CFPB Track Record on Anti-Discrimination Analyses Show Malfeasance
December 11, 2015Congressman David Scott (D), the same congressman that said, “God Bless the online lenders” back in October had some choice words for the Consumer Financial Protection Bureau recently after learning they manipulated data to falsely support evidence of racial bias in lending. According to the Wall Street Journal, Scott called their data “shamefully flawed.”
As explained by the WSJ:
The bureau has been guessing the race and ethnicity of car-loan borrowers based on their last names and addresses—and then suing banks whenever it looks like the people the government guesses are white seem to be getting a better deal than the people it guesses are minorities. This largely fact-free prosecutorial method is the reason a bipartisan House supermajority recently voted to roll back the bureau’s auto-loan rules.
The House of Representatives responded on November 18th by voting 332-96 in favor of stripping some powers away from the CFPB. In a bill, that hopes to be known as the Reforming CFPB Indirect Auto Financing Guidance Act if it is also passed in the Senate and signed by the President, attacks the CFPB’s guidance of the Equal Credit Opportunity Act as it applies to auto lending.
“Bulletin 2013-02 of the Bureau of Consumer Financial Protection (published March 21, 2013) shall have no force or effect,” the bill states outright.
Bulletin 2013-02 addressed the auto lending industry by saying, “the ECOA makes it illegal for a ‘creditor’ to discriminate in any aspect of a credit transaction because of race, color, religion, national origin, sex, marital status, age, receipt of income from any public assistance program, or the exercise, in good faith, of a right under the Consumer Credit Protection Act.”
The CFPB reviewed loan data as expected to see if there were racial disparities but disturbingly did not actually know the race of the borrowers in many cases. So they guessed, according to the WSJ, by reviewing the last names and addresses of the borrowers. When being shown the results of their guesses against a sample of data for which they actually had racial background data, the CFPB only successfully guessed correctly 54% of the time. Despite being aware of this, the CFPB sued Honda, Fifth Third Bank, and others for discriminatory lending practices. Honda was pressured into settling for $24 million and Fifth Third for $18 million even though the CFPB’s data and methodology were false.
The House bill also requires that the CFPB publicly disclose the methodologies and analyses used to assess discrimination in auto financing, lest they continue to manufacture their own data, draw conclusions based on that, and then extort corporations for tens of millions of dollars through lawsuits, investigations and public shaming.
88 Democrats in the House joined their Republican colleagues in passing this bill.
This kind of blatant malfeasance is especially alarming considering the CFPB is already licking their chops to collect data on small business lending so that they can test it for racial and gender disparities as well.
As small business underwriting is markedly different from the commoditized world of consumer lending, it would be near impossible for a pious, law-abiding, and even omnipotent CFPB to make meaningful determinations. Considering that the CFPB we have acts in a manner as described above, small business lenders have a lot to worry about over the implementation of Dodd Frank’s Section 1071.
Prosper Loan Linked to Terror – A Preliminary Assessment
December 9, 2015By now you have probably heard that one of the San Bernardino terrorists received a $28,500 deposit from WebBank.com two weeks prior to committing the attack. After Fox News broke that story, I may have been the first to publicly connect it to an alternative lender which was later revealed to be marketplace lender Prosper about 12 hours later.
As a Prosper investor myself, here are some things you should know:
The $28,500 deposit (if that was the exact true amount) would have been net of the origination fees. In all likelihood this was a loan for around $30,000 and the borrower only netted $28,500.
Those that have speculated that it would be impossible for someone making $53,000 a year (as Syed Farook did) to qualify for an unsecured loan of this amount are wrong. There are loans on the platform right now that fit these parameters. Online Lenders like Prosper and Lending Club are pretty aggressive with their lending.
The notion that Prosper somehow could’ve detected what the borrower planned to do two weeks later just isn’t possible. In lending, this is known as the asshole factor, meaning that even if the applicant meets all the criteria, they could just decide to be an asshole, and there’s no way to predict that.
There are strict laws in place to prevent all kinds of discrimination, meaning that even if Prosper had formed some kind of suspicion about the borrower, it may have been illegal to act on that suspicion. Such is the hypocritical paradigm of fair lending where factors that are measurable predictors of negative performance (or worse) cannot be legally used. Federal laws have purposely tried to create an environment where lenders make decisions on an objective basis they consider to be fair. In business lending for example, there is a law within Dodd-Frank that has not been implemented yet, but seeks to prevent loan officers from knowing the gender or even the name of the prospective borrower to protect them from subconscious discrimination.
Investigators have publicly announced that the terrorists were not on any watch lists and therefore there are no systems or checks that Prosper could’ve plugged into to have gotten the information.
Prosper and other alternative lenders already have Anti-Money Laundering Policies. I know this because I complained about Lending Club’s over a year ago.
The Wall Street Journal stated, “Only some nonbank financial institutions, such as mortgage lenders, are subject to Treasury rules requiring lenders to report suspicious activity to the government under the Financial Crimes Enforcement Network.” Maybe that’s true, but there is nothing suspicious about someone applying for a loan online who is not on any watch lists. I can’t think of anything that could’ve been suspicious unless they submitted fake pay stubs or forged documents.
“There’s no due diligence that’s done into how these loans are actually going to be used,” said Brian Korn, a partner at the law firm Manatt, Phelps & Phillips, LLP in the WSJ. This is true and at the same time related to anti-discrimination laws. Judging a loan applicant by their detailed monetary plans could potentially induce gender or ethnicity bias, even if subconscious.
There will be plenty of questions in the coming days from Americans, the media, and government officials about what alternative lenders are doing to make sure they’re not funding terrorists. Part of what they may learn is that for all the data that alternative lenders have at their disposal to make intelligent decisions on an automated basis, some of them cannot be legally used. They’ll also find out that there’s only so much that predictive analytics can actually predict.
It’s very unlikely that Prosper could’ve handled anything differently…
CFPB Officially Begins Work on Small Business Data Collection Rule
November 23, 2015
On Friday, the CFPB issued its semiannual update to its rulemaking agenda. The agenda lists the Bureau’s major current and long-term initiatives. Long listed as a long-term item, the Small Business Data Collection rule required by section 1071 of Dodd-Frank is listed on the update as a current initiative.
The move is unsurprising given the number of lawmakers that have publicly called for implementation of the rule. CFPB director Richard Cordray also recently mentioned that the Bureau would begin its initial work on the rule early next year.
In the update, the Bureau states that it plans to build off of its recent revision to the home mortgage data reporting regulations as it develops the new Small Business Data Collection rule. The first stage of the CFPB’s work will focus on outreach and research. This will be followed by the development of proposed rules concerning the type of data to be collected as well the procedures, information safeguards, and privacy protections that will be required of the small business lenders that will report information to the Bureau.
CFPB Signals Alarming Interest in Small Business Lending
November 10, 2015
The Consumer Financial Protection Bureau posted an alarming job opportunity on LinkedIn last month for the position of Assistant Director for Small Business Lending Markets. Ominously self-labeled as an “Expression of Interest” rather than a job opening since the job is not currently open to applications yet, the CFPB has inadvertently revealed its own expression of interest in small business lending.
If there was any doubt that data collection required under Section 1071 of Dodd Frank was never going to happen, the CFPB also revealed that there will not only be a person responsible for small business lending, but in fact an entire team. And they won’t just be collecting data, but they’ll be monitoring it, analyzing it, interpreting it, and advising on rulemaking, according to the listing.
Candidates are being offered a once-in-a-career opportunity to make the market for small business finance fairer and more transparent.
So much for just collecting data, the CFPB apparently plans to directly insert itself into the fairness of transactions conducted between commercial entities.
Perhaps, we are not too far off from a world like this:
Check out my thoughts about the troubling narrative developing around small businesses in the Sept/Oct magazine issue of AltFinanceDaily.
Blurring Small Business: A Troubling Narrative is Gaining Steam
October 30, 2015Almost 18 months ago at LendIt’s 2014 conference, Brendan Carroll, a partner and co-founder of Victory Park Capital said that in regards to business lending, “the government doesn’t have the same scrutiny on this sector as it does in the consumer space.”
This double standard is the crux of American capitalism. In business you can win or lose, be smart or foolish, risk it all or play it safe. Government regulations don’t let the average consumer be subjected to the same stakes. They are viewed to be at a natural disadvantage against businesses and thus there are laws to protect them, and perhaps rightly so.
Since entrepreneurship is a choice, businesses and the people that own businesses are held to a higher standard of acceptable risk taking. In the free market, the pursuit of profit holds the system together.
This economic worldview is part of the reason why entrepreneurial TV shows such as Shark Tank are so popular. In the Tank, contestants can just as easily walk away with a terrible deal as they can a good one. And when bad deals get made, and they do, I’ve yet to see regulators descend on the set to fine or arrest Daymond John, Kevin O’Leary, or Barbara Corcoran.
But Shark Tank features entrepreneurs on a remote stage detached from their daily environment, giving it the look and feel of a game show. If you want to see cold hard dealmaking with mom-and-pop shops on an up close and personal level, just watch CNBC’s The Profit. On the show, small business expert Marcus Lemonis does not sugarcoat what he is. “I’m not a bank. I’m not a consultant. And I’m not the fairy godmother,” he bluntly told one small business owner. It doesn’t matter if it’s a family owned store or a full fledged corporation, Lemonis is looking to make a deal and make some money. When it comes to business, he is well… all business.
Just as the CFPB hasn’t shut down Shark Tank, (which one has to wonder if they’ll be subject to Reg B of Dodd Frank’s Section 1071) none of Lemonis’ deals have been scrutinized by a Federal Reserve study, nor has the Treasury Department issued an RFI to better understand why entrepreneurs go on the show in the first place.
It’s no wonder then at LendIt 2014, Carroll also said that there wasn’t the same sort of moral hurdle when it came to institutional capital investing in business lenders as opposed to consumer lenders.
Moral was a telling word choice because the morality of certain commercial transactions have recently come under fire by groups claiming to represent small businesses. The premise of their argument is that commercial entities are no more sophisticated than consumers, that a corporation and the average joe are equal in their ability to take risks and make decisions for themselves.
Their evidence is that sometimes in business-to-business transactions, particularly in lending, one side accepts terms that would be considered far outside the norm for consumers, terms that violate a moral threshold. One has to wonder where a loan with an infinity percent interest rate ranks on this morality scale, a deal that’s actually been made and accepted several times on a TV show. Referred to as a “Kevin deal” since they are Kevin O’Leary’s favorite, the borrower is obligated to pay a perpetual royalty on top of repaying the loan itself. In simple terms, it’s a loan that can never be paid off.
In the case of Wicked Good Cupcakes, a business that appeared on Shark Tank in 2012, a mother-daughter team struck a deal that would cost them 45 cents per cupcake in perpetuity to Kevin O’Leary. Many fans criticized them for it and yet the two have said that they have no regrets.
The fact that Wicked Good Cupcakes decided what made sense for them and was happy about it, damages the storyline that businesses need to be saved from their own decisions. But there’s another problem, government entities themselves may be inadvertently effectuating this false narrative by inferring incorrect conclusions from their own research.
Nowhere is this more evident than in a report recently published by the Federal Reserve Bank of Cleveland that analyzed small businesses and their understanding of “alternative lending.” The report shared the results of two focus groups that had been shown terms for three hypothetical products that supposedly represented actual products in the real world.
Unsurprisingly, the report concedes “when comparing the products, participants initially reported the three were easy to compare and that they had all the information to make a borrowing decision.” But the researchers pressed on until they got an answer that fit their expectations, that small businesses are confused when it comes to money and finance.
In a hypothetical scenario where a commercial entity sold $52,000 of future receivables for $40,000 today, it stated that the “lender” would withhold 10% of each debit/credit card transaction until satisfied. Participants were then asked to guess the interest rate on this loan if they paid it back in one year. That caused a lot of folks to scratch their heads and that’s because it was a trick question.
The question itself introduced conflicting facts and lacked crucial variables to make an intelligent guess. Nevermind that respondents prior to that question said that there was “nothing confusing” about the products presented as is. The original feedback should’ve been enough. Below are some of the responses offered before they were deliberately tricked.
- “Nothing Confusing.”
- “No, it’s pretty straight-forward.”
- “I can’t think of anything more I would need to see, really.”
- “This is enough info for me to make a decision.”
The researchers concluded however that the answers to their trick question suggested there were “significant gaps in their understanding of the repayment repercussions of some online credit products and the true costs of borrowing.”
And while it might be true that they semi-admit to what they did when they wrote, “using only this information, calculating a true effective interest rate would not have been possible without making some assumptions,” the headline that spread thereafter was that small business owners are confused by alternative lenders.
But even if that was the case, at what point does confusion become unfair in a purely commercial transaction? And what would be an appropriate remedy?
We’ve been down this road before where federal regulators have set mandatory disclosures in order to bring transparency to a lending environment believed to be obscure. And just recently on September 17th, 2015, the House Committee on Small Business Subcommittee on Economic Growth, Tax and Capital Access pressed community bankers on the impact of such measures dictated by Dodd-Frank.
Congressman Trent Kelly asked if all the added new pages to loan agreements make it easier for their borrowers to understand. “Do they understand what they’re signing?” he asked.
B. Doyle Mitchell Jr., the CEO of Industrial Bank that was speaking on behalf of the Independent Community Bankers of America responded that they do not. “It is not any more clear,” he answered. “In fact it is even more cumbersome for them now.”
If anything, the Federal Reserve study offered compelling evidence that small businesses are happy with the way alternative lenders are currently disclosing their terms. It is only when government researchers tricked them that they became confused. That should say it all.
One consequence of entrepreneurship is that businesses are not created equal in their ability to assess financial transactions and no amount of disclosures or intervention can save them. There must be losers in order for there to be winners.
Case in point, there are lenders out there doing deals so lopsided that they actually turn to each other and say, “I can’t believe she took that.” Such is the case of RuffleButts, a children’s fashion line that appeared on Shark Tank in 2013.
“When they wake up, they’ll realize they messed up,” said Mark Cuban in reference to the deal Lori Greiner proposed and closed. An article on BusinessInsider.com covered the episode and unabashedly concluded, “Shark Tank isn’t a charity. The investors are putting in their own money, so they have every incentive to push to get the best deal possible for themselves.”
Shark Tank has risen in popularity because it is a reflection of a culture that believes dealmaking, both good and bad, is inherent to the endeavor of entrepreneurship. When a bad deal is made, regulators don’t come on the show to urge a do-over.
But what’s dealmaking got to do with the local pizza joint seeking $20,000 that doesn’t have the time to mess around on TV shows? Unlike lenders who refer to their transactions as loans or units, merchant cash advance companies and the agents who negotiate the transactions appropriately refer to their agreements as deals. How else would one label an agreement in which a commercial entity sells future receivables for a mutually agreed upon price?
And if the Federal Reserve study indicated anything, it’s that business owners feel there’s nothing confusing about these deals.
So it would seem that everything as Americans know it, watch it and understand it, is business as usual.
Even Brendan Ross, the president of Direct Lending Investments, was quoted by the BanklessTimes as saying, “I want to emphasize there’s absolutely nothing novel about lending money to businesses. This isn’t some phenomenon we are rediscovering. There isn’t going to be increased regulation because this isn’t new.”
Perhaps the only thing that could be considered new is that loan sizes have gotten smaller and the types of products small businesses can access has diversified. Along the way, some of these new startups have decided to offer products in line with a self-professed moral code, which is to deliberately lend money at a loss and lash out at lenders who seek profit.
There’s a term for lending startups that don’t make money. They’re called “failed startups.” By casting small businesses as being no different from unsophisticated consumers, it’s quite possible that shows like Shark Tank and The Profit would become illegal in the process. Disclosures meant to help make things more transparent could actually make things less clear and more cumbersome, just as they have in the past.
I don’t think anybody is in favor of small business failure or an environment where confusion prevails, including the guys making infinity percent interest loans like Kevin O’Leary. But if the goal is to increase transparency, it should be in a way that businesses on both sides are content with.
The Federal Reserve study showed the system is working well as is and that prescribing mandatory changes to fit some universal standard would only serve to usher in an era of confusion that everyone is trying to avoid. Lenders can always do better to serve their clients, but the free market must prevail. As Mitchell, Industrial Bank’s CEO said when he testified in front of the Small Business Committee, “the problem with Dodd-Frank is you cannot outlaw and you cannot regulate a corporation’s motivation to drive profit at all costs so while it has a lot of great intentions in over a thousand pages, it has not helped us serve our customers any better.”
Chairman of House Financial Services Committee Requests Information from CFPB on Fair Lending Enforcement Actions, Requests Interview with Director of Fair Lending Office
October 18, 2015
Earlier this month, the Chairman of the House Financial Services Committee, Rep. Jeb Hensarling (R., Texas), sent a letter to the CFPB requesting information related to the Bureau’s recent investigations in to alleged fair lending law violations by auto lenders. This information may be helpful in understanding how the Bureau conducts fair lending focused exams and investigations. The Bureau recently announced plans to conduct its first small business lending focused exams within the next year.
Chairman Hensarling’s letter was co-signed by Rep. Sean Duffy (R., Wis.) and requests emails and other records that document how the Bureau built its recent cases against Ally Financial, American Honda Finance Corp and Fifth Third Bancorp. In each of these cases the CFPB alleged that the companies pricing policies resulted in minorities being charged more than white borrowers. In the three actions, the lenders did not admit or deny wrongdoing.
Chairman Hensarling’s letter also asks if the Bureau will make the director of the CFPB’s Office of Fair Lending and Equal Opportunity, Patrice Ficklin, available for a transcribed interview. An interview may provide lawmakers additional insight in to the Bureau’s efforts to address allegedly discriminatory pricing policies.
Ms. Ficklin recently spoke at the ABA’s Consumer Financial Services Institute where she explained that she expects the Bureau’s upcoming small business lending focused exams to provide the CFPB with useful information about small business loan underwriting criteria. Ms. Ficklin said that this information will assist the Bureau as it begins its work on the small business lending data collection regulations required by Section 1071 of Dodd-Frank.
Chairman Hensarling’s letter requested a response on Ms. Ficklin’s availability by Oct. 13 and the other requested documents by Oct. 20.
CFPB to Begin Work on Small Business Loan Data Collection Rule After Completion of HMDA Revisions; Plans ECOA Examinations Within the Next Year
September 30, 2015CFPB Director Richard Cordray testified yesterday before the House Financial Services Committee. During the session, Director Cordray was asked when the Bureau plans to begin work on its implementation of the Small Business Loan Data Collection Rule of section 1071 of the Dodd-Frank Act. Noting the recent calls for implementation of the rule by members of Congress and a number of community groups, Mr. Cordray stated that the Bureau plans to begin work on the rule following the completion of its overhaul of the Home Mortgage Disclosure Act rules. He stated he expected the Bureau to finish the revisions to the HMDA regulations by the end of the year.
Mr. Cordray also noted that the CFPB plans to begin examinations of financial institutions regarding their compliance with the Equal Credit Opportunity Act as it relates to small business lending. “We have a little window of authority [over small business lending] under the Equal Credit Opportunity Act and we have indicated that we will begin examinations of institutions on their small business lending within the next year,” he said. ECOA is one of the few statutes applicable to small business lenders that is enforced by the CFPB.
The Director’s statement follows the Bureau’s recent ECOA enforcement action against Hudson City Savings Bank for alleged redlining in its consumer lending operations in New Jersey, New York, Connecticut, and Pennsylvania. Given the Bureau’s recent and controversial use of the disparate impact theory, it will be interesting to see if the Bureau expands the use of the theory when it begins its examination of institutions regarding their small business lending operations.
Dodd-Frank and More Paperwork Make Lending Harder
September 19, 2015
It’s not just alternative lenders that have concerns about Dodd-Frank, Section 1071 and the CFPB. Several community bankers recently testified in front of The House Committee on Small Business Subcommittee on Economic Growth, Tax and Capital Access to explain just how detrimental regulations have been to their lending operations.
While the discussion encompassed all types of lending including consumer mortgages, B. Doyle Mitchell Jr, the CEO of Industrial Bank said that, “Dodd-Frank was intended for maybe 50 to 100 institutions. It was not intended for mainstream institutions, minority banks around the country.” Mitchell was speaking on behalf of the Independent Community Bankers of America (ICBA).
While repeatedly making the case about how important community banks were to local communities, he explained that Dodd-Frank had not helped them achieve their goals. “It has only increased our costs,” he testified.
Mitchell also expressed a feeling of perpetual anxiety over the loans they make, worrying that a regulator will not like them.
Dixies FCU CEO Scott Eagerton, who was there speaking on behalf of the National Association of Federal Credit Unions (NAFCU) said, “I really feel like we’re getting away from helping people and making sure that we make the loans that Washington agrees with and I think that needs to change.”
While alternative lenders were not on the agenda, the subject of government mandated transparency and its intent to help make things easier for borrowers is both timely and relevant. Referencing some of the new disclosures required in loan documents by Dodd-Frank and/or the CFPB, Congressman Trent Kelly asked if all the added pages to loan agreements make it easier for their customers to understand.
“Do they understand what they’re signing?” he asked.
Mitchell responded that they do not. “It is not any more clear,” he answered. “In fact it is even more cumbersome for them now.”
Regulators should pay special attention to this especially in light of a Federal Reserve study that came to the same conclusion. In Alternative lending: through the eyes of “Mom & Pop” Small-Business Owners, small business owners were asked if they understood financing terms offered by typical online lenders. The feedback was overwhelmingly positive that they did. But when asked a trick question about annual percentage rates, most got confused. While some advocacy groups interpreted this to mean that small business owners are confused by online lenders, it actually offers pretty compelling evidence to the contrary. A future standard of government mandated transparency as it relates to annual percentage rates would only serve to make it harder for small businesses to understand contracts, not easier.
Both Eagerton and Mitchell made the case that increased compliance costs undermined the ability of community banks to grow the economy. “You cannot expect a trillion dollar institution to focus on hundred thousand dollar loans,” Mitchell said. And Subcommittee Chairman Tom Rice said, “the burdens created by Dodd-Frank are causing many small financial institutions to merge with larger entities or shut their doors completely, resulting in far fewer options where there were already not many options to choose from.”
Eagerton argued that,”lawmakers and regulators readily agree that credit unions did not participate in the reckless activities that led to the financial crisis, so they shouldn’t be caught in the crosshairs of regulations aimed at those entities that did. Unfortunately, that has not been the case thus far. Accordingly, finding ways to cut-down on burdensome and unnecessary regulatory compliance costs is a chief priority of NAFCU members.”
But Congressman Donald Payne, Jr wondered why the ICBA was objecting to Section 1071 of Dodd-Frank, the part that grants the CFPB authority to collect certain pieces of data from financial institutions. Regulation B of Section 1071, for those that aren’t aware, was intended to study gender, racial and ethnic discrimination in small business lending.
Payne likened the law to The Home Mortgage Disclosure Act (HMDA), pronounced HUM-DUH, in which raw data is disclosed to the public but no penalties are specifically imposed if the data leans one way or another.
Mitchell responded to that by saying HMDA was a good example of something that was already very burdensome and another reason why Section 1071 was a bad idea. “While there is a clear need to outlaw discrimination at any level, I don’t think [this law is] necessary for community institutions,” he said. He pointed out that his bank could suffer reputational damage in the community by disclosing the gender and racial statistics of their business loans to the public at large.
While he did not expand on what he meant by reputational risk, one could fill in the blank that he meant the context that such data would lack. For example, if 75% of Hispanic-owned businesses were declined for business loans while only 25% of African-American-owned businesses were declined for business loans, one might infer from that raw data that there is potential discrimination taking place. Since small business loans are less FICO driven than consumer lending and focused more on the story of the business and the projected financial future, it is impossible to infer anything from raw data as it relates to discrimination.
“Simply put, Dodd-Frank needs to be streamlined,” said Marshall Lux, Cambridge, MA, John F. Kennedy School of Government, Harvard University.
And “the problem with Dodd-Frank,” Mitchell voiced, “is you cannot outlaw and you cannot regulate a corporation’s motivation to drive profit at all costs so while it had a lot of great intentions in over a thousand pages it has not helped us serve our customers any better.”
You can watch the full hearing below:
