Payday Lending – Some Thoughts

There was an interesting discussion in the comments section of this post about payday loans.  I assume everyone here knows what they are, but just in case someone does not, payday loans are short-term loans of generally two weeks or so that are taken out by borrowers with the expectation that the loan is paid in full when the borrower receives his or her next paycheck.  In practice, payday lenders are the lenders of last resort for borrowers (typically lower-income borrowers) that have little to no access to any other sources of cash or credit.  The practice is very controversial, outlawed in some states and heavily regulated in others.  The controversy was well represented on both sides in the comments section.  Critics point to the high APR’s, serial refinancings and the deceptive advertising practices used to get potential borrowers into a debt trap.  Organizations like the Center for Responsible Lending have produced numerous reports documenting the problems and abuses within this industry (here).  Supporters claim that the presence of a market geared towards serving an otherwise underserved segment of the population is a good thing, dispute the charges of predatory lending on those grounds and argue that the high costs of payday loans are a function of both default risk and high overhead costs (representative examples – here and here).I’ll start with this comment by Brandon Berg:

If payday lending is really “predatory” or “exploitative,” then they must be making very high profits, right? So there should be plenty of room for someone to step in with an alternative that offers much better terms and still earn a good ROI.

The obvious question is, why hasn’t that happened? Without major barriers to entry, it’s very difficult to maintain extraordinary profits. So the answer is likely either that there are extraordinary barriers to entry, or that payday lenders do not in fact make extraordinary profits, and are offering the best terms they can reasonably be expected to offer given the features of the market in which they operate.

To bring my understanding of the business up to the point where I felt confident enough to write about it at the League, I read a number of different sources.  I have included some links below.  One of the more informative sources that I will refer to frequently is the 2011 annual report (the 10-K) of one of the larger payday lending companies, Advance America (here).  While I believe that the term GAAP really means “Generally Anything at All Possible”, certain information within the document was useful, and I will share some of that here.

To respond to Brandon directly, I am going to make three points.  The first is that because of the way the payday lending markets function in practice, a market with borrowers of a very high risk nature (low-income, poor credit and, in some cases, desperate) coupled with lenders whose profitability depends on not just making as many loans as possible but also as many repeat loans to customers, the market is fertile ground for predatory lending practices.  Predatory lending is a function of the way that loans are originated and there is no profit threshold for it; therefore, I think Brandon is too dismissive towards the predatory lending claim.  Second, while critics of payday lending see the high fees as usurious (on an APR basis, they can exceed 500% in some cases), using Advance America’s 10-K as a proxy for the industry, profit margins for payday lenders are not extraordinary by any means.  The last point I am going to make is a response to the implications that Brandon makes about competition and the features of the market.  Competition may help borrowers in the payday lending markets by offering better rates, but because the profitability of businesses competing in this space is very dependent on making repeat loans to customers, a practice many including myself consider predatory in nature, new entrants into the market will choose to adhere to these practices. In other words, a solution to something like predatory lending will not occur through the normal workings of competitive markets.  I’ll end the post with a few thoughts of my own.

I.  Predatory Lending

Definitions of predatory lending vary, and I have not been able to find a working legal definition.  However, I think that the the FDIC has a reasonable working definition, one I will use for the purpose of our discussion.  While it applies to subprime lending, the same principles will apply to payday lending as well:

Predatory lending, on the other hand, is not limited to one class of borrowers. Signs of predatory lending include the lack of a fair exchange of value or loan pricing that reaches beyond the risk that a borrower represents or other customary standards.

Furthermore, as outlined in the interagency Expanded Examination Guidance for Subprime Lending Programs, “predatory lending involves at least one, and perhaps all three, of the following elements:

• Making unaffordable loans based on the assets of the borrower rather than on the borrower’s ability to repay an obligation;
• Inducing a borrower to refinance a loan repeatedly in order to charge high points and fees each time the loan is refinanced (“loan flipping”); or
• Engaging in fraud or deception to conceal the true nature of the loan obligation, or ancillary products, from an unsuspecting or unsophisticated borrower.”

Whether a firm does or does not engage in predatory lending is a function of the way loans are originated as opposed to a profit threshold.  While I will get into more detail later, I see the payday lending market as a competitive market with profit margins that are not so out of whack given the revenue structure, cost structure and the underlying risk.  At the same time, I can make the case that at least two if not all three bulletpoints are prevalent in payday lending.  I will address the first two.

Payday lenders do very little underwriting outside of verifying the place of residence, employment and the borrower having a checking account.  Per Advance America’s 10-K, the company does not perform credit checks on potential borrowers.  No other obligations are taken into consideration including whether or not the borrower may have sufficient funds to pay back the loan upon maturity.   The only risk assessment performed is to determine the possibility of fraud.  Nothing in the underwriting criteria used by payday lenders can accurately determine whether or not a borrower can afford the loan.  To me, the obvious reason for this is the second bulletpoint.

The second bulletpoint is my biggest problem with this industry in light of the customer base that it serves.  I was hoping that the Advance America 10-K would disclose a breakout of its customers and the average loans they take out per year on a percentage basis.  To no surprise, it is nowhere to be found.  However, this data is available in this FDIC paper.  Granted, the data is a bit older than I would like and the sources are anonymous, but upon review, I saw no reason not to include it here.

I used the data in the Mature Stores column on Table 5 located on page 35 of the pdf:

• The average number of loans per customer is approximately 8 (coincidentally, this is the average loans per customer in Advance America’s 2011 10-K)
• Only 13.7% of borrowers took out one loan in a twelve month period
• Approximately 30% of borrowers took out more than 12 loans per year.  Assuming a two-week loan-term and at least 13 loans, that equates to being in debt to payday lenders for at least six months of the year
• In total, more than 51% of borrowers took out at least 7 loans

In theory, payday lenders can be profitable without chronic borrower so long as they can find enough customers that satisfy their virtually non-existent lending requirements, but the fact of the matter is that this is not how this market works in practice.   Profitability is a function of repeat lending.  Without any kind of underwriting that can determine whether or not a loan is unaffordable, there will be people who take out loans that they can not afford and only be able to pay them back when they take out another loan.  When we take into consideration the kind of people who typically take out short-term loans, it is a recipe for disaster.   Via Pew:

Borrowers perceive the loans to be a reasonable short-term choice but express surprise and frustration at how long it takes to pay them back. Seventy-eight percent of borrowers rely on lenders for accurate information, but the stated price tag for an average $375, two-week loan bears little resemblance to the actual cost of more than $500 over the five months of debt that the average user experiences. Desperation also influences the choice of 37 percent of borrowers who say they have been in such a difficult financial situation that they would take a payday loan on any terms offered.

II.  A Very Preliminary Estimate of Payday Lending Costs

At this point, I’ve only addressed the predatory lending part of Brandon’s comment.  According to what he says, we should expect to see “extraordinary profits”.  That term is a bit subjective to me, but I have reviewed some numbers, some from the FDIC report I mentioned above.  This is older data from 2002-2004, but it is a good starting point.  Based on the data within Tables 2, 3 and 4, I calculated that a pre-tax profit margin of 26% and an assumed APR of 460% based on the per-loan revenues, the average loan size and the average loan length.  To put that 460% into perspective, the APR that a lender would have to charge to break even based on this data is approximately 341%. (1) Those numbers feel right to me.

For further review,  I have added some key financial data points from the Advance America 10-K:

• 2011 Revenues – $625.9 million
• 2011 Center Gross Profit  – $181.2 million
• 2011 Pre-tax profit – $105.3 million
• Center Gross Profit Margin – 29.0%
• Pre-tax margin – 16.8%

Other financial metrics

• Average Loan Size = $375
• Average Charge per Advance = $55
• Average Loan Term = 18 days
• Implied APR = 294%
• Implied Breakeven APR (based on pre-tax income per loan) = 264%
• 2011 Provision for Doubtful Accounts – $107.9 million (17% of revenues)

Other general metrics

• Loans originated – 10.6 million
• Customers served – 1.3 million
• Loans per Customer – approximately 8
• Number of days with payday loan obligation outstanding – 144 (i.e. 20 weeks or almost 5 months)

I expected the APRs to be lower here than in the FDIC report given that this is a company that operates in states where payday lending is subject to regulatory restrictions (i.e. profit margins in Virginia, Washington, South Carolina, Kentucky, Colorado, Wisconsin and Illinois are very low if not negative).  However, in less regulated markets, Advance America will charge an APR up to 664%.

In my opinion, the profit margins on a risk-adjusted basis are are frankly ordinary if not low.  It is a competitive industry with barriers to entry that are not high. Fixed costs (salaries and occupancy costs) and loan losses are the three largest expense items totaling approximately 60% of revenue and over 80% of operating expenses.  Store locations have to consistently manage and turn over small-dollar loans in order to generate the revenues necessarily to stay afloat, and going after loan defaulters is likely a costly proposition.   Also, payday lenders by their controversial nature operate in an environment with some measure of regulatory uncertainty.  Changes in regulations could either significantly affect profit margins or cause payday lenders to exit markets altogether, as Advance America has in Georgia (2004), Pennsylvania (2007), Oregon (2007), Arkansas (2008), New Mexico (2008), New Hampshire (2009), Arizona (2010) and Montana (2010[/efn_note].

III.  What Competition Can and Can’t Do

Brandon asks: “The obvious question is, why hasn’t that happened? major barriers to entry, it’s very difficult to maintain extraordinary profits. So the answer is likely either that there are extraordinary barriers to entry, or that payday lenders do not in fact make extraordinary profits, and are offering the best terms they can reasonably be expected to offer given the features of the market in which they operate.”

The answer is the latter.  There are at approximately 20,000 payday lending locations throughout the United States.  While the business has traditionally been operated by the storefront payday lenders like Advance America, there has been recent competition coming from select commercial banks (Wells Fargo, Fifth Third, U.S. Bancorp, Regions Bank and others).  The circumstances are somewhat interesting because banks are subject to state usury laws.  However, these banks have invoked their national charters to bypass state laws (which is not without controversy).  Acccording to the Center for Responsible Lending, APRs for bank-originated payday loans range between 225% to 300%.  While it does not bring comfort to people who want to see APRs substantially lower, the banks can compete against the traditional payday lenders on fees (it’s certainly better than 664%).

As far as how banks operate in the market, they are no different from their traditional payday lending counterparts.

The median bank payday borrower took out 13.5 loans in 2011 and spent at least part of six months during the year in bank payday debt. Over a third of borrowers took out more than 20 loans, bringing the mean number of loans per borrower to 19.

As the profitability in the business is dependent on lenders issuing multiple loans to the same consumer base and arguably guarantees that it is able to do this by not determining whether or not borrowers can afford to pay back a loan without the need for another loan in its place (and take advantage of the fact that there are people so desperate for loans that they’ll take whatever money put in front of them), there is no incentive for new market entrants to alter the business practices that are customary in that market.   Going against those practices would likely jeopardize the profit potential, put them at a competitive disadvantage and put them out of business.

This dynamic is not unlike the dynamic in the subprime lending market last decade.  The “best” competitors were not only the ones that offered the best rates but also dropped their underwriting standards to the point where just about anyone and everyone could get a loan irregardless of whether or not they could afford it.  When the profit incentive depends on markets dynamics that are problematic, increased competition offering “better terms” is an insufficient solution.  The markets don’t work that way.

Parting Thoughts

I keep coming back to this comment from BlaiseP:

Well, we used to have laws against gambling and loan sharking. As with illegal drugs, we’d only drive the high-risk market underground.

I do not like the payday lending business.  While I can give some measure of credibility to arguments made by supporters of the practice (if only because there are customers that can take out a payday loan, pay it back and not need to take out repeat loans), the industry depends on repeat borrowers to earn its profits and can almost guarantee such a practice because of non-existent underwriting and unsophisticated if not desperate borrowers.  That these transactions are voluntary in nature does not wash away the ugly reality in which transactions take place.  Advocates of payday lending on free markets grounds would do themselves a huge favor by at least addressing this fact.

At the same time, people who call for tighter regulation of payday lenders should recognize that usury laws with the kinds of interest rate caps that I’ve seen proposed (i.e. The Center for Responsible Lending has proposed 36%) would put payday lenders out of business (if they aren’t shifting their focus to higher APR open-ended lines of credit).  That Advance America has exited several states is evidence of this.  In addition, because there are people who take out payday loans and can pay them back, a service that has value to them is taken away.  Can other financial institutions step in and fill the void at interest rates that some of us at the League would find reasonable (call it 36%)?  My opinion is no.  Loan originations are costly and banks as risk-averse institutions would not be willing to many any kind of loans to the majority of payday loan customers (they don’t do it now).  Maybe the banks would lend to the kind of payday loan borrower that can pay back its loan without taking out another one; however, based on the data I was able to find, those borrowers represent a minority of the total customer base.  In addition, they may not be able to generate enough volume to make this kind of lending profitable.

I find myself at the end of this post wishing that I had a better answer.  Having the high-risk lending market in the sunlight enables everyone to see how ugly the business is.  At the same time, driving the market underground would make things considerably worse.

(1) For the sake of brevity, I have not included back up for my calculations.  I can provide them upon request.

(ed note: post image credit)