By Michael Baptista on Wednesday 4 May 2016
Michael Baptista <email@example.com>
Seventy-five years ago organized crime offered payday loans at lower rates than equivalent lenders today. Why?
One hypothesis would be the Mob’s superior collection methods (the effectiveness of those baseball bats). The likely answer is less colorful. We now have many more consumer credit choices from banks and credit card firms. So, the people who today rely on payday loans are weaker credits overall. As a group, their financial needs are met poorly, if at all, by the finance industry. It is also a group that is likely to grow as median wages stagnate. Which makes this a topic of growing importance. This post throws up some hard questions and does not pretend to have all — or even most of — the answers.
Do payday lenders charge very high rates?
It certainly seems so. For example, Advance America (AA), on its website states that a 36% APR — a rate consumer advocates often argue should be a ceiling — would amount to a fee (technically, there are no interest charges at AA) of US$1.38 on a two-week US$100 loan. The actual fee is US$15. No wonder the industry is locked in an endless quest to shape public opinion and capture the regulator, often with some success.
So payday lenders make huge amounts of money?
No, they don’t — not the sums you’d expect. The above-mentioned Advance America (AA) a leading firm in the sector was bought in 2012 for just US$780mn (which included assumed debt of US$125mn) by a subsidiary of Grupo Salinas of Mexico. At the time, AA had revenues of around US$600mn and estimated net income well below US$50mn. Looking at EZCorp and Cash America — which operate as pawnshops as well as short-term consumer lenders and are listed — the former made a loss in 2015 and for the same year the latter earned less than US$30mn in net profits. Imagine if payday lenders had to pay the fines that the more respectable banks so often incur.
In fact, weak profitability seems to characterize the industry.
High credit losses hurt, of course, and are to be expected. But the customer acquisition costs are even more striking. In 2012 when AA was acquired it had 2,600 points of sale in 29 states and made 10m loans. Consider those numbers — AA averaged just over 10 loans per day at each point of sale — even fewer if loans were also originated on the internet. A little more than a loan an hour; hopelessly inefficient. This is not untypical of the sector.
Can competition reduce the cost to borrowers? Apparently not.
Greater competition in certain states has done nothing to reduce rates. The reason appears to be that competition is not based on price but on location — hence the existence of those inefficient stores — and on immediate access to credit irrespective of price. At the point in their lives when people need a payday loan, it seems they are motivated to get hold of the dollars at almost any cost.
Why make loans that borrowers can’t afford?
Given high customer acquisition costs, the industry may have a natural incentive to roll over borrowers at very high rates — undermining the initial premise of a short term hand-up and the incentive to sound underwriting. Consider that in the 35 states that allow lump-sum payday loans repayment absorbs around 33% of an average borrower paycheck. In Colorado, which mandates affordable installment repayments, this number is 4%.
Nevertheless, we have to bear one thing in mind:
For many people payday loans appear to be a useful, perhaps essential, source of funding for times when there are few, and sometimes no, alternatives.
Many well-meaning people and activists would like to regulate the industry more strongly or even regulate it out of existence. See John Oliver’s characteristically sharp piece for an example of this flavor of analysis. Funny, yes, but outrage is cheap and John Oliver’s response, and that of many others, leaves unanswered the question faced by this group of customers — if not payday loans, then what? From the Old Testament down predatory lending has been condemned. Ethically, that may be correct. But can we offer practical alternatives?
Is there a role for FinTech here?
The credit spectrum moves relatively smoothly from prime lending through the range of credit cards before it hits an interest rate cliff of payday lenders and pawn shops — a market discontinuity which suggests dysfunction. How can FinTech help?
Increased computing power and the access to huge datasets suggest credit underwriters can innovate beyond the traditional model — in place since the 1970s — of a dozen or so standard linear regressions. Lending based on affiliation is also an area to explore. Affiliation uses data, social-vouching and standard-setting characteristics of workplaces and communities. The use of more data from wider and more current sources — e.g., social data — offers the hope of increased credit access and more bespoke pricing to millions of people. Firms making a contribution in this field include ZestFinance, Lenddo, Upstart, Avant Credit and many others.
However, we should not end our analysis there. Imagine a perfect system for the prediction of credit defaults. More people would be able to borrow and at more bespoke rates but what about the minority predicted to default? Perfect foresight would leave us with a rump of people in need but with 100% default probability. How do these people meet emergencies, smooth consumption etc.? There is no good easy answer, certainly not a short-term one.
Some of the answers are at a macro-economic or societal level and involve responses to automation, globalization, skills gaps etc. Part of the long-term answer is also better financial education that must start early in life and shape consumption, savings and investment in the self.
We also need to learn that some people need equity, not debt. The equity may come in various forms e.g., permanent capital (cash, assets) or training to improve earnings capability. Whatever form it takes, it would allow individuals — in time — to take on debt rationally and responsibly.
So, FinTech-driven underwriting is not the whole of the answer, but it is an important and irreplaceable part of a set of solutions that could allow consumers to borrow when they need to with dignity and without being swallowed up whole in the process.
Relevant financial statements and press releases for Advance America, EZ Corp (NASDAQ: EZPW) and Cash Amercia (NYSE: CSH)