145

9
The Fringe Auto Industry

Owning a car has become a necessity in many American cities. In particular, many of the post-World War II car-based cities of the Midwest, Southwest, South, and West Coast have notoriously poor public transportation—fewer than 5% of U.S. roadways are served by public transportation. Having a reliable vehicle is important for getting to work on time, for picking up children in day care, for shopping at the lowest-priced stores, for visiting friends and family, and for finding employment. Vehicle ownership is also fertile ground for all types of fraud, from used-car purchases to auto title pawns, and even to tire rentals.146

This chapter explores some of the hurdles that the poor encounter when trying to find and keep basic transportation. In particular, it examines how the used-car industry is organized, the difficulties that the poor face when trying to find affordable used cars, the ins and outs of used-car financing, and subprime financing. It also looks at loosely regulated fringe auto insurers and auto title pawns. Finally, the chapter offers some solutions to help rein in the fringe auto economy.

Buying a Used Car

When I started this book, I was certain that salespeople in seedy used-car lots were more aggressive and avaricious than their brethren in upscale car dealerships. To my surprise, most salespeople I encountered at fringe car lots were actually more laid-back than those in mainstream auto dealerships. Most didn’t pounce on me, and grab my hand and vigorously shake it. Nor did they circle like hungry predators, stalking me as I went from one used car to another. These street-savvy salespeople appeared to understand that longstanding economic abuse made the poor sensitive to respect in financial transactions. In fact, many seemed to empathize with the financial plight of their customers, earnestly believing they were doing the customers a service, since no one else was willing to serve the poor. They were probably right. Perhaps they understood their own proximity to their customers’ plight, since no doubt more than a few had emerged from the ranks of the poor. On the other hand, maybe they were just talented sociopaths able to spin a good yarn.

The path to car ownership for the poor is mined with old high-mileage cars, high down payments, extortionate interest rates, and overpriced insurance. However, before we examine the obstacles faced by the poor in finding and keeping reliable transportation, we’ll take a look at the organization of the used-car industry.147

In 2000 about 40 million used vehicles were sold annually in the United States—11 million by franchised new-car dealers and the remaining 29 million by independent used-car lots.¹ Used-car lots fall into two categories: independent lots and franchised dealerships. Independent, or non-franchised, lots sell only used cars. Franchised used-car lots, on the other hand, are part of new-car dealerships authorized by a car maker to sell its vehicles. Used cars at these dealerships are generally newer, cleaner, and more expensive than those in independent lots. Financing on newer used cars is often available only to relatively creditworthy buyers.

Independent used-car lots generally sell older, less expensive, and higher-mileage vehicles. For example, the typical used car in a franchised dealership is three years old, while the typical car or truck in an independent lot is eight years old. In the independent lots I visited, I rarely found a vehicle with fewer than 50,000 miles on the odometer. In fact, any car with under 80,000 miles was considered “low mileage,” and many had 150,000–200,000 miles on them. Independent car lots often sell vehicles rejected by franchise dealerships, and about 5 million flow from franchised dealers to independents through auctions or other forms of wholesaling.² Because of this market segmentation, most poor buyers end up in independent car lots, some of which are “here today and gone tomorrow.” The used-car business is profitable, and new-car dealers earned 22% of their total profits from used-car sales in 2000. In fact, since the early 1990s, used-car profits have outstripped new-car profits.³

There are important differences between buyers who use franchised dealers and those who go to independent lots. For instance, many buyers who visit franchised lots want to upgrade their vehicle or swap it for another model. Since most already have transportation, they can take their time to find the right car at the right price. Buyers in independent lots often look for a vehicle because they need one, and many are so desperate that they’ll purchase almost anything that fits their budget.

Too often, low-income buyers end up with vehicles that have salvage or junk titles, called “branded titles.” State motor vehicle departments assign these titles to stolen vehicles that have been retrieved after being declared a loss by an insurance company; were in an accident and deemed non-repairable; or were declared a total loss due to flooding or some other natural mishap. Vehicles with branded titles are ineligible for traditional financing and extended warranties, are more expensive to insure, and are not eligible for manufacturer warranties or recalls. Regardless of their condition, branded-title vehicles are considered “junk” by insurers, state motor vehicle bureaus, and car manufacturers. As a result, they’re worth only a fraction of their book value.148

In one independent car lot I came across a six-year-old Acura with 70,000 miles on it. The retail blue book value (in excellent condition with a clean title) of the car was $8,000, or what the dealer was asking for it. When I inquired about the title, the salesperson said he didn’t have it but he could get it. The car was in good shape and drove well. In fact, I was even tempted to buy it. Being cautious, I wrote down the vehicle identification number (VIN) and ran it through Carfax.⁴ As it turned out, the car had been wrecked and had a salvage title. Angry, I went back to the dealer and demanded to know how he could sell a branded-title vehicle for full retail price. He nonchalantly shrugged his shoulders, turned, and walked away. Just another day in the fringe auto economy.

The salary structure in the used-car industry contributes to the shortage of affordable vehicles. Because salaries are based on commission, salespeople in franchised lots have little incentive to sell a $5,000 vehicle when they can earn twice that on one costing $10,000. They’re also reluctant to spend hours trying to find financing for a credit-challenged buyer who wants a $5,000 vehicle, only to be turned down by one lender after another. As one salesman in an independent lot put it, “Those guys at the Ford place don’t want to hassle with poor folk, so they send them my way.” Not coincidentally, his lot specializes in credit-challenged buyers, and the loan rate ranges from 23% to 28%.

Financing Used Cars

The lending practices of financial institutions in regard to the $370 billion used-car industry contribute to many of the transportation obstacles faced by the poor. The good news for used-car buyers is that the interest-rate gap between new and newer used cars has narrowed, and in some cases it is only a fraction of a point. Lenders have come to realize that used-car loans are less risky, since the vehicles have already experienced the largest drop in depreciation. The bad news is that mainstream lenders like Bank of America, Wells Fargo, and Chase refuse to lend money on high-mileage vehicles (over 100,000 miles) or those more than 4–6 years old. This bias limits options for the poor, because 128 million of the 213 million vehicles on the road today are over 7 years old, and 30% are at least 10 years old.⁵ In addition, many lenders only finance vehicles purchased through more expensive franchised dealerships.149

There are several financing tiers available to used-car buyers. The first is prime auto loans, which are offered to borrowers with an excellent credit rating. Interest rates are low, since these loans are tied to the prime rate. In fall 2004 the interest rate for new and newer used cars was about 4.75%, with a higher rate for those who have lower credit scores but are still in the higher tier.

The next tiers involve various forms of subprime lending. In particular, the second tier includes higher-interest loans that are geared toward buyers who have moderate credit problems but still have sufficient credit-worthiness to secure a loan. The third tier, called “third-chance financing,” has considerably higher interest rates than the second tier, and the loan terms and conditions are usually more severe. For example, third-chance lenders often require a higher down payment and have harsher late penalty fees. In some instances, interest rates charged by third-chance lenders may be similar to those of other subprime lenders, but these lenders are more aggressive in pursuing loans, and they require deeper loan discounts, thereby increasing the price of the vehicle. For example, while second-chance lenders will wait 30–60 days to repossess a vehicle, third-chance lenders often repo within a few days after a payment due date. All subprime loans include high interest rates, involve a substantial down payment, and, in some cases, may require the vehicle to be purchased from a franchised dealership.

The fourth tier is nonprime lending, or dealer financing, whereby vehicles are financed in-house through a “buy here, pay here” (BHPH) transaction. This kind of financing often carries the highest interest rates and is totally removed from any linkage to the prime rate. As Table 9.1 illustrates, those who can least afford it pay considerably more in monthly payments and interest charges than creditworthy buyers.

Table 9.1. Monthly payments and interest charges on a $10,000 vehicle with a two-year loan.

150

The heart of the loan decision is the credit scores that are used to set interest rates and loan terms. Once a loan is made, companies then use behavioral scores—including the borrower’s payment history with the loan company and other creditors—to target customers most likely to default. Phone clerks call customers almost immediately after a payment is due and follow up until the customer agrees to pay or agrees to a repossession. Surprisingly, only 5% of subprime car loans are charged off as unrecoverable debt, a low number given the problematic credit histories of some borrowers.⁶

Kim Landry is a 23-year-old data-entry specialist. After graduating from high school, she found a job that paid $14 an hour with full benefits. Her first purchase was her dream car—a red Camaro. When Kim started working, she was deluged with credit card offers. Never having had credit, she was flattered and applied for several credit cards. Things were going well until Kim went into a depression. Although able to work, she began spending with abandon, which was reflected in her high credit card bills. Kim’s overspending also resulted in several late payments.

Her auto insurance skyrocketed to almost $4,000 a year after her second accident. The dream Camaro suddenly became a nightmare, and she wanted to find a car that was cheaper to insure. Kim ended up in a no-haggle used-car superstore. According to CNW Marketing Research, her choice of a no-haggle lot cost her $500 more than if she had gone to a traditional used-car lot.⁷ Although Kim had never defaulted on a loan, her short and blemished credit history meant that she was ineligible for a prime-rate auto loan. She ended up with a 2000 Honda Civic for $13,000 that she was able to finance with $2,000 down on a four-year loan at a 12% APR. Her monthly payments were $290, and her total interest charges were $3,000, or double what she would have paid with a 6% loan.151

Subprime financing is a large industry (nationwide estimates range from $75 million to $194 billion a year) and includes lenders like Ford Motor Credit and General Motors Acceptance Corporation.⁸ These auto lenders extend credit to borrowers with poor or unstable credit histories. Depending upon the customer’s credit risk, interest rates can vary from 10% to 35%, or the state usury limit. In states with strict usury laws, sub-prime lenders often set high loan fees or use other means to boost profits. Although some companies lend directly to consumers, most subprime lending occurs through dealer-originated loans.

Despite the potential profitability, mainstream banks are reluctant to become directly involved in subprime lending because of their conservative lending culture and the stigma associated with these kinds of loans. Lending money at a 25% interest rate and then repossessing a car doesn’t make for good public relations. Besides, it’s safer for banks to lend to the lenders.

Although potentially profitable, subprime loans also pose considerable risks for lenders. For example, the average subprime auto borrower has a 25% chance of being 60 days past due on a payment, at which point the car is likely to be repossessed. According to the Federal Reserve, a prominent credit-scoring vendor reports that 90% of prospective subprime borrowers have at least one significant negative credit event, 20% have gone through bankruptcy, and about 10% have had at least one car repossessed.⁹

Subprime auto lenders control losses by demanding loan terms that offset the credit risk. Lenders catering to the riskiest borrowers purchase loans from dealers at a discount to the principal value (for example, they buy a $7,000 loan for $5,000). The riskier the borrower, the greater the loan discount. Third-chance lenders—those who serve the riskiest borrowers—purchase loans at 50%–66% of the principal loan amount.

This financing structure explains why many used-car dealers refuse to negotiate a final price until after the buyer undergoes a credit check. Because dealers know they will have to discount loans, used-car prices are inflated to make up the difference. This works like a shell game. An independent dealer sells a car for $7,000 that cost it $4,000. If the car is financed through a prime lender, the dealer’s profit will be $3,000. But if it sells the loan to a subprime lender at a $2,500 discount, its profit drops to $500. To realize a $3,000 profit, the dealer prices the car well above its actual value. Because of discounting, subprime borrowers are hard-hit by sky-high interest rates and high vehicle prices. Borrowers are also subject to deceptive practices, since higher vehicle prices are actually a hidden finance charge to the buyer for the discounted loan. This is one reason why the poor rarely find good deals in independent car lots that cater to sub-prime buyers.152

Subprime lending can cause conflicts between lenders and dealers. Loans underwritten on terms favorable to dealers mean greater losses for lenders, since the dealer has an incentive to sell the buyer the most expensive car that he can, thereby maximizing his profit. More-expensive cars result in higher monthly payments for borrowers and a greater chance for a loan default. The dealer can also extend the loan term or lower the down payment to make the car more affordable, which diminishes the buyer’s incentive to repay the cost of a vehicle in which he or she has little equity.

Subprime lenders protect themselves in several ways. First, they try to screen dealers to ensure loan quality and minimize dealer fraud such as misrepresenting car titles, coaching borrowers to fill out applications fraudulently, and inflating car values by underreporting mileage or claiming standard features as options. Consequently, many large prime and sub-prime lenders refuse to purchase loans from independent car lots; instead, they rely on franchised dealers that are less likely to be duplicitous because of manufacturer screening and inspection processes. The other way they protect themselves is to repossess a car quickly.

Ralph Christianson lives in a moderate-income Houston suburb and earns $21 an hour as a machinist, which puts him—at least theoretically—above the poverty line. Five years ago his wife left him. In the divorce settlement, she got the house, most of the furniture, and the newer of the two vehicles. By the end of the bitterly contested divorce, Ralph was heavily indebted to his attorney, complete with a stiff monthly repayment schedule.153

Ralph used his Visa card mainly for cash advances that carried a hefty 19.9% APR. When he maxed out his cards, he secured new ones to pay the monthly payments he owed on his old cards. In the end, he declared bankruptcy. In fact, Ralph’s credit history put him in the lowest lending bracket, and he was forced to resort to a third-chance lender when his car gave out.

Ralph bought a 1999 Chevrolet Cavalier for $5,000 at Excelsior Motors, an independent used-car lot. Although the car had been in an accident, it was rebuilt, had a good title, was less than six years old, and had just under 100,000 miles on it. Ralph’s down payment was $1,000, and he financed $4,000 at a 28% interest rate for 24 months. His monthly payment was $229, reflecting an interest cost of $1,275. Because of Ralph’s credit history, Excelsior Motors used a third-chance lender, which discounted the loan by 50%. Since Excelsior had paid $1,000 for the car and invested $300 in refurbishing it, even after the loan discount, its profit was still $1,200. If Ralph repays the loan, it will cost him almost $6,300 for a car with a trade-in value of $1,440. Like many fringe economy customers, Ralph knew he was getting ripped off, but he just couldn’t see any other alternative.

The profit in subprime lending can be a powerful temptation even for franchised car dealerships. Katia Williams is a 28-year-old African American woman who is employed as a math teacher in a suburban high school. She makes a comfortable living and has a frugal lifestyle. She pays her bills on time, and her credit card debt is small in relation to her income. When Katia went shopping for a new Toyota, the salesman told her that, based on her income, she would qualify for a prime rate loan at 6%. After completing some paperwork, he disappeared into the finance office and returned an hour later with a worried look on his face. “Katia, you have credit problems, and the best rate I can get you is 11%.” She was stunned. After composing herself, Katia asked, “What problems are you talking about?” His response was, “I can’t talk about it. You’ll have to ask the credit bureau. But I’ve got a special lender that will approve you right now.” Katia left the showroom angry and confused. At the next Toyota dealer she was approved for a 6% car loan.

Was racial stereotyping behind Katia’s “credit problems” (even though the salesman and finance manager at the first dealer were both African American)? A well-kept secret in the auto industry is the practice of lender kickbacks to dealers who charge higher interest rates. For example, if a lender’s current loan rate is 8%, but the dealer charges the customer 10%, the dealer usually gets to keep a portion of the additional finance charge. On a five-year loan for $20,000, that extra 2% adds $20 to the monthly payment and $1,200 to the total interest costs. The higher the interest rate, the higher the dealer kickback.¹⁰154

Alternatively, the salesman could have duped Katia into “packed” or “loaded” payments. In this scheme, when Katia asked about the monthly payment, the salesman would quote her an inflated figure. For example, if the real monthly payment was $345, Katia might have been quoted $385. If Katia had agreed to the $385 monthly payment, the salesman might have gotten the extra money by pushing high-profit items like an extended service warranty, anti-theft window etching, undercoating, a car alarm, or credit life insurance. On a five-year loan, this would add $2,400.

Virtually all subprime auto loans include extremely high interest rates. According to the Federal Reserve, a first-time home mortgage is considered high interest if it is eight points above the yield on a 30-year Treasury note. In 2004 the prime rate was roughly 5%, and a subprime car loan at 13% would have been considered high interest. In comparison, a second-or third-tier subprime auto loan at a 26% APR rate is twice the Federal Reserve’s classification for a high-interest loan.¹¹

There are several reasons why subprime lenders can get away with charging such high interest rates. First, the lack of competition among sub-prime lenders and the limited finance options for those with problematic credit allow lenders considerable freedom in setting rates. Second, the refusal of the federal government and most state governments to enact and enforce stringent protective legislation against predatory lending allows subprime lenders to do business almost with impunity. Third, a bad economy is a good economy for subprime lenders, because their customer base increases and they can borrow cheap money and resell it (in the form of loans) for much more to low-income consumers.

Buy-Here, Pay-Here Lots

155

Like many fringe economy businesses, BHPH lots (sometimes called “note lots”) often appear to be minor storefronts relegated to low-income neighborhoods. But looks can be deceiving. According to journalist Terry Box, these 19,000 BHPH lots account for 22% of the used-car business nationally. They’re also one of the industry’s fastest-growing areas and could be responsible for 30%–40% of used-car sales in the next decade.¹²

BHPH lots are at the bottom of the subprime feeding chain: they provide in-house financing for their used cars; they don’t require credit checks; and they don’t forward payment information to credit bureaus. In-house financing usually requires a hefty down payment (about $1,000 on a $5,000 vehicle), and buyers pay weekly. Late payments can result in immediate repossession. As Table 9.2 illustrates, BHPH lots can be very profitable.

Like many fringe businesses, the BHPH industry can be risky, and about 30% of all cars are repossessed.¹³ On the other hand, these lots are more profitable than franchised car dealerships.¹⁴ By 2002 the average retail price of a used car in a franchised lot had risen to $11,793, with a gross profit of $1,741. In comparison, the average retail price of a BHPH used car had gone up to $7,810, with a gross profit of $3,772. Sales expenses in every category—vehicle reconditioning, advertising, sales commissions, and floor-plan costs—were lower for BHPH lots.¹⁶ Table 9.3 illustrates the profitability of BHPH lots.156

Table 9.2. Costs and profitability of a typical buy here, pay here used-car dealer in 2000.¹⁵

BHPH lots are so profitable that even traditional car dealerships are getting in on the action. Chris Leedom, a guru of the BHPH industry who has coached more than 1,500 dealers, observes that “many of the participants in our Buy-Here, Pay-Here Training School are rookies. These dealers are savvy, have capital, and are looking for attractive returns. Buy-here, pay-here certainly offers attractive returns when executed properly.”¹⁷ Many of the rookies that Leedom is talking about are franchised dealers wanting to cash in on this high-profit industry.

Large BHPH dealerships are generally not marginal fly-by-night operations. For example, in 2004 the National Association of BHPH dealers hosted its annual convention at Caesars Palace. More than 1,500 people attended the conference from the United States and Canada, plus 60 sponsors, including Wells Fargo Financial, SeaWest, CarMax, and Auto Trader.

Table 9.3. Profitability of selling cars and trucks in buy here, pay here dealerships, 2000.¹⁸

157

Like other parts of the fringe economy, the BHPH sector is undergoing financial consolidation. DriveTime (formerly Ugly Duckling) is a BHPH chain, owned by Ernest Garcia, that operates 76 dealerships in eight states and 11 metropolitan areas. The company sells more than 50,000 cars a year, with interest rates ranging from 20% to 30%. DriveTime’s gross sales in 2003 were $729 million, and its one-year sales growth was 82.2%.¹⁹

America’s Car-Mart (formerly Crown Group) is a NASDAQ-traded company with 76 dealerships in seven states. Located in Bentonville, Arkansas (the home of Wal-Mart), Car-Mart sells more than 24,000 vehicles a year and has maintained profitability in every year since it began in 1981. Company revenues grew from $128 million in 2001 to $176 million by 2004.²⁰ Car-Mart proudly claims to honor its customers—every 5-, 10-, and 15-time repeat customer is placed in the company’s exclusive Silver, Gold, or Platinum Club. The ostensible honor is to have your name engraved on a plaque in the front of the store. That’s probably the least Car-Mart can do to honor customers who pay 20%–30% interest on their vehicles.

The J.D. Byrider network is a unique franchise with 124 locations in 30 states and Canada. Byrider specializes in 5-to-10-year-old cars that sell for about $7,000. All of Byrider’s franchises are composed of two companies: a used-car company (J.D. Byrider) and a subprime auto finance company (CarNow).²¹

In 2004 the Kentucky attorney general filed a lawsuit against Byrider and its franchisees. The charges included failing to repair vehicle defects under an implied warranty; making unfair, false, misleading, and deceptive statements about warranties; refusing to recognize a customer’s lawful right to revoke his or her contract; making false, misleading, and deceptive statements about vehicles’ being “certified” or “inspected”; and requiring buyers to purchase credit life insurance and service contracts, and failing to disclose those as a credit cost (that is, violating the federal Truth in Lending Act). The complaint also alleged that Byrider’s business model is unlawful, since it unfairly makes consumers vulnerable to abusive sales tactics. Finally, the complaints included Byrider’s discouraging customers from purchasing certain cars; hiding or failing to reveal the real purchase price; and requiring detailed financial information and a credit check before disclosing a vehicle’s price.²² It seems that Byrider’s mission to “Deliver dependable cars and provide affordable financing in a friendly and professional atmosphere” may need some fine-tuning.158

BHPH dealers foresee a brisk future as more middle-class families face increased debt and blemished credit. In fact, the BHPH sector is beginning to stratify, with middle- and higher-end lots selling vehicles costing $10,000 or more. Some are even selling newer cars and trucks for $20,000 and up. According to Michael Linn, CEO of the National Independent Automobile Dealers Association (NIADA), “We’re no longer just talking blue-collar working people.… We’re talking doctors, lawyers. It’s a growing industry because of what is going on economically, and the influx of immigrants. The common denominator is no credit or damaged credit.”²³

Like much of the fringe economy, the BHPH industry is driven by the profitability of financing rather than the profitability in selling a product. As one BHPH customer described, “They wanted $1,900 for that car.… These people wouldn’t take cash; they wouldn’t take cash for any of their vehicles. I asked, and he said that they wouldn’t let us buy the car. They wanted us to put $1000 down and pay $89 a week for two years, which totals much more than the car’s actual worth. If it broke down, you couldn’t get your down payment back.” BHPH dealer Ingram Walters observes, “The BHPH business is not the car business. It is the collections business.”²⁴ BHPH industry analyst Chuck Bonanno has a similar message: “If you repossess cars when they fail mechanically, repair them only to sell it to another customer, you miss the point of buy-here, pay-here. We want $70/week from everyone and forever!”²⁵

CARLOTTA AND SUNSHINE MOTORS

Sunshine Motors is a typical small BHPH car lot. It has 30-40 cars at any given time, it’s located on a wide Texas highway, and its sales office is in a small prefab building. Its stock consists mainly of high-mileage vehicles bought at auction, at least six years old, and of little interest to most fran-chised car dealers. Sunshine purchases its vehicles well below book value, rarely paying more than $2,000 for any car. The minor reconditioning generally costs less than $300. Sunshine’s strategy is to sell a lot of $5,000–$8,000 cars fast.159

A big sign painted with a cheery sun sits in front of its lot. In prominent letters the sign advertises that Sunshine will “tote-the-note” and provide in-house financing. As in many of these car lots, salespeople and apparent hangers-on mill around in dense clouds of cigarette smoke and overflowing ashtrays. The tops of their desks are empty, and calculators are nowhere in sight. When I asked a salesman why he didn’t have a calculator on his desk, his response was, “The computer figures everything out.” This isn’t surprising, since the last thing a fringe economy salesperson wants is for the customer to add up the numbers. Sunshine’s salespeople are so laid-back that they almost seem uninterested in selling cars. On the other hand, they may just have good instincts about who will buy, reserving the heavy come-on for real customers.

Carlotta Hernandez is a 35-year-old Guatemalan who has lived in the United States for 15 years. Her husband, Raul, works for a lawn service and earns minimum wage. Only her children speak fluent English. Carlotta has built up a small housecleaning business that provides the lion’s share of the household income. She has also built a loyal clientele, who, at her request, pay in cash. Raul is also paid in cash. Although the combined family income provides a modicum of comfort, the Hernandezes don’t have a bank account or credit cards. They pay their bills in cash or money orders that they purchase from a local check-cashing outlet.

Carlotta had just had their fourth child, and their car was too small for the family. Although the Hernandez family had always paid for cars in cash, the new baby left them short of money. Without established credit, a bank account, pay stubs, and employer verification, they were forced to turn to a BHPH lot.

Sunshine Motors was designed for customers like Carlotta. There are no complicated forms to fill out, since there’s no credit check or subprime lender to satisfy. Carlotta put $1,000 down and would pay weekly until her loan was paid off in two years. Her interest rate would range from 23% to 28%, depending on the deal she could strike with the salesperson.

Carlotta bought a 1991 Chrysler minivan with 132,000 miles for $7,000. If the minivan had been in excellent condition (which it was not), the retail price would have been $5,000. Carlotta overpaid by at least $2,000 but was able to negotiate a two-year 23% APR loan, for a payment of $80 a week. Like many fringe economy buyers, Carlotta was more concerned with the amount of the weekly payments than with the interest rate. If she had calculated the total cost, Carlotta would have found that the loan interest was $1,500, which increased the minivan’s cost to $8,500. If Sunshine Motors had purchased the minivan at trade-in value, it would have paid only $1,900 for a vehicle costing Carlotta $8,500. Her $1,000 down payment alone paid for half of Sunshine’s investment, and in only three months its entire costs would be paid off. The remaining 21 months would be almost pure profit for the dealer.160

If Carlotta’s minivan needed expensive repairs (likely for an older, high-mileage vehicle), she would be forced to choose between paying off the loan, having the vehicle repossessed, and losing the down payment (plus the monthly payments she’d made), or selling the minivan and adding money to close the deal. Chuck Bonanno details the dilemma: “Our customers typically don’t pay for repairs because they can’t afford the repairs and not because they refuse to make the repairs. Remember that when vehicle repair estimates inch toward down payment requirements in your market, it only makes economical sense to consider the options: fix the one I got or get a new one. The fear of bad credit is not a factor to our customer and will typically not influence their decisions.”²⁶ To keep customers in the financing loop, some BHPH dealers offer service plans. Sunshine Motors does not.

BHPH lots also make money on repairs. As one BHPH dealer put it, “When their battery dies, they call us. I send a wrecker and pick it up. Now I got a $45 wrecker bill. If it’s the battery, it’s $45 for the battery plus $20 to put it in. But they don’t even have the money to do that. So I say, ‘Can you give me $30 down and I’ll finance the other $70?’ Now they’re $100 in the hole plus interest.” Another BHPH customer observed, “If your car breaks down, you can take it there and they just keep tacking on the repairs to your bill. Some people have this old car, and they’re having this six-year, seven-year bill from them.”

Given the age and high mileage of Sunshine’s cars, it’s no surprise that when I asked the salesman about the length of its loans, he said, “Don’t worry, no one pays off a loan. We have repeat customers. People just keep on trading in cars and buying more expensive ones. Most of our customers don’t keep their cars for more than a year.” In any case, Sunshine Motors can’t lose. If Carlotta’s minivan were to be repossessed, the dealer would resell it to the next customer for roughly the same price. Since Carlotta would have repaid Sunshine’s initial investment in only three months, any subsequent sale would be almost pure profit.161

Repossession looms large for BHPH customers. When I asked the Sunshine salesman about this, his response was, “We don’t repossess much. We want the customer to be happy and to come back and buy more cars. Hell, I can show you customers that owe us $600 and we still haven’t repoed them.” I felt reassured until I drove down the road to Small City Auto Sales. The salesman there had a different take on the issue: “I don’t like to do in-house financing unless I have to. If I finance a vehicle, I’ll repo it the day after a payment is late. Just like Sunshine.”

Although the fear of repossession is real for Sunshine’s customers, it may be the last resort for dealers, because it signals the end of the relationship. The key to profit in the fringe economy is keeping borrowers firmly ensconced in the financing loop. In fact, the most invidious part of the BHPH system is that it locks the consumer into its system in two ways. First, even if Carlotta makes timely payments and pays off the loan, her credit will not be enhanced, since Sunshine doesn’t report transactions to a credit bureau. Carlotta’s responsible behavior will go unrewarded, and she won’t be building a positive credit history. The next time Carlotta needs a vehicle, she’ll again be forced into the fringe auto economy. While many fringe economy consumers are keen on avoiding a credit check—or are misled by salespeople into believing that they will never qualify for a loan—in-house financing diminishes the possibility that a responsible borrower can rectify his or her bad credit. Captive buyers are therefore forced to remain dependent on the largesse of Sunshine Motors’ “good deals.” This cycle continues indefinitely, and with each trade, Sunshine’s profits grow while people like Carlotta go deeper into debt. Once the economic hook is set, it goes deep.

Second, having bought a grossly overpriced vehicle, Carlotta can’t resell it until after the loan is paid off. If she’s lucky, she can get back her $1,000 down payment, but she’ll have lost $7,500 in 24 months of high-interest payments. She’ll also be back to square one. Carlotta’s other option is to trade the minivan back to Sunshine Motors for yet another overpriced vehicle. Since Sunshine has already recouped its initial investment several times over, it can offer Carlotta more than her minivan is worth. In turn, she can buy a $12,000 vehicle (worth maybe $6,000) with her $2,000 trade-in.162

High-Cost Auto Insurance

The poor are also hard-hit by auto insurance. For example, many people with older cars only insure them for state-mandated liability coverage rather than for collision (damage to their vehicle). It makes little sense to spend $600 a year for collision coverage on a car worth $1,000, especially after a $500 deductible. To protect their loan, BHPH dealers and sub-prime lenders require borrowers to insure their vehicles for liability and collision, regardless of its cost-effectiveness.

According to a Conning and Co. study, 92% of large insurance companies run credit checks on potential customers.²⁷ These checks translate into insurance scores that are used to determine if the carrier will insure an applicant and for how much. Those with poor or no credit, like Carlotta and Ralph, are denied coverage, while those like Kim, with limited credit, pay high premiums.

Insurance companies argue that credit scoring helps prevent low-risk policyholders from subsidizing higher-risk policyholders, thereby lowering their premiums by 60%–80%.²⁸ Despite the industry’s reliance on insurance scoring, it has provided no hard evidence to support its claim that credit-impaired or low-income drivers are any less safe or more prone to file claims than creditworthy ones.²⁹ What is clear, though, is that insurance scoring is a form of redlining that punishes those with poor credit, minorities, and the young. State and federal government agencies should enforce existing anti-redlining statutes by taking action against insurers who violate the law. Government should force insurers to offer drivers with no moving violations or at-fault accidents policies at their standard or preferred rates. This would ensure that everyone has an equal opportunity to buy affordable insurance.

Because Carlotta and Ralph would likely be refused coverage by first-tier insurance companies, they would end up in the fringe auto insurance market. The A.M. Best Company has two categories for ranking the financial strength of insurance companies: Secure Ratings and Vulnerable Ratings. Most large auto insurers are rated as secure, and most fringe insurers are rated as vulnerable.³⁰ These categories reflect the ability of insurers to pay out claims and protect the interests of their customers. For example, large auto insurers will pay out claims even if faced with huge losses resulting from floods, hurricanes, or other natural catastrophes. Facing similar losses, marginally capitalized insurance companies may declare bankruptcy to avoid honoring claims. While most states have guaranty funds to pay claims if an insurance company fails, those funds can be quickly exhausted in an emergency. About 17 U.S. insurance companies are liquidated, dissolved, or placed in receivership each year.³¹ Fringe or second-tier auto insurers are a big risk for low-income auto buyers, who are responsible for repaying their loans even if the insurer becomes insolvent.163

Mainstream auto insurers calculate premiums based on six-month or one-year periods. On the other hand, fringe auto insurers typically provide only monthly quotes, and, not surprisingly, these are outrageous compared with rates from large auto insurers. If Ralph and Carlotta had excellent driving records and were accepted by a mainstream insurer like State Farm or GEICO, their annual full-coverage premiums would range from $700 (GEICO) to $900 (State Farm) for the Chrysler minivan and from $800 (GEICO) to $1,100 (State Farm) for the Chevy Cavalier. If they chose only liability coverage, their premiums would drop to $500 a year.

Because of the lenders’ requirement for full coverage, Carlotta and Ralph would pay double the insurance premiums necessary for an older vehicle with little trade-in value. Moreover, since they overpaid for their vehicles, even full insurance coverage would leave a huge gap between what they would receive for a total loss and what they actually owed. Borrowers are responsible for the difference between insurance compensation and loan repayment, a difference that could cost thousands of dollars. To protect themselves, some buyers buy expensive “gap” coverage to supplement their regular auto insurance.

Carlotta and Ralph ended up with a minimally regulated, high-rate local insurance agency. If Carlotta chose Houston’s Alamo Insurance, full coverage for the Chrysler would be $2,100 a year, or three times the $700 quoted by GEICO. Ralph would pay an astounding $2,800 a year, or more than three times the $800 quoted by GEICO. In only one year, Carlotta and Ralph would pay more in car insurance than the wholesale value of their vehicles. If they shopped carefully, they could find slightly cheaper insurance at AAA Insurance (not related to the American Automobile Association), a local Houston company. At AAA they’d pay $1,400 and $1,800, respectively. But full insurance coverage even at the lowest rate would raise Carlotta’s monthly auto payments to $380, while Ralph’s would jump to $365.164

Fringe auto insurers can charge outrageous premiums for several reasons. For one, they have a captive consumer who has already been rejected by large insurance carriers. Second, the loan terms of BHPH dealers and subprime lenders create a steady stream of car owners desperate for insurance. Third, many fringe auto insurers are minimally regulated, and state insurance regulators are lax in rooting out predatory insurers, especially those serving the poor. Not coincidentally, fringe auto insurers take the pressure off mainstream carriers to provide coverage for the poor. Finally, many state vehicle inspections require a proof-of-insurance card before a vehicle can pass inspection. Some car owners pay the high monthly premium to get the insurance card, pass the inspection, and then drop the coverage. This may be one reason why fringe auto insurance rates are quoted monthly rather than biannually

Carlotta, Ralph, and tens of thousands of other poor car buyers are victimized thrice: once by predatory fringe auto dealers with inflated car prices; again by finance companies charging scandalous interest rates; and finally by avaricious auto insurers. Each year Carlotta and Ralph will pay about $4,500 for the privilege of driving a battered old car. In fact, they will spend almost as much each month on junk cars as the middle class spends on newer, sound vehicles.

Vehicle Inspections and the Poor

The effects of insurance scoring, coupled with greedy fringe market auto insurers, result in vast numbers of uninsured motorists—400,000 in Philadelphia, 500,000 in Los Angeles, 10% of St. Louis drivers; and 21% of Texas drivers.³² About 14% of U.S. drivers carry no auto insurance whatsoever.³³165

The rising cost of state vehicle inspections also helps to discourage drivers from making their vehicles legal. Mandatory New York State vehicle inspections cost $35; Texans pay $40. Moreover, whether vehicle inspections actually protect public safety is open to question. As one vehicle inspector put it, “I think these things are a waste of money. I fail about two cars a week. The other inspectors I know fail about the same.” One of the major causes of inspection failures is worn tires. Luckily, the fringe economy has come to the rescue.

Rent-A-Tire and Rent-A-Wheel are the nation’s largest tire-rental outlets, with more than 30 stores in California, Texas, and Arizona. Rent-A-Tire was started by Cash America International, although it divested itself of the company when it merged with Rent-A-Wheel in 2002.

Roberta Goldstein is a nursing assistant and a single mother of two teenagers. Although she tries to maintain her 1998 Ford Explorer on limited finances, it failed Texas’s vehicle inspection because of worn tires. Cash was tight for Roberta, and she was at the limit of her Visa card. Never a scofflaw, she feared driving illegally. When Roberta checked Discount Tire, the cheapest tires she could find cost $400. Driving around, Roberta discovered Rent-A-Tire. At her wits’ end, she had little choice. In only two hours, Roberta was out of Rent-A-Tire and had the Explorer successfully reinspected.

Rent-A-Tire’s application form is straightforward, and Roberta was relieved that there was no credit check, because she had had several late Visa and utility payments. To close the deal, Roberta needed $108. Although the salesperson explained how the rent-to-own agreement worked, Roberta only partially paid attention, since all she could think about was making her only transportation legal again. After signing the agreement, she drove off with four possibly new tires (Rent-A-Tire resells its repossessed tires).

Roberta’s tires came with a high price tag. Her weekly payment was $45, or $180 a month (almost half the cost of new tires) for 26 weeks. At the end of the six-month rental, Roberta would have paid $1,170 for tires worth $400. Although she could purchase the tires anytime and receive a 50% discount off her balance, the cash-out was based on the initial price of $600, which was still $200 higher than the cost of buying new tires at Discount Tire. While Roberta’s rental payment included mandatory theft insurance on the tires, it didn’t cover road hazards, which meant that she was still responsible if her tires became irreparably damaged. Rent-A-Tire has no grace period. If Roberta were to be one to three days late with her payment, she would be required to pay two weeks in advance. If she were four to six days late, she’d have to pay three weeks in advance. Roberta’s tires would be repossessed if her payment were more than seven days late. Mandatory vehicle inspections are a blessing for companies like Rent-A-Tire.166

Auto Title Pawns

Although auto title pawns began in the South, by 2000 these outlets were a common sight in many large metropolitan areas. In fact, auto title pawns are legal in 20 states. These loans are fairly straightforward transactions. A consumer needs a short-term loan, but instead of using his television or stereo as collateral, he uses his vehicle title. This substantially increases the amount he can borrow, because cars are generally worth more than appliances or electronics. Vehicles are also easier for lenders to resell at auction. However, unlike pawnshop transactions, auto title pawns don’t require the borrower to relinquish the use of his property during the course of the loan, even though the lender owns it.

Auto title loans can have several stipulations. For example, some title pawn companies will not lend on vehicles 12 years or older. Others will not lend when the loan exceeds 25% of the borrower’s monthly wages.

An auto title pawn can include a lease-back arrangement, whereby the lender buys the car for the price of the loan and then leases it back to the borrower. Once the interest, fees, and cash advance are paid, the lender resells the vehicle back to the borrower. Lease-back transactions are often used to bypass state usury laws.

Gary Higgins is a 25-year-old lumberyard worker from Alamogordo, New Mexico, a city of 15,000 people. When Gary worked, he earned $6.50 an hour, which was about the average wage in rural New Mexico. Gary lives with his girlfriend, Lettie, and their 2-year-old son in a rented trailer just outside the city limits. Lettie works for Wal-Mart and earns $7.50 an hour. Getting by was hard when Gary and Lettie both worked, but after he broke his leg in an accident, it became even harder. Like many rural New Mexico residents, Gary didn’t have health insurance through his job. Without his salary, the family couldn’t pay the rent.167

Gary inherited his grandmother’s 1998 Oldsmobile. The car had only 45,000 miles on it and was in excellent condition. It was the only asset that he and Lettie owned. They couldn’t sell their only car outright, because Alamogordo has no public transportation and Lettie would therefore have no way to get to work. Because Gary was unemployed, Alamogordo banks would not consider a personal loan. This couple felt that their only option was to pawn the auto title.

High Desert Title Pawn is located in a small strip mall on Alamogordo’s busiest street, which isn’t saying much. It’s run by Terry Hinojosa, a Charles Bronson look-alike in his mid-40s. Despite his rugged demeanor, Terry displays a warm empathy for his customers: “I’m here to help these people. They’re my people. I know where they’re coming from, and I know what they’re facing. I don’t want to repo anybody’s car, I just want to help them out of a jam.” As is the case with many of the salespeople I’ve met in the fringe economy, I’m not sure whether to help Terry enroll in a social-work program or nominate him for the Bullshitter of the Year award.

To secure the loan, Gary had to provide a paid-up vehicle title free of any liens and an extra set of keys. He signed over the title to High Desert, which appraised the car based on the lowest possible value (the wholesale price in rough condition). Some auto title pawns lend up to 50% of the vehicle’s value in poor condition, while others, such as High Desert, lend only up to one-third. The maximum loan from High Desert was $1,250. If Gary defaulted, High Desert would get a car worth at least $7,000 for $1,250, a sum that wouldn’t include Gary’s previous payments.

Car title loans are written for 30 days and typically involve an APR of 300% or more. Although loan terms vary between companies, High Desert operates in the following way: Gary’s original loan of $1,250 was due in 30 days with a payoff of $1,560 (25% interest). If the loan weren’t repaid, the car would be repossessed on the 31st day. Gary could request a 30-day extension after paying $310 in interest charges. In fact, he could get almost endless extensions as long as he paid the interest charges. Gary’s interest costs would total more than 50% of the original loan after 60 days. In only five months, his interest charges would exceed the original loan amount. If the loan were extended for a year, Gary would pay $3,800 in interest charges on a $1,250 loan.168

If High Desert repossessed Gary’s car and sold it at auction or to a car dealer, he’d receive no proceeds from the sale, even though its value was greater than the loan. Should Gary default after four months (when the interest payments equaled the original loan), High Desert’s proceeds from the resale would be almost pure profit. Once Gary relinquished the title, he would lose fiscal control of the car until the interest and cash advance were paid. Since Gary no longer owned the title, he couldn’t easily resell the car to get out from under High Desert. Not surprisingly, many title loan companies find it more profitable if the borrower defaults.

Other auto title pawn companies operate in a slightly different manner. Car Title Loans of America has 37 outlets in five states. If the company appraises a vehicle at $2,000 (the wholesale value in poor condition), it will give the borrower a 30-day loan for 50% of the car’s value. After 30 days the loan payoff is $1,250, or the original amount of the loan plus 25% in interest and fees. After paying $500 in interest payments for the first two loan periods, a borrower can request an extension for a maximum of one year. At that point, the monthly payment rises, because the borrower is now expected to pay $100 a month toward the principal and continue to pay the interest. By the fourth month, the principal will be only $900, and so on, until the loan is paid off or the car is repossessed. In an ironic twist, the company states that “Car Title Loans of America is… organized to provide financial help for customers.… [The company]… offers its customers more than just money. At the time a loan is made, customers are given their choice of ‘How to Escape Financial Bondage,’ The New Testament,’ or ‘God’s Promises’—tools that hopefully will help them get in a financially sound situation.”³⁴ Creating a financially sound situation under a crushing 300%-interest loan isn’t easy, even with the help of the Bible.

Reforming the Fringe Auto Sector

169

Its easy to blame the excesses of the fringe auto economy on BHPH lots, sleazy salespeople, unscrupulous subprime lenders, and rapacious insurance companies. While not blameless, these institutions and actors are symptomatic of larger problems, including the reluctance of mainstream banks to provide financial services to the poor and society’s obsession with credit scores. Nowadays, credit ratings have become the benchmark by which moral probity is judged. Bad credit is the equivalent of bad character, and few politicians are willing to stick out their necks for people with bad character. This partly explains why there’s so little legislation to protect the poor from predatory economic activity.

The fringe auto economy provides an important, if expensive, service for the poor. Independent used-car lots resell older vehicles that mainstream dealers would otherwise discard or sell for export. Moreover, BHPH lots finance poor credit risks that even many third-tier lenders would run from. Subprime lenders provide the means for the working poor to secure transportation so that they can hold down a job. Although second-tier auto insurers charge extortionate premiums, low-income car owners would be bereft of insurance without them. Even auto title pawns provide an important service by allowing borrowers to drive their cars while owing money on them, something that traditional pawnshops won’t do. So it’s not surprising that the biggest opponent to auto title loans in Florida has been the pawnshop industry.³⁵

Outlawing the fringe auto economy won’t solve the problem, because that will punish low-income consumers as much as unscrupulous car dealers, lenders, and insurance companies. Moreover, crafty dealers, lenders, and insurance companies would undoubtedly find other ways to do business. Despite this, there are several ways to exercise some control over the fringe auto economy. For instance, states can enact stricter usury laws with fewer loopholes. There’s little economic justification for BHPH lots and subprime lenders to charge five or six times the prime rate for an auto loan, even for a high-risk borrower. Maximum interest rates for all auto financing should be keyed to the prime rate and should not be permitted to exceed it by more than a fixed number of points.

Other reforms are also needed. Mandatory disclosures should be required in all used-car sales, especially for dealer-financed autos. How much a dealer discounts a car note to a subprime lender should be explained to buyers so that they can see how the discount affects the price of the vehicle. In addition, BHPH auto dealerships and auto title pawns should be required to report all transactions to a credit agency, which could help responsible consumers build or rebuild their credit histories. This reporting may also help weaken the reliance of the poor on the fringe economy. Another way to discourage the poor from using the fringe economy is to provide consumer education, which begins with understanding the economics of fringe buying. However, this won’t be successful unless disclosure statements and other legal forms are drafted into succinct language that is easily comprehended by non-attorneys.170

Several interesting experiments are under way to address transportation problems for the poor. In fact, there are currently 40 nonprofit car-ownership programs in the nation that provide as many as a few hundred cars a year or as little as five. One example is Fannie CLAC, started by auto-industry veteran Robert Chambers. CLAC is a nonprofit car-ownership program in Lebanon, New Hampshire, that helps low-income people buy new cars and thereby avoid the used-car market altogether. Chambers has persuaded auto dealers to offer new base-model cars at $100 over dealer invoice. Fannie CLAC then negotiates with banks to secure loans for clients at favorable rates. In 2004 these loans typically lasted 66 months, carried an interest rate of 4.75%, and cost borrowers only $243 a month. CLAC guarantees the value of each loan, thereby eliminating the lender’s risk. So far, the default rate on CLAC-guaranteed loans has been less than 3%—lower than the industry average. In turn, CLAC requires most clients to undergo credit counseling before it will guarantee the loans. To further insure the loans, CLAC clients drive used “bridge cars” that it lends them for $200 a month while they build a credit history and become accustomed to making car payments.³⁶

Another example is the Good News Garage, which Hal Colston started in 1996 in Burlington, Vermont, with $35,000 from Lutheran Social Services. Good News solicits donations of used cars, inspects them, and repairs the ones with life left in them. It then sells the cars to needy families for the cost of repairs—usually less than $1,200—and offers a 30-day warranty. In 2003 Good News provided 210 cars to low-income families. Seattle’s Working Wheels program furnishes clients with late-model cars donated by government agencies. Detroit’s Driven to Succeed program helps low-income buyers purchase previously leased cars. Despite these notable attempts, most nonprofit car programs have hundreds of families on their waiting lists, and the need far exceeds the availability of affordable autos.³⁷171