Microfinance, American style: Part 1, the bad
By: David A. Smith
In business, does motivation matter? Or are markets sufficiently rational that our apologias are meaningless, and we should be judged exclusively by our actions? This philosophical question lies submerged under every new lender and loan product, for every action – extending or denying credit, charging too high a rate – can be criticized.
“In many ways, the job of a WaPo columnist is easy …”
After the fact, we can always criticize:
Lenders who refuse good credit.
Lenders who charge ‘excessive’ or usurious interest.
Lenders who extend ‘teaser’ credit to people who cannot repay.
While bad lenders make bad loans, some bad lenders also make good loans, at least in the sense that the loans are repaid, albeit at ruinous cost to the borrowers. Who then lends to the unbanked – and what are their motivations for that lending? This compound question runs through a lengthy profile in the Washington Post showing the perils and surtaxes of being unbanked:
For years, the country’s makeshift network of payday lenders and check cashers has operated with little competition or federal regulation.
If, like me, you’re part of our formal financial system, you need sharp eyes to spot the unbanked. My downtown 7-11, for instance, in addition to doing a land-office business in Mass Lottery tickets and cigarettes, also sells a stream of money orders, typically at $2 or so apiece.
Check-cashing around the corner and around the world …
… and cheap refills on Grotesque Gulps!
While the marginal profitability of each such transaction cannot be terribly high, it’s a legitimate service – and a much more honorable profession than that of payday lending, about which I posted 2½ years ago in Payday lending: doing well …?
Ev’ry evening you will find him,
Around our neighborhood.
It’s the old dope peddler
Doing well by doing good.
“By do-oo-oo-ing good.”
The lenders’ interest is in the very simple question: can we get our loan repaid? By taking a postdated check, the lender jumps the payment queue, assuring itself Mr. Milford pays his loan first, leaving his Christmas presents for last.
A postdated check is not in and of itself a bad thing, but there is certainly something vampiric in the payday lender’s approach.
But I’m so innocent and small …
In many states, including
Who takes out a two-week loan? People who have difficulty envisioning the future. People living from paycheck to paycheck. People who lack financial literacy or the habit of saving. Such people are vulnerable:
In September, Congress, responding to complaints that military personnel were the targets of “predatory lenders,” imposed a limit of 36% annual interest on loans to military families.
As I made clear in that post’s second part, Part 2 … by doing good?, I found the whole notion of payday lending barely this side of despicable.
It’s despic-ic-icable!
For decades we have tolerated the payday lenders, largely unregulated, on the reasonable theory that people are under no compulsion to seek them out. That is changing now:
But as the financial crisis sparks a new wave of consumer protections, lawmakers and the private sector alike are training their sights on an industry that caters to the most vulnerable of populations: the estimated 40 million households on the margins of the nation’s financial system, with limited, if any, access to banks or credit.
Catastrophe being a precondition to fundamental financial reform, when once the groaning granite blocks of legislative inertia start to move, their grinding weight scrapes all before them. Regulation advances, turn by turn.
You hope it comes out as sausage!
Congress is debating the creation of a Consumer Financial Protection Agency that would provide federal oversight of the industry for the first time.
If as government you think consumers are being bilked, you can do three things: shine a light on the bilking in hopes of making smarter consumers, cap charges, or ban the business altogether. Yet lending – providing credit to people who need it – is not illegal per se, and most lending is desirable for everybody, particularly the borrowers. Thus, throughout Congress’s approach will run two possible structural remedies: (1) greater disclosure/ transparency (as everyone becomes a Bank of Glass), and (2) usury limits.
In addition, several bills have been introduced to cap the often-triple-digit interest rates on payday loans, long considered by many one of the industry’s most abusive practices.
Just the phrase ‘triple-digit interest rates’ sounds usurious. Framing it that way is easy, because payday lenders generate their revenue not through fees but through interest. Yet at the same time, those payday lenders normally quote interest not in whirling-odometer percentages but in dollars per period, which brings in the second feature: the small sums advanced. Introducing our protagonist:
If I could just get rid of these debts
Anthony Jeffers lives in
Only on close reading did I catch that bit of urban-sophisticate snobbery.
Where the smokes are grown …
– and he travels to
We don’t ask why Anthony feels compelled to live in
The costs are high – he pays for an apartment in both places.
Probably he has a wife/ girlfriend and child/ren. His circumstances should be relevant to his story
The expenses overwhelmed him last year, so Jeffers turned to a payday lender to get $800 for his rent. When he repaid the loan two weeks later, he owed about $1,100, meaning he paid more than 30% interest, or 975% on an annualized basis.
Even making allowance for risk and processing fees, there’s no question $300 for a two-week loan of $800 is brutally expensive – but one does have to ask, Anthony, what are you doing maintaining two apartments?
It comes in handy, in a Mad Men sort of way
“All you’re thinking of is getting your money to take care of your situation,” said Jeffers, who was standing outside a check casher in the District on a recent afternoon after buying a money order to pay his rent back home. “It just seems like a lot of interest to pay back.”
It is – and Mr. Jeffers should find one of several possible solutions – move to Washington, find a roommate or bunking situation for when he is in Washington, find work in North Carolina (presumably harder), or borrower from family/ friends – but all these things are really easy for me to say. I’ve spent a lifetime thinking about finance; Mr. Jeffers is just trying to keep body and soul together.
“People are always damaged by these products. . . . This can be the thing that pushes them over the brink,” said Rachel Schneider, innovation director of the nonprofit Center for Financial Services Innovation.
Schneider
“In a recessionary environment, the consequences of using predatory products are more apparent.”
Enter the question of motivation. Mr. Jeffers and other payday-lending customers find themselves in these pickles because they’re not well capitalized, they’re not financially literate, and they lack the luxury of options. They are desperate. Encountering those who are desperate, we who are not have power and that makes our choice of action a moral one: do we help or hurt?
Industry representatives say they provide necessary services for households that have become alienated from traditional financial institutions. Many of their customers have poor credit and may not qualify for basic bank accounts [Meaning loans – Ed.].
Microfinance seeks to help. Loan sharks and shysters seek to hurt.
We’re all one big happy predator-prey ecosystem, aren’t we?
Though the number of unbanked is difficult to track, Schneider said anecdotal evidence suggests that their ranks increased as the recession deepened.
One thousand? One hundred thousand? Nobody knows.
How many ice creams does it sell?
[We could probably dimension it by measuring the number of payday lenders; speculating as to how many payday-loan customers each one has; and multiplying out. – Ed.]
Being unbanked does not necessarily mean falling into the clutches of a payday lender – but I’m sure it correlates.
The center estimates that median household income for the unbanked is $26,390 – about half of the national median – and many have little to no savings.
In other words, the median unbanked customer is Very Low Income as federally defined (50% of Area Median Income, AMI), and eligible for Housing Choice Vouchers – which are unfortunately in short supply.
Three bills in the House and one in the Senate that were submitted this spring seek to curb one of the industry’s most controversial practices: charging triple-digit interest rates for short-term loans to risky customers. The bills would impose caps as low as $15 for every $100 borrowed and, in some cases, require greater transparency of the lending terms.
Transparency absolutely. Caps are more complex:
The cap’s too tight
The payday-lending industry has opposed capping interest rates, and its trade group, the Community Financial Services Association, is raising $1 million from its members to lobby against the bills. CFSA spokesman Steven Schlein said the group has reserved judgment on the proposed Consumer Financial Protection Agency.
Opposition is not necessarily proof of malevolence:
“It’s all in the details,” he said. “It would be a big change for us.”
Right. The CFSA’s members’ business model is built around on-the-spot credit decision-making, high interest rates (to cover for default and costs of collection), minimal regulation and minimal paperwork. Even if we grant them the noblest of motives, to overlay government disclosure and government regulation will drive up their unit costs of originating and servicing a loan. That will disrupt their business model, and it’s certainly possible that the post-regulation, post-reform “better” loans might be more expensive and less available than the lend-first-collect-later model that the payday lenders now use.
The Financial Service Centers of America, which represents check cashers, said that it supports increasing transparency to customers but that additional federal regulation “is unnecessary and duplicative and will only increase the cost of financial services to consumers without any corresponding benefit.”
The FSCA could well be right. Check cashing is also a form of credit decision, and if the check is bad, the cashier is out the money with no hope of recovery. So there are transaction costs, and they can rapidly mount up as a percentage of a $20 or $50 check. One could so burden the hummingbird that it could never fly.
The trade group for payday lenders said it began requiring members to display their fees on posters in their stores last year.
Good! Why do I have the feeling the members are doing this only because they are running scared?
Industry advocates argue that innovation – not legislation – is the key to reform.
Why not both?
You may need both
Might the innovative response to payday lending be the emergence of 21st century American microfinance?
[Continued tomorrow in Part 2.]
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