Yesterday we had brave words and sound logic from Kenneth Feinberg, Treasury’s ’special master for compensation,’ who as quoted in the Wall Street Journal (quotes in blue Times Roman), hopes his new standards “will be voluntarily picked up” throughout corporate America.

You’ll pick it up if you know what’s good for you

He might’ve tried starting with Freddie Mac:

The government-controlled mortgage finance company is giving CFO Ross Kari compensation worth as much as $5.5 million. That includes an almost $2 million cash signing bonus and a generous salary that could top $2.3 million.

It cannot be a coincidence that there are no publicly available pictures of Ross Kari

Would you want your face splashed across the front pages?

There can be no doubt Freddie Mac needs a highly capable CFO, and soon:

The McLean, Va.-based Freddie Mac has been without a permanent CFO for more than a year, when its two top executives stepped down as part of the government takeover in early September 2008. Acting CFO David Kellermann committed suicide in April.

Hideous though the circumstances are, the need to get the best is an argument to pay the necessary price.

Freddie Mac is not just another company.  It’s alive today, and nearly 80% owned by the government, only because almost $51 billion in taxpayer funds were pumped into it over the last year. More bailout money also may be needed in the quarters ahead as losses from its troubled mortgages mount.

An excellent argument to get the best bomb-defusers we can.  Wonder what Mr. Feinberg thinks of it?

You should do it for what I say it’s worth

Perhaps Mr. Feinberg was seeking to give more optics, and less substance?

Some bankers and outside experts said Mr. Feinberg was overstating the extent of the cuts. Many bankers will continue to enjoy seven-figure pay packages, including one who will receive $9.9 million.

Stock isn’t cash, but stock has value, especially in a liquid and public traded company.  Even if the stock is restricted, or the options do not vest for a period of time, they are money and value.

Of the 136 employees whose pay Mr. Feinberg reviewed, 29 are on track to collect total 2009 pay of at least $5 million, according to documents released by Mr. Feinberg.

So are Mr. Feinberg’s rules a big cut, or aren’t they?

And his calculations of 50% cuts in total pay for the top 25 at each firm from a year before depend partly on departures of certain highly paid employees.

Clever, that: It’s 50% less than the overpaid people who are now gone.

While some highly paid executives are exiting, at least one other is entering:

Leave banking and go into burgers?

[Mr. Kari's] cash signing bonus totals $1.95 million and will be paid out in semi-monthly installments over the year.

What makes Mr. Kari worth a signing bonus, the sort of inducement normally associated with star athletes?

You paid a lot for this hat

Market reality, that’s what:

That money is supposed to cover what he forfeited in stock options and grants when he left Fifth Third Bancorp, where he served as CFO since last November.

Mr. Feinberg and the regulators can no more stop the market than they can deny economic gravity.  If the top-quality financial CFOs are worth $1.5 million a year, then anyone who takes a vow of financial chastity has made the decision not to be a top-quality organization.  Particularly when asking someone to leave his home and walk away from previously-agreed deferred compensation.

“You expect me to solve everything?“

Freddie Mac also said it would immediately allow him to sell his home to the company, waiving a 60-day offer period that is required for other executives. It did not, however, specify which of his homes would be covered; Kari has residences in Ohio, Oregon and Washington State, according to the filing.

Hence a trap of aligning incentives via extended deferred compensation. 

A better approach for Kari’s compensation would have been to require him to wait at least three years to receive a bulk of his compensation, instead of allowing him to get as much as 80% of it in cash over one year.

Someone can always come along and buy it out – and, if Freddie Mac and FHFA are an indication, someone will.

No doubt that Kari is an able executive and has a hard task at hand. Before his 10-month stint at Fifth Third, he worked in the executive ranks at the insurance company Safeco and Wells Fargo.

Freddie Mac’s regulator, the FHFA, highlighted his qualifications in a statement it made after the pay package was disclosed. The agency said the approval of Kari’s pay was done after consulting with the Treasury Department.

Treasury, it should be noted, is where Mr. Feinberg works.  

“I have absolutely no idea who that man speaking is.”

When formulating his new draconian policies, he had to have known that Freddie Mac was ready to violate them even before they were announced.

The FHFA declined further comment, and the Treasury Department didn’t return a request for comment.

In its statement, FHFA also said that Kari’s hire came at a “critical time for our nation’s economy and for the company.”

That argument is no help at all.  Companies always face critical times.

Had he stayed at Fifth Third, [Mr. Kari] would not have been able to cash out of his equity compensation until the bank repaid the $3.4 billion in TARP funds it received. But Carol Bowie, head of the Governance Institute at RiskMetrics Group, a financial risk management firm, notes that his cash signing bonus at Freddie Mac effectively allows him to accelerate his receipt of equity he forfeited when he left Fifth Third.

Thus we have it that Mr. Kari was already tied up in regulation, but his new employer wanted him so badly that it paid his ‘exit fee.’ 

Bowie acknowledges that attracting top talent is critically important to a troubled company like Freddie Mac, and supports the idea of executives being paid for their skills.

Which brings us back to my initial question: are the Feinberg caps designed to realign incentives, or to punish the putative transgressors? 

Some small-town bankers are resentful of the coming scrutiny by the Fed, blaming many of the foolish loans and reckless trades that led to the financial crisis on larger institutions. “We’re all having to pay for the sins” of the big banks, said Rusty Cloutier, CEO of MidSouth Bancorp Inc., Lafayette, La.

At the current rate by which we are absolving ourselves and others, eventually we will decide that the entire crisis is the single-handed responsibility of one man, whom we can tar and feather and count ourselves righteous.

With my “securitization”

In the end, the problem is insoluble.  Neither Treasury nor FHFA nor any other regulator can nullify the market’s perception of value.  The best they can do is standardize regulation, insist on transparency, and try to align the incentives.

To make sure firms follow the new rules, Mr. Feinberg imposed reporting requirements on top executives and directors.

Are you trying to sneak money through security?

Regulatory reform is a process, not an event.  Mr. Feinberg’s moves are a blunt instrument.  I hope that, after delivering their thundering shock, they will gradually fade away.

“It’s simple – chop pay”

He said he hopes the standards “will be voluntarily picked up” throughout corporate America.

Fat chance.

Send post as PDF to

The huge banking institution is giving their new CFO compensation worth as much as $5.5 million. That includes an almost $2 million cash signing bonus and a generous salary that could top $2.3 million.

Catastrophe being a precondition to fundamental financial reform, in the aftermath of the banking crisis and the massive multi-billion-dollar Federal intervention, government is pursuing both the continuing crusade to choose culprits and then excoriate them, and also to put in place a new more expansive post-Paulson regulatory structure  that will reduce systemic risk in the US and global banking systems. 

A spokeswoman justified the pay because it was comparable to what others in the financial services industry make.

“A foolish consistency of the hobgoblin of small minds.”

Both objectives are ostensibly served by Washington’s new announcements of dramatically intrusive rules governing executive pay, as reported in the October 23 Wall Street Journal (quotes in blue Times Roman):

In a one-two punch at the pay culture of banks and Wall Street firms blamed for the financial crisis –

Take that, Gotham City banking malefactors

So now it’s the pay culture?  One single villain?

You mean there’s another?

To be sure, compensation structures shape and reflect corporate culture and played a contributing role in this epic mess, but to demonize a handful of executives is to exculpate everyone else – and we were all greedy, all starving for yield, and all short-sighted.  The entire world got drunk on risk, and we all have the mother of all hangovers.

And we’re not happy about it, are we?

– the U.S. government announced plans to aggressively regulate compensation at thousands of lenders and impose steep pay cuts at seven companies that received billions in federal aid.

Retribution and correction often intermingle.  From the parent who shouts this hurts me more than it’ll hurt you to our schizophrenic attitude toward incarceration – is it supposed to be punishment, or penitence? – human beings who have been hurt want those who hurt them to feel a measure of pain.

While the moves had been anticipated for weeks, Thursday’s separate announcements by the Federal Reserve and Treasury Department represent unprecedented federal intervention in pay decisions traditionally left to boards and shareholders.

In our post-crunch regulatory structure, are we trying:

1. To align incentives?

2. To cut executive pay?

These are not the same thing, and to do the latter in the guise of the former will only lead to tears.

The central bank moved to incorporate reviews of compensation into its routine regulatory process, a step that will affect large and small financial firms across the U.S. as well as American subsidiaries of non-U.S. financial companies.

That’s a good idea; transparency and periodic scorekeeping are helpful. 

The crackdown –

Notice the inflammatory language of vengeance.

– is likely to influence how financial firms pay top executives, traders, loan officers and others whose actions could threaten the soundness of the institutions.

Another implicit confusion.  Government has no business preventing companies from taking risks, but it does have a legitimate business in preventing companies from taking risks that threaten the financial system.  Americans are rightly angry that, in protecting the American economy, the regulators have rescued banks from themselves.

As expected, Treasury official Kenneth Feinberg said cash salaries paid to the highest-earning executives at seven companies getting exceptional federal aid will be capped at $500,000, while the group’s total pay level, annualized, will be 50% lower than a year before.

Mr. Feinberg, I note, has no background whatsoever in finance; he’s a lawyer, a prosecutor, and a mediator.  All these are very odd credentials for his current role.

Judging by his pictures, Mr. Feinberg is fond of shaking his finger

If these are such good ideas, why aren’t the shareholders doing it themselves?  Why rely on Uncle Sugar to do it? 

The rulings cover the highest-paid 25 employees at each of the seven heavily aided companies: Citigroup Inc., Bank of America Corp., American International Group Inc., General Motors Co., GMAC Inc., Chrysler Group LLC and Chrysler Financial.

Are the regulators pandering to the populist mob, or are they doing something that cannot be done except by an external and disinterested agency?

Standards are meaningful only when applied to all.  Individual entities competing with one another – whether companies for market share, or companies for executives, or even individual executives – cannot be expected to renounce potential comparative advantage. 

“I think it will make an important difference” because many banks have been reluctant to change their pay practices unilaterally out of competitive worries, said New York’s banking superintendent, Richard Neiman.

How big a difference?  This big

Mr. Neiman’s got it exactly right. It does no good to take a stand on principle for lower athlete pay if others are profligate.

We bleed Yankee blue … or Steinbrenner green

Indeed, the inevitability effect practically guarantees people will try to steal a march on their competitors, once they know new rulemaking is certain.

Compensation experts said it would be hard for companies to escape the new oversight, though individuals could do so by jumping to hedge funds, private-equity funds and other financial firms beyond the reach of the new curbs.

Exactly.  If compensation is regulated at a defined group of institutions, the most highly compensated will simply jump to new unregulated institutions.

You have to pay me to try this

Many years ago, I was negotiating guarantees from a developer whose integrity I doubted.  (One does this now and then in business.)  To assure that I didn’t have the company’s net worth lost in the shell game, I insisted on having the parent company on the guarantees, not a single-purpose subsidiary.  I thought myself clever – except that shortly thereafter, the developer formed a new parent company, of which the one signing our guarantees then became a subsidiary.  Over the ensuing years, the sponsor ran al the income through the new parent, thus gradually atrophying my guarantor.

Out of that, I learned a lesson – if you want to squelch a behavior, you have to squelch every possible outlet.  In regulatory terms, if you want to cap pay across the board, then you must regulate it everywhere:

Some state regulators said they plan to issue similar requirements for state-regulated banks not covered by the Fed plan.

The rulings will be effective for just November and December; employees won’t have to repay salaries already received.

That’s a sound principle – aside from the impracticality and legal liability associated with attempting to claw back payments legally made under binding contracts.

But the rulings will become the starting point for next year’s salary figures and until the companies repay their government aid.

It sounds like you’re capping 25, but you’re capping everybody.

These moves are the brainchild of Kenneth Feinberg, the Treasury Department’s special master for compensation.

“Stop pointing out that I point my finger a lot.”

Mr. Feinberg is taking seriously his moniker of czar; he is willing to command with laserlike precision:

Don’t come to my attention

Mr. Feinberg said he will have to approve pay for the next chief executive at Bank of America. He already pushed outgoing CEO Kenneth Lewis into giving back $1 million he received so far this year and forgoing the rest of his $1.5 million salary for 2009.

While I have no sympathy whatsoever for Mr. Lewis, that certainly sounds like schoolyard bullying of no conceivable economic or public-policy benefit.  It’s retribution, pure and simple.

And I did so well for B of A, too

Some critics said that Mr. Feinberg was too soft on the banks and that his main accomplishment – forcing firms to use more stock and less cash when paying employees –  didn’t go far enough to rein in compensation.

He’s using a blunt instrument to get their attention.  Being blunt, it won’t necessarily work well.

You dare say this doesn’t work?

While the Fed didn’t propose pay caps, it said it will review compensation policies at “28 large, complex banking organizations,” which it didn’t identify. It will be a “horizontal review” that in effect compares them to one another.

Making this so funny is that scarcely weeks earlier, the government itself violated every single Feinbergian principle when it hired a new CFO for an entity entirely under its control.  As reported Business Week (quotes in red Arial):

When [the new CFO] joins Freddie Mac on Oct. 12, he will receive a base salary of $675,000 and is entitled to an additional $1.66 million in cash for the year. The company said he will be paid in installments, but did not specify the timing of those payments in a Sept. 24 securities filing. The company declined to comment beyond the filing.

He will also receive performance-based pay at the board’s discretion. The target amount for that cash compensation is $1.16 million, but what is actually given to Kari could be higher or lower.

His cash signing bonus totals $1.95 million and will be paid out in semi-monthly installments over the year.

Feinberg says cap cash pay at $500,000, his fellow agency approves paying $1,950,000 as a signing bonus.

The Federal Housing Finance Agency, which oversees Freddie Mac, approved the pay package.

Can we reconcile this seeming contradiction?

“Don’t try to contradict me”

[Continued tomorrow in Part 2.]

Send post as PDF to

I’ve given you every chance to move, Black

As revealed in a recent Guardian (UK) article, if the private participants don’t move, the government can find itself stalemated.

Why aren’t you moving?

It was a £1.5bn cash injection that was supposed to make a dent in England’s 5m-strong housing waiting list.

Five million waiting list?  In a country of 60 million total? 

The NHF, which represents housing associations, estimates that households on the waiting list in some areas would have to wait 280 years for a home.

I’ve got a good chance to be next up

Chief executive David Orr says: “What was already a significant problem [of demand for affordable housing] is getting worse on a day-by-day basis.”

Doesn’t that signal there is something powerfully wrong with the UK’s housing production system?

“In the short term, we have got to do as much as we can [to build], given the circumstances.”

So when housing minister John Healey announced the government’s new affordable housing drive this summer, first reactions were positive.

Want a billion pounds?

“The cash was a bit of a surprise and very welcome,” says Richard Capie, policy director at the Chartered Institute of Housing (CIH). “When was the last time you saw money coming from education, health and transport into housing?”

Capie can’t remember seeing money flowing from education into housing

But now the excitement has subsided, questions are being asked about the government’s new plans and its attempt to spend its way out of the house-building slump. Can the money really do anything to ease waiting lists?

Depends on how many homes the money builds, and at what affordability level.

And how can we provide enough affordable homes for the future once the funding runs out?  Such issues will be at the heart of the National Housing Federation (NHF) annual conference starting in Birmingham today [23 Sep 09 – Ed.].

Certainly, plenty of cash is going into addressing the development downturn: the new £1.5bn comes on top of £1bn in the Budget, including a special fund to restart stalled development projects. Housing associations are building, despite:

[1] Tougher access to finance

[2] Tightening land supply

[3] The collapse in demand for ownership that makes it impossible to cross-subsidise schemes with homes for sale.

You’re out of the building business

Tell again why they’re building?

Keith Exford, chief executive of one of the biggest developing housing associations, Affinity Sutton, says his association “is whole-heartedly open for business.”

Of course they are.  Sharks gotta swim, and bats gotta fly.  Developers gotta chase the next deal ’til they die.

But he warns that the recession is straining the system. “If you are going to do social housing without the benefit of cross-subsidy, then you need more grants and you build fewer houses out of available resources,” he says.

Cross-subsidy, which I liken to the unicorn – much pursued and seldom captured – is predicated on selling market-quality homes at market prices without having to spend  market costs (usually for land) to develop them.  Then the ‘excess’ profits resulting are plowed back in to greater affordability on the other apartments.

“We need to start thinking about the current development model as I can’t see how it can survive.”

That development model is precarious.  More than precarious.

Must answer me, these questions three

Ere the other side he see

In the US, we’ve seen that the LIHTC delivery system has been disrupted, and although it is slowly repairing, it has some ways to go.  The British system is under different but no less profound stress.

The NHF also argues the government is undermining social housing growth by insisting that housing association rents be cut by 2% because of falling inflation.

First case of mutual stalemate.  It’s tempting to scale back resident rent increases, but every dollar so saved is a dollar less of free cash flow to the Housing Associations – which, as non-profit MEEs, deploy their excess capital into building new homes.  By easing the stress on current residents, they prevent other people from becoming residents in the new homes Housing Associations would otherwise develop.

Orr estimates the cut would cost associations £260m a year, slashing development by up to 4,000 homes a year.

To save the many 2% a year, we leave 4,000 out in the cold.

If it were up to me, I’d charge them 2% more

And this is self-defeating; in the long run, lack of supply will push up rents.

“When we are expecting to see public capital investment reduce, reducing associations’ revenue capacity just makes development more and more difficult.”

What would make a real difference, associations say, is a readier supply of mortgages for those wanting shared ownership.

Certainly – but if the overall interest rates go lower, that will also push up prices.  Stalemate again?

They also urge more flexibility from councils on planning to make it easier for developers to build. Councils, associations believe, should not expect as much from planning gain – where developers incorporate affordable housing in return for planning permission – as they once did.

As I’ve previously posted, the UK’s form of inclusionary zoning, Section 106, is a zero-sum game.  Whatever the locality wins, the sponsor loses.  Every dollar of affordability grasped by the locality is a dollar less profit, land value, or risk cushion.

Councils themselves have now been put centre stage in developing new social housing. Earlier this month, the government confirmed 47 councils will share £127m to build more than 2,000 homes, with more money up for grabs in the autumn.

That’s £63,500 per home of permanent sunk (non-recoverable) cash equity out.

One per new affordable home?

There are also planned reforms to the way council housing is funded, allowing councils to keep money from rents. The Local Government Association (LGA) is urging the reforms to be pushed through quickly. LGA chair Margaret Eaton says: “Councils could build up to 300,000 new homes and improve conditions for millions of tenants if there is root-and-branch reform of the housing finance system and the government takes away the barriers to building.”

Like the love affair with greenfield preservation.

But some authorities are unhappy about the house-building drive, since it means the funding they need to improve their existing stock is on hold.

Another stalemate?  Spend more to build new and you have less to rehab existing? 

That’s the consequence of the public housing dependency trap.

The authorities affected – around a dozen that have set up arm’s-length management organisations (ALMOs) –

In addition to housing associations, UK public housing is operated by local authorities.  Under the Labour government, strong coercion was applied to compel those authorities to set up professional management operations (Arm’s Length Management Organizations, or ALMOs).

I’m tickled to be an ALMO

Having relied on the government for funding, the ALMOs find themselves in the position of Flounder in Animal House: “You effed up.  You trusted us.”

– now stand to lose hundreds of millions in decent homes programme funding. Gwyneth Taylor, policy director of the National Federation of ALMOs, says the government should not renege on its promises to existing tenants.

Taylor doesn’t believe in reneging

“They are throwing all their eggs into one basket, when there’s no guarantee all the £1.5bn will be spent,” she says.

Catch the subsidy!

Block that metaphor!

For the Conservatives the answer lies in scrapping current house-building targets, which, according to shadow housing minister Grant Shapps, are just imaginary numbers. “In many ways it’s not through lack of money that we are not building enough homes… [the government] has got the wrong approach, with: 

[1] Too much targeting

[2] Inefficient ways to spend money

[3] Lots of schemes that add little, and

[4] Cumbersome administration.”

(”Other than that,” he added, “they’re swell fellows.”)

For Exford, recently appointed to the Joseph Rowntree Foundation’s new housing taskforce, which aims to develop policy options, the solution could lie in more homes for intermediate and market rent.

Basic principle: if you add supply anywhere on the income/ cost continuum, you will ease stress throughout the system.  That would be a move to loosen the stalemate.

More flexible options could bridge the gap between those who can afford ownership and those who qualify for scarce social housing. “We need a more sustainable, mixed-income, mixed tenure product range,” he says.

The CIH’s Richard Capie argues that, in the wake of a government pledge to make the allocation of social homes fairer – councils are being urged to inform communities better about who gets housing, for example – there should be a range of “price points” for affordable housing.

“Someone in a social home on £65,000 and someone next door on housing benefit both pay exactly same rent. It’s not about them being in the properties – that’s a good thing – but should we be looking at rent geared to income? That would give you more rental income and that’s how you build more homes.”

Means-testing is another form of poverty trap.  Another possible mutual stalemate.

The time is ripe, many feel, for change, and this is acknowledged by Sir Bob Kerslake, chief executive of the Homes and Communities Agency: “It is critical that the sector actively joins the debate and is open to new models. Who knows what the process will bring, but we are more likely to succeed through collaborative thinking across the housing and regeneration world.”

To make a move, you’ve got to break the mutual stalemate.

At least it’s not stalemate

Send post as PDF to

[Continued from yesterday's Part 1.]

Yesterday’s post opened the topic of payday lending as exploitive microfinance, designed not to maximize the borrower’s well-being but rather to hold that borrower on the razor’s edge of permanent default, as illustrated by this article from the Washington Post:

Meanwhile, big companies are muscling into a sector that has been dominated by independent operators, lured by the promise of a largely untapped $13 billion market. Wal-Mart, the world’s largest retailer, stepped up the competition earlier this year by slashing prices on its most popular financial services, such as check cashing.

Three years ago, I wrote about these ‘industrial loan companies,’ or banks by any other name describing them in favorable terms, although with a caveat:

“That’s caveat, not Cavett, as you know full well”

Pursuit of CRA investment test credit is a principal driver in LIHTC equity investment, leading to very high prices and resulting highly efficient use of government tax expenditures. And however much banks may tout their CRA performance, there’s no question it’s a burden to them, so if banks are competing against non-banks without a CRA obligation, they will be at a competitive disadvantage.

Consider then an entity that:

1. Has an enormous market capitalization.

2. Is active from coast-to-coast.

3. Takes deposits.

4. Makes loans and provides financial services to its depositors.

Is that a bank by any other name?

“O Romeo, that which we call a time-deposit, by any equivalent interest rate would yield as much.”

If it is, should it be subject to the CRA?

Ask Wal-Mart, as shown in this Economist article:

When Wal-Mart rolls into town, small shopkeepers quake. Now that the world’s biggest retailer wants to enter the financial business, America’s bankers are trembling, too. On April 10th the Federal Deposit Insurance Corporation (FDIC), one of America’s bank regulators, held the first day of public hearings on Wal-Mart’s bid to open an industrial loan company (ILC).

Industrial loan companies are a symbiotic species advantage – the ILC symbiotically lives inside the retailer, and provides the retailer’s customers with credit to buy the retailer’s products.  That’s powerful competition, and we’re all for it – if it’s properly regulated (as to capital, transparency, and consumer protection) and provided it bears the same social responsibilities banks do – namely, CRA.

Beyond ILCs, we are seeing a rebirth of American microfinance (a business model that I believe was born in the USA just over a century ago:

Start-ups have emerged to offer lending to niche groups, such as Hispanic immigrants, at dramatically lower rates.

Niche lending is key to establishing a microfinance institution (MFI).  Focusing on the niche gives the lender better touch on the customers, which reduces probability of default.

Even as non-banks are making small American microfinance loans, banks too are finding their way into the space:

Some credit unions offer short-term loans as an alternative to payday lenders. North Side Community Federal Credit Union in Chicago, manager Ed Jacob said, introduced a six-month, $500 loan with 16.5% interest several years ago.

Microfinance, American style, coming to you from the streets of Chicago

Five hundred bucks for six months?  That’s the very definition of a normal microfinance loan worldwide.

Mohammad Yunus would be proud of you, NSCFCU

The credit union has since made 5,000 such loans, and it has become one of the most popular products.

Meanwhile, start-ups such as Progreso Financiero in California are targeting new niches. James Gutierrez founded Progreso in 2005 to make short-term unsecured loans of $250 to $2,500 to Hispanic families lacking credit scores and banking records. The company charges 36% interest, significantly less than other payday lenders charge but still more than double the average consumer credit card interest rate.

While we think of America as exporting financial innovation, here is Gutierrez importing innovation, proven in Mexico and Peru and Brazil, into El Norte. 

With Progreso’s main Web site in Spanish, he probably doesn’t even have to translate the forms.

Financiero has made about 25,000 loans to its customers in California but needs to make 100,000 before it can turn a profit because the loan amounts are so small and the cost of doing business is high, Gutierrez said.

Let’s take him at his word, and return to that ‘usurious’ 36% interest rate.  Convert that into 3% per month, apply it to a $500 loan and a six-month average duration, and you get a princely sum of $90 gross revenue per customer.  Out of that must be paid costs of money, costs of administration, loan loss reserves, cost of collection, cost of marketing and advertising …

Hence the challenge of microfinance, American style.  To make a profit from inception, you have to charge rates that seem very high expressed as a pure percentage.  Then, even if you charge a rate that will take many people aback, you make so little per loan you need 100,000 customers to turn a profit.

To get the rates down, get the customer volume up

Jacob said the credit union doesn’t make any profit from its payday-loan alternatives.

Motivation matters.  If you sell a drug to cure someone of addiction, that is very different from selling a drug to get someone hooked.

Too much payday borrowing

Instead, it hopes to boost members into good financial standing so they can then apply for profitable products such as auto loans.

Moving someone up the bankability pyramid makes the prospect profitable to you because you can lend them a larger sum for a longer interval.  Lending profitability isn’t about interest rate so much as it is about the total ‘loan area’: Amount x Term.

Motivation matters.  So does the lender’s use of profits, since that influences the lender’s orientation on rate compression – something to pursue, or to resist?

Some industry veterans are also moving into the sector. Just this year, Wal-Mart lowered the price of its prepaid debit card to $3 and its fee to cash checks to a maximum of $3.

The more nodes, the lower marginal cost

Finance scales.  Like other network-based businesses, it has a substantial establishment cost of intangible and intellectual infrastructure.  As those costs are shared across an expanding customer base, higher marginal profits ensue, allowing lower fees – which in turn expands the market further.

It also allows shoppers to pay many of their bills in stores. The giant retailer estimates that about 20% of its customers are unbanked.

20% of the people who buy there have no bank

Except on the historical context of microfinance born in the USA, I have yet to post structurally on how retailers are natural entrants into the business of financing.  They have interactions with the unbanked – Wal-Mart’s 20% figure is simply staggering.  They are motivated to extend credit so they can sell more products, and they have a hidden pricing advantage in that the profit component of each object sold is, in effect, marginal first-loss exposure for them.  They develop extensive credit histories on their customers and can use computer analysis to provide credit scoring.  Given these facts, the wonder is not that Wal-Mart is in the banking business, but that more such retailers aren’t.

“Our customers are living paycheck to paycheck and watching every penny,” said Jane Thompson, director of Wal-Mart’s financial services.

Wal-mart may be creating the Model T Bank.

The next global bank?

But perhaps the biggest hurdle the industry faces is improving customers’ financial literacy. Many are afraid of leaving their money in banks, do not have the documentation to open a bank account or have had accounts closed. They also may not understand how loans are structured.

There lies the regulatory and policy challenge – how do you distinguish between Bad and Good microfinanciers, when your prospective customer is unable to do so for himself?

D.C. resident Gregory Warf, 20, said he doesn’t want a bank account. He turns his savings over to people he trusts, like his brother, or hides it.

Familiarity dulls people’s risk sensitivity; we have many examples of unworthy siblings.

Oh, you can trust me, Simba

If he needs to cash a check, he goes to the nearest liquor store, which charges him a fee. And if he needs money – say, $10 to put on his SmarTrip card – he asks a friend.

Not trusting anyone dooms Mr. Warf to high transaction costs and cuts him out of the banking system.

“I’d rather have my money in my possession,” Warf said. “I don’t really trust anybody else.”

Except that those two statements are contradictory over time.

Send post as PDF to

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 New Mexico, lenders also make no effort to see if customers have borrowed elsewhere, which is how Mr. Milford could take out so many loans at once. If they repay on time, borrowers pay fees ranging from $15 per $100 borrowed in some states to, in New Mexico, often $20 or more per $100, which translates into an annualized interest rate, for a two-week loan, of 520% or more.

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 North Carolina, where the unemployment rate is 10.7% –

Only on close reading did I catch that bit of urban-sophisticate snobbery.  North Carolina is a big state, and its unemployment rate varies dramatically between the coastal and rural areas versus (say) Charlotte or the Research Triangle.  But to the Washington Post’s editors, it’s all one big Tobacco Road blur.

Where the smokes are grown …

– and he travels to Washington every other month to hunt for construction work.

We don’t ask why Anthony feels compelled to live in North Carolina, instead of bunking with roommates in Washington. 

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.]

Send post as PDF to