A helping hand, or new age loan sharking?

Every industry battles image problems. But imagine the public relations headache when even those in the industry admit that not everyone is playing by the same rules or ethics.

So it is with the alternative financial services industry-payday and title lenders, check cashers and even pawnshops, part of the so-called "fringe banking" market. Aside from pawnbrokering, a form of pledge literally centuries old, the rest of this market has largely sprung up only in the last decade or so, give or take a few years depending on which business and what state you're talking about.

Following in lock step with that growth is a public perception of the industry—particularly payday and title loan businesses—as nothing but a bunch of shady, fly-by-night operations.

"They have an image problem," said John Caskey, a Swarthmore College economics professor and leading expert on the industry. The image stems from too many anecdotes about high fees, poor disclosure and "particularly aggressive actions on collections," Caskey said.

Even those in the industry acknowledge the stereotypes and public relations conundrum. "People's perception of the industry is that someone is getting cheated ... [and] we're here to prey on the poor," said Cary Geller, owner of four Money Center stores offering check cashing and payday loans in the Twin Cities. "I would have trouble coming to work if that were the case."

"They [the public] think we're out to rip somebody off," said Steven Busse, manager of Advantage Loans of Rapid City, S.D., which does payday and title loans in two locations. "I'm sure some of [the criticism] is justified. ... If you were that type of [abusive] person, it could be done."

While pawn and check cashing businesses have their critics, neither tends to receive much attention from consumer advocates, or at least as much as they once did. Pawnbrokering, for one, has gained a certain amount of acceptance from its longevity as an industry. Check cashing (also known as currency exchange) is a single transaction that establishes no binding, future commitments.

Payday and title loans, whose high fees and term structure can tend to snowball on unsuspecting and financially naive applicants, shoulder most of the criticism of the fringe banking industry. Title loans are "so unconscionable they should be prohibited," while payday loans are "designed so consumers get in trouble," according to Jean Ann Fox, director of consumer protection for the Consumer Federation of America, one of the industry's strongest critics.

"We think there needs to be small consumer loans without loan terms that are harmful" to consumers already facing financial hardship, Fox said."You don't get out of a hole by digging it deeper."

While emotional hard-luck stories about industry abuses are not hard to find, the industry has in some ways received a bum rap for doing legitimate business in subprime markets and providing a service where other financial entities have been unwilling. Few industries are critic-free; while there is evidence of unlawfulness, it doesn't illegitimatize the entire industry or the market it serves.

The developing fringe

One thing about this market is crystal clear: It is booming, particularly in states that do not regulate or otherwise cap the fees these businesses are allowed to charge. A state official in South Dakota, where fees are not capped, said the industry "has mushroomed" there, estimating there were at least 95 fringe banking outlets, not including pawnshops.

In the last two years, the number of check cashing stores in Minnesota has roughly doubled to almost 70, according to Terry Meyer of the state Department of Commerce. The number of such outlets nationwide has more than doubled in the last five years to 6,000, many of whom are also beginning to offer payday loans, according to an industry association.

Title lending also appears to be growing. Wisconsin started licensing title lenders last year, and there are now 26 such locations in the state. (In general, however, comparatively little is known about the title lending industry. For one, Wisconsin is among few states to directly license or regulate title loans as a separate lending entity. Compounded by the fact that the industry has no affiliated association, general records of the industry are poor. State trends in the pawn industry are similarly difficult to determine because these businesses are typically licensed at the municipal level.)

The leader of the fringe banking pack—in both number and controversy—is payday lending, which has seen dramatic growth nationwide and in the Ninth District. An industry association estimates there are 9,000 outlets across the country; an investment banking firm put the number at 10,000-this for an industry that hasn't even reached double digits in age, and is nonexistent in 18 states.

The number of licensed payday lenders in Wisconsin went from just one in 1993, to 17 in 1995, to 195 as of August of this year, according to the state Department of Financial Institutions. In the last four full years, the number of loans has increased tenfold to 840,000, and their value has increased almost 20-fold to $200 million.

Franchised chains are driving much of the growth. Cash N' Go is the largest payday lender in Wisconsin with 39 outlets, including eight in the 26 northwestern counties located in the Ninth District, all started since 1996. Advantage Title Loans has 17 offices in South Dakota. Pawn America has 11 stores in Minnesota and is planning four new ones.

Such fast growth has sparked interest among consumer groups and legislators to control or otherwise regulate an industry believed to take advantage of those who can least afford it. Not all of the stereotypes heaped on the fringe banking industry fit exactly right, however.

Many believe the industry caters to the very poor; while it is a segment of the market, it's a small one. The average customer for a payday loan, for example, has a full-time job and an income between $25,000 and $35,000 annually. A third-party analysis of Title Loans of America, one of the largest title loan companies in the nation, found that 20 percent of its customers earned less than $20,000 annually, while close to half made more than $40,000.

Check cashers are mistakenly thought to hone in on welfare recipients. But earlier this year, the Department of the Treasury contracted a survey of 130 nonbank financial service centers. Among those doing check cashing, 80 percent of all checks cashed were payroll, and just 16 percent were government checks.

"I'm not interested in [customers on] welfare," said Geller about the check cashing side of his business, because it would subject him to the "ebbs and flows of a whimsical federal government. ... I would starve to death."

If the shoe fits ...

A more accurate characterization of the industry—particularly title and payday loans—is that it serves lower-middle income working folks experiencing some financial crisis. "There is a percentage of the population who sometimes has a need for a small amount of money for a short period of time, and banks are not going to provide that loan," Geller said.

One-Stop Shopping for Alternative Financial Services

The alternative financial services industry—a.k.a. fringe banking—is a loose term for nonbank entities providing some banklike service. Sometimes included in this group (but not discussed in these articles) are rent-to-own businesses and specialty auto and mortgage lenders. Below is a basic description of the banklike services and businesses that are the focus of these articles. Payday loans: Payday loans are typically very small consumer loans—usually $150 to $300—backed by postdated checks or authorization to make an electronic debit against an existing financial account. The check or debit is held for an agreed-upon term, usually about two weeks or until an applicant's next payday, and then cashed unless the customer repays the loan reclaims his or her check. If the customer does not have funds for the check to clear, the same process is followed to obtain an additional loan or extend the existing loan, commonly referred to as a rollover or renewal.

Title loans: Title loans are also small consumer loans that leverage the equity value of a car as collateral. The car title must be owned free and clear by the loan applicant; any existing liens on the car cancel the application. Loan terms are often for 30 days, and failure to repay the loan or make interest payments to extend the loan allows the lender to take possession of the car. Check cashing: Check cashing outlets, also called currency exchanges, cash payroll, government and personal checks for a set fee, often ranging from about 3 percent to 10 percent of the face value of the check, or $1, whichever is greater. These stores typically offer additional services and products, like money orders, wire transfers, bill paying and prepaid phone cards. A growing number are also offering payday loans. Pawnbrokering: Pawnbrokers provide financing on the basis of the value of tangible property brought to a store. Typically a flat fee is charged for the transaction, and the merchandise is held for an agreed-upon period of time for repayment and reclaiming of property. Upon contract expiration, if the loan is not repaid or extended by an interest payment, the broker assumes ownership of the merchandise and can put it up for resale.

The industry says such loans are intended to be a financial bridge until a person's next paycheck. Consumer groups argue that such loans—given the high fees, short terms and the cash-strapped nature of the applicant—are rarely paid off. When this happens, the loan is renewed or "rolled over" by simply taking out another loan to pay off the first one, or an interest payment is required to extend the loan. As a result, when a loan comes due many customers face a lose-lose choice, Fox said. "Do I bounce a check ... or do I just pay the fee [for a rollover or extension]?" Fox said. "It's a 'gotcha' kind of transaction."

Once the loan is paid off—even on time—the consumer ends up paying an annual percentage rate (APR) often ranging from 200 percent to 2000 percent. (APR comparisons are themselves a matter of considerable debate. The industry points out, for example, that a payday loan is designed as a two-week loan with an appropriately scaled fee for the risk involved. Other common fees—like late fees on movie rentals or credit card payments, bounced checks—carry similarly high rates if converted to annual percentages.) The industry argues that rollovers happen less than anecdotes might suggest, pointing to some states like Minnesota that restrict rollovers. But in states that do not restrict rollovers, available evidence is not flattering to the industry.

A state of Illinois study on short-term loans found that almost half of title loan customers were repeat customers, and the average duration of loans (including extensions) was about 4 months. The study also found that payday loan customers average 13 loans (including renewals on original loans) at an APR of 533 percent. While the industry is quick to note it helps those in dire financial straits, that strain "is rarely short-lived," the report pointed out. "Customers playing catch-up with their expenses do not have the ability to overcome unexpected financial hardships because their budgets are usually limited. The high expense of a short-term loan depletes the customer's ability to catch up, therefore making the customer 'captive' to the lender."

In one of the few comprehensive studies to date on the habits of payday loan customers, the state of Indiana examined 47 licensed lenders with 123 stores, looking at the loan history of the most recent 25 to 50 accounts at each store over the previous year. Mark Tarpey, supervisor of the consumer credit division in the Indiana Department of Financial Institutions, said there were "a lot of claims of isolated abuses. We thought it would be useful to have some statistical data" to shed some light on the industry.

The study found that these 5,350 different accounts took out over 54,000 loans during the year. The study looked closer at a random subsection of about 1,400 customers at 36 locations. It found that three of four loans were renewed or rolled over, and fewer than one in 10 customers had no loan rollovers.

"The numbers surprised us," Tarpey said, particularly given that the industry was only about five years old at the time of the study. "It kind of confirmed some of our worst concerns" of keeping people in "perpetual debt."

But not everyone in the business is ready to bleed an unsuspecting customer dry. "I try to help people out who have no where else to turn," said Busse of Advantage Loans in Rapid City. Title loans at his company run from 8.34 percent to 20 percent monthly (100 percent to 240 percent APR), although with no usury laws in South Dakota, the sky's the limit. People often take out loans and "they are just paying the interest, interest, interest and not paying any principal," Busse said. If after six months, a person has only paid interest on the loan, Busse automatically converts the loan—even those at 20 percent—to the lowest 8.34 percent rate and puts them on a six-month installment payment to pay the loan off.

The difference in payment is not dramatic, but the outcome is. A $500 loan at 20 percent monthly makes for a $100 monthly payment in interest alone, and pays off none of the principal. Shifting the loan to 8.34 percent, and requiring the loan to be paid in six months ups the payment to $125, cuts total interest charges by 60 percent, and ultimately closes the loan.

"We need to make some money ... and I want to keep customers coming back," Busse said. If he can help customers get the loan paid off, "they're happy, and I've made some money."

If abuse is rife, where are the squeaky wheels?

Critics also point to abusive collection tactics, such as the threat of criminal prosecution for trying to pass bad checks for a payday loan, even though this is generally a matter for civil court.

"I've seen threats used on letterhead of some of the major payday lenders," Fox said.

But given alleged abuses and consumer-unfriendly tactics, one might think complaint hotlines would be ringing off the hook as the number of such outlets and their transactions expand annually. That doesn't appear to be the case. None of the Ninth District states registered more than a very small handful of complaints against the industry in the last year or two, despite the fact that total transactions numbered in the millions.

Meyer said Minnesota has had just a single complaint against the payday industry to his knowledge, and that lender was forced out of business in the state. Montana and North and South Dakota officials said their state received very few complaints on the industry. The number of complaints against all nonbank lenders in Wisconsin (which includes title and payday, but also other specialty lenders) was just 17 in all of 1998 and 1999.

But Fox said the "volume of complaints doesn't match the abuse" doled out by these businesses. "If consumers knew they were being abused, they might complain."

And in fact, there is some evidence to suggest this could be a factor. There were very few complaints in Montana before the passage of its payday licensing law last year. Since its passage, complaints "are starting to trickle in," said Kris Leitheiser of the Montana Department of Commerce. "We have several complaints in review right now."

Complaints in Wisconsin are also increasing, if still small. There were three complaints against all nonbank loan companies from 1993 to 1997, but 12 through August of this year. North Dakota saw an increase in complaints following a publicized warning to pawnbrokers in the state to stop doing payday and title loans, according to Gary Preszler, North Dakota banking commissioner. He added that it's not surprising the state received few prior complaints. "[Payday loan users] aren't going to complain" because they often feel they have nowhere else to turn, he said. "They find a friend in a payday loan."

Critics have also said that bankruptcies and consumer credit agencies would provide better measures of the industry's abusive tendencies. Tracy Nave, education marketing director for Montana Consumer Credit Counseling, said there were "a lot more clients who have those types of [payday] loans," and these lenders are not always cooperative in restructuring personal finances to get someone out of debt. Nonetheless, she acknowledged, "We haven't heard a lot of complaints."

Bankruptcies, on the other hand, have actually been falling nationwide and in Ninth District states for the last couple of years, according to the American Bankruptcy Institute. Two bankruptcy lawyers said that fringe banking outlets are showing up as creditors in bankruptcy court somewhat more frequently, but are still a small presence.

Greg Waldz, a Minneapolis bankruptcy lawyer, said he's only had a few bankruptcy cases where payday or title loans were part of the debt. "I definitely think they are on the increase. ... [but] numerically, it's not a huge thing."

Lindy Voss, a bankruptcy lawyer for 20 years and currently at Prescott and Pearson, Minnesota's largest personal bankruptcy firm, said there was "not really" any correlation between the increase in fringe banking activities and bankruptcies, adding the firm "very seldom" saw payday or title loans as part of a bankruptcy filing. In fact, personal bankruptcies have been on the decline since 1997 in Minnesota—"we're down probably 30 percent," Voss said—the very period in which the industry has seen strong growth.

Sic the state on 'em

Lawmakers and advocacy groups have turned to the state to protect consumers from what they believe is fraudulent, or at least unethical, industry practices. In most cases, this has meant passing state laws capping various fees charged by these businesses, which has created a fragmented array of regulations governing each segment of the industry in different states (see accompanying state tables).
Minnesota, Montana, North Dakota, South Dakota, Wisconsin

Among Ninth District states, North Dakota has all but outlawed the fringe banking industry, save for pawnshops. Payday and title loans are allowed under small consumer loan licenses, but have a maximum interest rate of 30 percent a year for the first $1,000. Preszler said payday and title loan companies inquire often about fee caps in the state. "Because of usury, it's not economic for them so they don't bother with the license," he said.

The state has about 25 businesses doing title or payday loans through pawnshops, according to Preszler. After receiving the state's warning letter to cease such transactions, one merchant told Preszler that he would discontinue payday lending, but would continue doing check cashing.

"I told him, 'The bad news for you is you better contact a lawyer because you don't have the authority to cash checks,'" Preszler said. North Dakota allows no check cashing outlets because the state considers it a core banking function that requires a charter.

South Dakota and Wisconsin require licensing for these check cashing, payday and title loans operations, but do not cap fees that vendors can charge. Check cashing is unregulated in Montana, and payday fees are "capped" at 25 percent of a check's face value, which in annual terms calculates to 650 percent for a two-week loan.

The presence of fee caps and other regulation on the industry is both dramatic and somewhat unknown. Caskey of Swarthmore College, for example, said that his research has showed there are a "far greater number of lenders" where there are no fee caps (South Dakota, Wisconsin and, until recently, Montana) compared with regulated states like Minnesota and North Dakota.

Any state fee cap "puts us out of business," said Bob Reich, president and chief executive officer of Title Loans of America, which has 30 offices in the Ninth District. When the state of Kentucky passed interest rate caps, "We shut down every store ... because [the legislated rates] wouldn't even cover our costs," Reich said.

But many other outcomes regarding regulation are unknown. For example, no data or research could be found about the net effect that regulation has on the target population's access to credit and long-term financial well-being.

Also unknown is the simple matter of whether fringe banking businesses are compliant with existing regulations like usury and fee disclosure. Critics arm-wrestle with the industry over whose anecdotes are more representative. In truth, neither side has very good estimates on how compliant the average vendor is, because few are checking regularly.

In Minnesota, examinations are done by the state on a complaint basis only. In Montana, the new deferred deposit law will provide funding (through license fee revenue) for the state to do annual compliance examinations on all licensed payday lenders, according to Leitheiser.

But the law will not cover title lenders in the state. According to one high-ranking Montana official, "many" title lenders choose to stay unlicensed, which subjects such loans to state usury laws—a rough maximum of 15 percent APR. "[I]t is fairly certain that most, if not all, of these [unlicensed title] lenders are charging rates far in excess of what is allowed. Some of these businesses may be ignorant of state law. Others claim to be operating under pawnshop laws. The rest seem to believe that the law doesn't apply to them, or are unconcerned about whether it does."

A report by the state of Tennessee found more than half of all payday lenders were noncompliant with existing laws. However, the report attributed the high rate to new legislation "imposed on a newly regulated industry." It added that the industry "has been very responsive" to correcting violations which decreased significantly upon re-examination.

Increased state regulation is also causing the industry to adapt to survive. For example, many stores are commingling different services and products. The National Check Cashers Association recently changed its name to the Financial Service Centers of America (FSCA) to reflect the fact that 40 percent of its membership now also offer payday loans, according to Henry Shyne, the group's executive director.

Despite stringent caps on payday lending, the number of payday licenses in Minnesota through August of this year has almost doubled to 34, according to Meyer of the Department of Commerce. Most of the new licenses went to existing check cashing outlets looking to expand their product line.

Geller is one of them. "In this state, it's impossible for a [payday] stand-alone to exist at these rates," Geller said. "The fees are not great enough."

More ominous to some is a practice called "charter renting," whereby a payday lender partners with a nationally chartered bank. Through the interest rate exportation authority of banks, the partnership allows payday lenders in any state—regardless of existing regulations there—to import the more lenient usury laws of the state where the bank is located.

Said Caskey, "State usury laws won't matter any more, or not much."

So far, only a small handful of such partnerships exist, but they could have a quick impact. ACE Cash Express is the nation's largest check-cashing chain with a network of more than 1,000 stores in 32 states. Taking advantage of the trend in complementary services, ACE brought payday lending to roughly 30 percent of its stores in 18 states, according to the company's annual report.

Stephens Inc., an investment banking firm, called ACE's entry into payday lending "potentially the most important event of the past couple of years for the company." One reason is the growth potential, thanks to what ACE called a "strategic relationship" with Goleta National Bank of California, which will allow Goleta "to offer small consumer loans in stores throughout the ACE network," regardless of existing state regulations.

"It is legal, but I don't like it," said Donna Tanoue, chairman of the Federal Deposit Insurance Corp., during a June speech to bankers.

The consumer catch-22: Choice vs. protection

Ultimately, who's "right" as it relates to this industry depends on whether consumer protection trumps consumer choice and credit access, or vice versa. Clearly, there have been and continue to be abuses in this industry—people in the industry admit as much. Equally obvious, however, is a market demand for these financial services and products that would otherwise go largely unmet among a population that both critics and the industry agree has few other resources. Where and how to draw the regulatory line is a hotly debated gray area.

"You have to be somewhat paternalistic, or [otherwise] I don't see the need for any usury laws," Caskey said. The average fringe bank customer is "low or middle income with little or no political clout," Caskey said, and as such, consumer protection "ought to be disproportionately directed" to these people.

Preszler agreed. "The problem with it is some of this is absolutely predatory and government needs to do something" to protect citizens, he said. "We don't need to regulate it so that you make it uneconomical, but controlled so it doesn't create social costs."

Many in the industry even agree on the notion of some regulation. "There ought to be responsible regulation. In some states, all you have to be is breathing" to get a payday loan, Geller said. "In my mind that's not responsible."

Geller said he's thought about lobbying for changes in the law. "But the perception of the industry is so volatile, you could get hurt as much as helped" once proposed legislation opened up for debate at a state legislature.

The industry has also been working with different states to create "reasonable regulation that will allow [payday vendors] to stay in business," said Shyne of FSCA. "They feel it's better [to do so] rather than have something that's being pushed by consumer groups."

Consumer advocates have been pushing APR caps of 36 percent. Wisconsin saw just such a proposal last spring for title and payday lenders. At these rates, the interest on a typical two-week loan would be about 1.5 percent. Given a client's high-risk credit history, "how do you stay in business doing that?" Shyne asked.

Caskey believed that the profitable middle ground for payday lenders was "roughly in the range" of 10 percent monthly (120 percent APR, or roughly 5 percent of face value for a two-week loan). "If you don't [charge this much], you can't really do payday lending."

The industry has also tried to improve its image. The Community Financial Services Association, representing about half of the payday industry, requires members to adhere to a "best practices" guideline. This includes compliance with all applicable disclosure laws, truthful advertising, the right to rescind a loan within 24 hours and allowing no more than four rollovers even where there are no rollover prohibitions.

Tarpey of Indiana called the best practices strategy "a good PR document." But Caskey said it was a step in the right direction because "it's in their best interest to get rid of the poster child [of abusive vendors] for journalists," he said. "I think there's some good in that."

Several sources in the industry said too many consumer advocacy groups suffer from a superiority complex. "I know they mean well," Don Tucker, a lobbyist with the title loan industry, said of consumer groups. "They seem to think they know better. ... 'I know better for you than you know for yourself,'" Tucker said.

A common belief among industry critics is that "if you don't do what your neighbor does, you're wrong," Geller said. "They [consumer advocates] simply don't have their finger on the pulse of the people using our services. They think they do, but they don't."

"The real issue here isn't high interest, it's whether or not certain segments of society have access to credit," Reich said. He pointed out that various caps have made providers pull out of some markets. While that might make advocates happy, it might not serve the consumer in question very well. "Credit at a higher rate is better than no credit at all."

The dilemma facing the fringe banking industry "is like cigarette companies," Caskey said. A person knows that having a cigarette can be bad for your health, he said. But if that person nonetheless wants to start or continue that habit, "is it bad for you to sell a cigarette to that person?"

Related articles: fedgazette, July 2004 Banking on the fringe