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Why the Auto Bailout's a Dead End

Detroit's primary moneymaking vehicle has been selling credit, not cars. The Big Three may have finally run out of road.

| Mon Dec. 22, 2008 4:00 AM EST

Loan fraud is so widespread in the auto industry that even dealerships owned by a US congressman have been accused of engaging in it. Before coming to Congress, Rep. Vern Buchanan (R-Fla.) was one of the biggest car dealers in his state. (He has recently started selling off some of his dealerships.) This summer, he was hit with multiple lawsuits filed by former employees alleging that his dealerships routinely engaged in auto fraud, including submitting fraudulent loan applications to lenders.

The driving force behind all of these loan shenanigans is Wall Street. The automakers' finance arms (and banks, too) have made a fortune by packaging the inflated loans made by their dealerships and selling them as securities. It's the same scheme that ultimately brought down the subprime mortgage industry. And just like the mortgage lenders, the automakers and their finance arms must have been well aware that the loans generated by their own dealers were frequently bad ones. That's because consumer lawyers have been successfully suing them over this for years.

Tom Domonoske is a lawyer in Virginia who specializes in auto fraud cases. He says he's had dozens of cases where car dealers have created fictitious tax returns, pay stubs, and other paperwork to push through loans for people who couldn't afford them. But he says that even though the lender is frequently sued in these cases along with the car dealer, he's never once seen an automaker's lending arm cut off a dealership's financing after discovering fraud. "They want dealers to keep moving their products," he says. Rather than clean up the dealerships, the automakers simply started putting mandatory arbitration clauses in the loan documents so that customers who ended up getting screwed couldn't sue.

Until now, the negative impact of car dealers' sleazy credit practices mostly affected consumers. Meanwhile, it prevented GM and Chrysler from having to scale back production. The offers of longer loan terms and easy credit lured in customers who either had no business buying a car or couldn't truly afford the cars sold to them. "They essentially postponed a reckoning," says Joan Claybrook, the president of the nonprofit consumer group Public Citizen. Detroit automakers were warned years ago that these practices would come back to haunt them.

In 2004, major auto analysts noted that the lengthening loan terms and the increasing number of potential car buyers who were upside down on loans would lead to no good end for the auto industry, and GM in particular. Deutsche Bank analyst Rod Lache was prescient when he told Automotive News that the negative equity problem would only get worse if the automakers didn't address it. Observing that the average amount of money owed by someone trading in a car with negative equity had jumped from $2,900 to $4,000 in just a five-month period, he wrote, "The impact on US demand, price and mix from this phenomenon could be devastating, particularly if the impact is compounded by rising rates."

That's exactly what is happening now, a problem exacerbated by the credit crunch that won't be solved by simply giving the automakers taxpayer money. "Ultimately, no matter how much money Congress throws at the automakers, it's car buyers who will rescue them or not," says Rosemary Shahan, head of Consumers for Auto Reliability and Safety. Just as environmentalists have seen the bailout as an opportunity to change the way American companies make cars, it also offers a unique chance to change the way they sell cars. Shahan and other consumer groups have come up with a short list of things that Congress might do in this regard.

For instance, Congress could cap the amount that car dealers can increase interest rates on auto loans, as California has done. This would be a major step in limiting the growth of negative equity. Lawmakers could also create a restitution fund to help car buyers affected by dealership bankruptcy. This problem is growing as more dealerships go out of business and fail to pay off the original loans of customers who traded in old cars and purchased new ones.

Congress could also roll back a provision auto lenders won in the 2005 bankruptcy reform bill requiring individuals who file bankruptcy to repay the entirety of a car loan, even if they owed substantially more than their car was worth. Previously, someone in bankruptcy would only be required to pay back the loan up to the actual value of the car. Returning to the old system would allow more people to get out from under their debt—some of which was created through dealer fraud—and allow them to eventually rejoin the car market.

Unfortunately, none of these measures is even on the table, says Shahan, who was recently in Washington trying to inject the consumer angle into the bailout debate. Failing to provide meaningful relief to homeowners facing foreclosure has turned the banking bailout into something of a flop. Laura MacCleery, a lawyer who spent many years working on auto issues at Public Citizen before going to work for the Brennan Center for Justice, says she's amazed that Congress hasn't learned anything from the mortgage mess. "Are they going to make the same mistake twice?" she asks. The auto industry may be hoping the answer is "yes."

Photo by flickr user the toe stubber used under a Creative Commons license.

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