If the federal government bails out the Big Three, who's going to buy their cars? Like those homeowners around the country who have found they owe more money than their homes are worth, millions of Americans are similarly underwater on their car loans. That debt burden will make it virtually impossible for millions of potential consumers to buy a car for years to come. This factor will severely blunt any good that a cash infusion might do for Detroit. For this, the auto industry has no one to blame but itself.
According to industry analyst Art Spinella, president of CNW Research, fully 85 percent of Americans with a car loan have negative equity. Other studies show that these loan holders, on average, owe $4,400 more than their cars are worth. Millions of Americans didn't get upside down on their car loans without a lot of help. Enter the great scourge of the American consumer market: the car dealer. Car dealers have been out in force in recent days lobbying Congress and holding rallies at dealerships around the country to generate support for the rescue plan. As a result, there's been a fair amount of sepia-toned media coverage about the desperate plight of the poor, local car dealer, that pillar of the community who supplies softball teams with T-shirts. And it's true. These folks are now threatened right along with the Detroit assembly-line workers. The National Association of Auto Dealers predicts that 900 dealerships will fail over the next year.
Lost in all the news coverage is the fact that many car dealers played a central role in creating the current mess. As franchisees of the manufacturers, car dealers don't make much money actually selling cars. The markups are pretty slim, and in recent years, Detroit has squeezed their dealerships for more and more profits. In the old days, car dealers would come up with creative ways to compensate for the small margins, such as rolling back odometers to sell cars for more than they were worth. But after Congress cracked down on the practice, dealers (and manufacturers, too) found a better way to pump up their bottom lines: selling financing.
Back in 2003, Forbes magazine observed that GM was better described as a bank that happens to make cars than as an automaker. At the time, as much as 90 percent of the company's profits came from its lending arm (which also had a mortgage branch), not from car sales. For the past decade, much of Detroit's output has been little more than a vehicle for selling credit, and the dealers have done the dirty work for them the way local mortgage brokers generated large volumes of questionable loans for big banks and finance firms.
Here's how it works: When a customer comes into a dealership to buy a car, he already knows how much the car should cost (thanks to the Internet), but he usually relies on the dealership to arrange the financing, often because they advertise lower rates than banks. That's when the scam starts. Many car dealers routinely load up car loans with all sorts of expensive but useless add-ons. These include such things as "theft etch," when a dealer will spend $37 to etch the VIN number of the car onto the windshield, tout it as an "antitheft measure," and charge the customer upward of $2,000 for it. Unbeknownst to most car buyers, dealers also routinely—and legally—bump up the interest rate offered by the bank or finance company in exchange for kickbacks from the lenders, which are often the manufacturers themselves. And in many cases, dealers encourage customers to trade in a car that isn't worth the amount of their current loan by offering to roll the old loan into the new one, thus inflating the principal and making the loan more lucrative for the lender. That's how people can end up owing $40,000 on a Ford Focus. This only works because auto lenders now stretch out the terms to six or seven years to make the payments affordable, a practice that virtually ensures that many cars won't last as long as the loan. (In the 1980s, by contrast, Spinella says the average car loan lasted only three years and required a 20 percent down payment, which limited the kind of negative equity problem seen today.)
These are not aberrant practices. They are endemic to the industry. Earlier this month, the FBI raided two California dealerships accused of defrauding a local credit union by falsifying loan documents. And in September, Bill Heard, the country's biggest Chevy dealership group, a $2.1 billion operation with dozens of outlets all across the South, shut down after GMAC cut off its financing stream. The state of Georgia had sued the company, alleging that Heard dealerships had lied to lenders about their customers' income on loan applications, forged signatures on loan agreements, and packed car loans with all the usual junk. The state's consumer affairs office had been investigating the company since 2003, and had sued it before over deceptive advertising practices. Consumer watchdogs suspect that Heard's legal trouble lies at the root of GMAC's decision to stop funding the dealerships.