Auto Title Lending: Exploding Toasters

05/18/16

The CFPB has a new report out on auto title lending, and the findings are jaw-dropping. If ever there was a consumer financial product that looks like an exploding toaster, it is an auto title loan.  Default rates on auto title loans are one in three, with one in five resulting in a repossession. Is there any consumer product that is tolerated when one out of three products blows up? Even one in five? 

There's a lot of good data in the report (which assiduously avoids any interpretation, but just presents the facts), but beyond the default rates, here's what really jumps out at me: over 80% of the loans roll over and around half result in sequences of 10 or more loans.  That means that rather than viewing auto title loans as short term products with an extension option, they are really used more like longer-term products with a prepayment option. But more importantly, it tells us something about how to interpret default rates.  

Defenders of the auto title lending industry, such as Todd Zywicki, have argued (and also here) that the default rates are low. As I have previously pointed out, Zywicki's calculations are based on treating each loan in a multi-rollover sequence as a separate loan, thereby massively inflating the denominator in the default rate, and others have unfortunately relied on Zywicki's calculations. The CFPB study is the first study I've seen that calculates the real default rate and ignores the artificiality of treating rollovers as separate loans. 

Based on these default rates, let me suggest a new metric for thinking about abusive or unfair or unconscionable lending. The primary consumer protection concern in lending regulation is that consumers will end up with unmanageable debt burdens that will in turn result in consumption deprivations for their households and possibly a drain on public resources.  Historically society has tried to use the cost of the loan as the measure of whether a debt burden is unmanageable--that's usury laws. But how about looking not at the costs, but at the results, or at the anticipated results:  if a loan product's default rate is over a certain threshold, isn't that prima facie evidence that there is something wrong with the product?  Now sometimes a default rate ends up higher than anticipated--lenders miscalculate.  But what if the product is designed to have a default rate of 30%?  That's like selling tasty food that one knows has a 30% chance of being contaminated with a harmful microbe. We would never allow that in the public health context, so why is it ok in the financial context? 

Now come on Adam, you say, no lender would ever design a product to have a default rate of 30% because the losses will eat away the lender's profits.  Nuh-uh.  The traditional amortized loan model aligns the interests of the lender and borrower--if the borrower doesn't repay, the lender will lose principal and interest. But that's not how non-amortizing sweatbox-type products like payday and auto title loans work. (Ronald Mann via Jay Westbrook coined the term sweatbox in the context of a political economy explanation of credit card lenders support for BAPCPA, but I think the concept is even more applicable to payday and auto title loans.)

Sweatbox products are non-amortizing, and are designed to be rolled over.   Sweatbox lenders anticipate that borrowers will in fact rollover the products multiple times by lending an amount and on a payment schedule that the borrower cannot easily repay the loan from his or her regular income.  The key to understanding the sweatbox model is that even if the loan ultimately defaults, the lender will have recovered all its costs and made a profit provided that there are enough rollovers.  In such a situation, a lender may be willing to tolerate--heck, might embrace--higher ultimate default rates in order to grow the borrower base that will be profitable in the sweatbox.  Sweatbox products like payday and auto title loans pervert the traditional alignment of borrower and lender interests. 

Let's say you agree with me that actual or anticipated default rates might be an appropriate metric for evaluating abusiveness or unfairness or unconscionability. (Or maybe even deceptive lending, as I think it's material to know that a lender anticipates that there's a ⅓ chance you won't be able to repay your loan.) Aren't we back to the good old usury law problem of figuring out what is an appropriate cutoff?  Yes and no.  I'm not sure exactly where the line should be drawn (I'm all ears for suggestions), and one might think of any line drawing as a starting point for a safe harbor or rebuttable presumption, but there are some situations where the default rates are pretty clearly over any line that might be drawn. 

So what we have with title lending are real exploding toasters. At least they're not exploding Ford Pintos. Or Chevy Volts. 

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