dealers and the public," Pittler says. "It's entirely possible that legislation intended to protect consumers from excessive interest rates may result in their inability to obtain any financing at all."

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