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I generally agree with you on rate caps for these alternative financial services, but there also is a lot of misinformation in the market.

Some of the better legislation is around disclosure and labeling of products. I think that sort of thing makes more sense than the rate caps.

Another interesting unintended consequence - at least for refund anticipation loans (might also be true of payday loans), lenders in these restrictive states can charge a fee for "facilitating" a loan where the actual lender is a bank chartered in another state. The courts have ruled that this is valid. So a lot of these laws aren't binding anyway, and if anything promote precisely the lenders who are most predisposed to being somewhat deceptive. That's not a good thing.

It is a shady market. There's no laissez-faire way of finessing that fact. But that doesn't mean that rate caps are the answer - my opinion is that disclosure requirements probably are.

...military personnel, but no one seems to think they are being preyed upon in the same way immigrants are...

It doesn't change the thesis, but in actuality, payday lenders, title lenders, auto sales, car audio shops, rental centers, etc. have been under fire for a long time re: military personnel. Counseling the troops wasn't enough to get them to quit using the easy credit, so laws and regulations had to be passed:

http://usmilitary.about.com/od/millegislation/a/paydayloans.htm

Steve's helping out the team here.

The average payday loan is short-term and low-dollar value. A good deal of the "interest" is a transaction cost. $17 wouldn't cover the costs a bank would incur to process such a loan.

I call these bills loan prohibition. We know the failed history of other prohibition campaigns.

The poor will now borrow from loan sharks. If they have valuables, they will pawn them. And, for the illegal immigrants, they will remain indebted to the coyotes that transported them for a longer time. Perhaps crime will increase.

I do think Steve is pushing it on his anti-immigrant theme. As he notes, these laws are popping up everywhere.

I'm very happy about this new regulation. I planned to press and eventually bribe the Congress about it, but it hasn't been necessary.

Best regards,
Al Capone

What a good post!

Don't forget that someone did a study a few years back just after North Carolina and Georgia passed laws banning payday lending. The unintended consequence of the laws in these two states was an increase in the number of bounced checks among the poor and military, which imposed a far greater cost per dollar than what payday lenders were charging in interest.

Al and I are toasting the new bill. Our business will be booming in Arizona.

Regards,
Don Corleone

All these mobster-related posts are pretty lame.

I would politely remind Mr. Pimple of our strong preference that people not use multiple names. Either Ricardo Pimple or The Cuttlefish of Cthulu. Pick one and stick with it please.

Steve,

I vote for real names, only.

I see you failed to reference your claim that the default rate on payday loans is 50%. In my youth I used a payday lender once or twice. They require direct deposit in a bank account of good standing with proof of regular paychecks. Some payday loans done through check cashing outlets want the person to have their pay direct deposited right to them. Aside from producing fake pay stubs (which is technically fraud, not defaulting) or maybe getting fired the day after you get your payday loan, it doesn't seem so easy to default on them.

The loans are structured so you keep turning them over. For example, if you borrow $100 you may have to pay either $125 in your next paycheck or $25 to let the $100 'ride' another two weeks. If you're always short on cash, it's very tempting to keep renewing the loan for $25 over and over again rather than taking the big bite of $125. It doesn't take very long though before you've paid that original loan several times over in the fee/interest. You don't even technically pay the loan, its pulled out of your account the day your pay is deposited.

I don't doubt there's defaults with payday loans but I'm skeptical its 50% given the protections payday lenders give themselves.

"I see you failed to reference your claim that the default rate on payday loans is 50%."

So what? The claim is taken from the CNN article linked to in Dr. Horwitz' Freeman piece and is attributed to the vice president of state policy for the Center for Responsible Lending, an organization that appears to take a pretty dim view of payday lending.

"Payday loans are usually 14 day or 30 day loans designed to bridge the gap between paydays for consumers who have no access to other forms of credit, or who have problematic credit histories."

Is the only solution to completely liberalize interest rates?

If the goal of these loans is to bridge the gap between paydays, as Steve points out, but we also want rules to protect the borrowers from the danger of a huge increase in their debt if they, for whatever reason, cannot pay it back 14 days later but must hold it for one or more years (as Boonton seems to point out) -

wouldn't it then be a better form of regulation to allow for a 50% or even higher interest for a limited amount of time (one month if the goal of these loans is what Steve pointed out, maybe longer for other purposes) and from then on only allow debt to grow at a much lower limited percentage?

It seems to me that such rules could allow consumers access to credit, while protecting them from a growing debt burden in case they weren't able to repay.

Actually, credit card debt is not all that different from how payday loans are being described. A significant number of card holders have what amounts to permanent debt.

The question is whether it is the state's job to "protect" people from what they want to do. If so, then I guess the fast food police are correct. If debt should be outlawed, so should obesity. And drunkedness, etc.

Here is a link to an FDIC analysis of payday lending. Insured depository institutions have got into the market and some are taking a bath. Underwrting is tricky and charge-offs can be very high. It is a risky business.

http://www.fdic.gov/bank/analytical/fyi/2003/012903fyi.html

And here is an academic study of payday loans.

http://papers.ssrn.com/sol3/papers.cfm?abstract_id=1066761

So what? The claim is taken from the CNN article linked to in Dr. Horwitz' Freeman piece and is attributed to the vice president of state policy for the Center for Responsible Lending, an organization that appears to take a pretty dim view of payday lending.

Well two important things:

1. Your argument against the regulation is premised on the idea that the excessive interest rates the lenders charge is really a reasonable market rate due to the high defaults.

2. From the POV of theory, if the default rate is not high then the rates are odd. The standard theory says low default rates but high interest rates should drive many more lenders into the market to drive the rates down. If that doesn't happen then something is going on that cries out for an explanation.

The FDIC paper doesn't really go into their default rate. They point out that a few publically traded firms have seen as high as 83% charge off rates BUT the market is mostly made up of small, non-public firms that are not banks and do not report their default rates.

A NC Credit Union introduced a Payday loan product themselves and achieved less than a 5% chargeoff rate (http://www.usatoday.com/money/perfi/general/2006-09-19-credit-unions-usat_x.htm).

The academic study's abstract seemed to imply that Payday loan prices appeared to be set 'strategically' rather than based on the costs seen by actual default rates.

I would suggest then that while some inexperienced firms might see very high default rates, most payday lenders don't...at least not enough to justify their rates. While they are lending to high credit risk individuals, their product mitigates a lot of the risk. For example, since they are capturing the borrowers direct deposit they do not need to count on the borrower's willpower to pay his loan off. The terms of the loan are in weeks rather than months or year so a long term relationship is not required (hence the danger the borrower will get 'bored' making his payments year in year out as the memory of the fun he had spending the money fades away).

I would suggest then that Payday lenders are exploiting a market niche that is somehow shielded from competition. A few factors I'd consider are:

1. Borrowers are living with a very high discount rate. In other words have very little ability to focus on the long term. This makes them poor candidates for most products you see at a traditional bank. Even a simple no-fee checking account is premised on your ability to hold at least a tiny portion of your money in it until next paycheck and not make your account go red writing a bunch of bad checks.

2. The skill sets banks have to make good loans don't really apply to payday loans. Credit scores, for example, don't really apply here as much as a consistent paycheck and direct deposit that can be tapped to force repayments.

3. Class....banks don't want to deal too much with the 'type' that uses Payday loans. While the returns may be high on those small loans, they may drive away the larger 'classier' customers who deal in larger money. Additionally, since Payday loans appear as taking advantage of people who are either not very bright about finance or in desperate need banks that aggressively try to emulate the business model will be seen as being 'mean' by their regular customers. Payday lenders themselves, who have no need to care about their larger reputation, don't have to concern themselves with lost 'respectable' business.

4. Related to #1, borrowers are deperate for funds. They have little patience to comparision shop or implement a strategy that makes more sense in the long run (say get a low limit credit card that can be used for cash advances with lower rates than the payday lenders). It's interesting that the academic abstract implied collusion was high and lenders with 'captive markets' (say outside of military bases) had higher fees.

I suspect the unique characteristics of the customer base allows payday lenders to have virtual monopolies. Not a monopoly in the Standard Oil sense but a monopoly in the sense that if you are coming out of a 14 day walk through a vast desert the first guy with a bottle of water can charge you whatever he wants. The market has barriers to entry in the sense that in order to compete with a payday lender a new entry in the market has to get right up in the faces of those seeking payday loans. The check cashing outlets in the middle of ghettos have an advantage as do the outlets that jostle to come up #1 in Google searches. Larger institutions though do not want to engage in a 'race to the ghetto' for reasons 2 & 3.

If you have a type of virtual monopoly, caps on rates won't actually eliminate the product. If lenders can still make good profits even under the cap, they will simply continue to make Payday loans at the lower rates of profit. Even more ironic, if the caps and regulation of payday loans makes them appear more 'respectable', you might even get new entrants to the market as reason #3 becomes less of a factor deterring larger institutions from entering the market.

Even if the NC Credit Union achieved a 5% default rate, so what? Their product probably is available to members of the credit union only, who are likely to have a better risk profile than non-members.

Since when do the firms in this business have to "justify" their rates to you, or to anyone else? The market will sort this out; the publicly traded payday loan firms make a decent return for their shareholders.
Anyone who doesn't like the industry is free not to use the services it sells. You can even short the stocks of these firms if you want.
In the meantime, they don't need a rep of Comrade Stalin, or Comrade O to tell them what a "legitimate" return is.

They also don't have monopolies, "virtual" or any other. As for your "rate of profit" in the last paragraph, Rothbard blew that out of the water in MES by inquiring about "rate of loss."

Also, to pick up on one of my pet peeves, there are no ghettos in the U.S. Ghettos existed in medieval Europe and a few other places since that time (like in Warsaw, Poland in WW II, and in a few places in South Africa under apartheid). A ghetto is a community that is closely policed by the State; and only residents can enter or leave, and usually have to present state-issued IDs to go into or pass some sort of checkpoint. "Ghetto" is a frequently misused word. Even Elvis misused it in one of his songs.

Bill,

1. True the NC Credit union might have achieved an unusually low default rate by having an exclusive membership.

2. Please ditch the childish 'Comrade Stalin' slurs. Businesses do not have to 'justify' rates to me. The claim made here that the rates are based on high risk does have to be justified because, correct me if I'm wrong, this is a place where economics is discussed.

3. If the market is a limited niche market publically traded firms will not move in on the superior profits.

4. According to Answer.com one definition of a ghetto is:

"A usually poor section of a city inhabited primarily by people of the same race, religion, or social background, often because of discrimination."

While the term originated in the European context you've described you have no monopoly on word use in the English language.

5. "Virtual monopoly" isn't quite the best term. I think a better one would be "local monopoly" and nothing you've posted refutes my thesis.

Again the theory here is simple. Payday customers have a very high discount rate which simply means they would rather have $1 today than more than $1 tomorrow. Or in even more simple terms they want cash right now no matter how much it costs in the future. How do we know this? One only has to look at the terms of payday loans to know that the only people who would agree to them would have to be rational people with a very high discount rate, people very ignorant of what the terms actually mean, and people who are irrational.

The high discount rate creates a very tiny 'local market'. Payday loan shoppers will not spend a lot of time 'shopping around' so the first lender to get 'in t heir face' will win the business. This can be literally 'in their face' by being, say, the neighborhood check cashing outlet or virtually by coming up #1 on Google or by having online ads where the customers hang out.

The local monopoly explains why other businesses do not enter the market and compete away superior profits. If someone already has a check cashing outlet in the neighborhood, it's unlikely you can find a better location to open your own. Even if you did, you'd just displace his business.

On the other hand, the local monopoly is a limited market. It's like having a food concession at Yankee stadium. Yes you'll see greater profit margins than just a regular store selling soda, beer and pizza but its not like you can 'go public' and open a bunch of other concessions. The stadium will only accommodate those superior profits when there's a crowd there at games and thats it.

I agree wholeheartedly with the Freeman article, but I do think that Boonton raises some legitimate, well-reasoned points that cry out for consideration. And, indeed, isn't that what economics is all about? Investigating unique, real-life market circumstances, the ways in which they conform to theory, the ways in which they diverge from theory, and finally the reasons for such a divergence, not in an attempt empirically to "disprove" theory but to determine the hidden factors that are responsible for this "misalignment." I think that, from a certain standpoint, his assertion that these businesses have an enhanced ability to engage in monopolistic practices (relative to other markets or market circumstances) is valid, although his further implication that these businesses indeed constitute monopolies is not. (Nor, for that matter, is he correct in labeling Standard Oil a monopoly, which, even in the looser political or colloquial sense of the term as used by laypeople and otherwise advocates of antitrust interventionism, it certainly was not.) However, as to his very first point, almost needless to say, he is incorrect to say that Mr. Horowitz's entire argument against the legislation is premised solely on the idea that the high rate of interest is due in large part to the high default rate, since he also cites the inevitable reduction in legitimate lending services and increase in potentially dangerous black-market activity as a result of the price ceiling imposed by the state, not to mention the fact that the state should have no real right to impose such a thing on the market in the first place. Unfortunately, Boonton refutes his own second point, admitting that among public firms the default rate is even higher at 83%, and it is irrelevant that we do not know the statistics for the private firms who compose the majority of the market since there is no reason to believe that they do not experience similar default rates. As to the NC credit union: it is ONE example out of COUNTLESS; Mr. Stepp is probably correct that their service is available only to members, who likely have better average creditworthiness; and we do not know the rates of interest which this financial institution charges, as they may well be significantly lower, commensurate with the lower rate of default. As far as larger institutions not wanting to engage in a "race to the ghetto" (and, come on, we all know what the term means, the poorer part of town; its original meaning is irrelevant. Don't make me call Steven Pinker.), that is not necessarily true at all, since these companies could simply own these payday outfits under a different brand name. And just because a study "implies" collusion doesn't mean there actually was collusion. Ultimately, there is nothing "morally wrong" with these usurious rates of interest, since everyone is engaging in voluntary trade, and it would seem rather likely that there are very basic and sound economic reasons for charging these rates, aside from (gasp!) "sheer greed" or even monopoly control. That being said, Boonton raises some interesting points that I think are worthy of discussion, but not worthy of being moral justifications for ridiculous laws.

One thing that I think everyone is forgetting: what is the actual profit margin of these companies? Disapproving of "usurious" rates is rather meaningless unless these companies have steep overall profit margins. (And even if they do, I agree, so what, but at least we can put any moral objections to rest.) Very reminiscent of the rhetoric not too long ago about health-insurance companies' "excessive profits," even though they have some of the lowest profit margins of any industry.

My hypothesis is that their profit margins are large since they charge a lot and, if they know what they are doing, can keep the default rate low. But their market is limited making it hard to expand beyond that. A game changer could be Wal-Mart which is in the unique position of being literally everywhere. It already has moved into the check cashing/bill payment market and has previously made attempt to toy with banking directly.

It's difficult to think of an industry in which there are several competitors and a total of around 24,000 storefronts (that's more than BK and McD's combined) as having anything that is relevantly understood as a monopoly, esp. when they, to some degree, not only compete against each other but also credit cards.

Also consider whether these firms compete not just on price, but on terms. There's is some evidence I've found that length of loan is a competitive tool and that repeat borrowers get better terms, both rates and length. That is evidence of competitive behavior.

Finally, payday lenders are not just located in poor areas. They tend to congregate where there are other spending opportunities - e.g., strip malls and near larger shopping areas.

On the profitability of payday loan firms:

http://www.cfsa.net/Fordham.html

It's not particularly high.

You can also check the financials of the publicly traded ones.

Bill, Steve,

The cfsa piece was very informative even though I only skimmed it quickly. Few important points I noticed in it:

1. It noted that most payday firms are in private hands and despite claims of high default rates, they could aquire no evidence of it.

2. The default rate of 50% is highly doubtful considering the profile of the 'typical' borrower that appears on page 13 of the pdf. One study indicated that 66% rolled their loans over more than 10 times per year. Another study said 60.1% neweed 'less than five times in the past year". Given the fees and rates, repeated roll overs allow the lender to quickly earn the original amount back off of fees alone. There's not enough room for 50% of the loans to go bad.

3. What is reated several times is that the decision to use payday loans is based on convenience. This is consistent with both my hypothesis and Steve's observation that many are located near "spending opportunities" like strip malls and shopping areas. The payday borrower wants money fast, what better place to be than near the areas they want to spend the money?

4. The paper confirmed that payday lenders do have high expenses based on convenience. They locate in areas with expensive rents, they are open late or in the case of online outlets pay to advertise or achieve high rankings.

5. A monopoly is a market with one dominant seller. What defines a market, though, is a very relative term. Consider someone who owns an ATM that is set up inside a strip club that has a cover charge. He doesn't have a monopoly in the sense that non-strip customers can probably find quite a few ATMs very close by. He does, though, from the POV of strip customers who want cash and do not want to leave the club and have to pay the cover to re-enter. You should therefore not be surprised to discover that the strip club's ATM charges you a very high fee despite all the 'competition' from the banks just accross the street.

6. Just because you have a monopoly dosn't necessary mean you get mocho profits. In the case of the strip club ATM, the club owner may insist on such a large cut that the owner isn't making much more than a regular private ATM. Likewise the cost of 'being in the customers face' may eat away quite a bit of the monopoly's profits (the monopoly here being strictly a local one). This is a monopoly in the textbook sense but it's not a typical textbook example of a monopoly. Textbooks want to present 'big' monopoly examples (AT&T, Microsoft, the cable company etc.) but there's nothing in the traditional definition that a monopoly.


This takes us to the question of what would be results of regulation? Well imagine the gov't passed a law limiting strip club ATM fees to be say no more than 10% above the average of the ATMs in the nearby area. Would strip club ATMs disappear? Highly unlikely. Strip club owners want to see their customers have easy access to cash in their clubs for obvious reasons and ATM owners clearly want to provide ATMs for fee revenue (otherwise there wouldn't be other ATMs in the area outside the club). I suspect what would happen is ATMs would still be in strip clubs but club owners and ATM owners would take less fee revenue. How much less each one takes would be a bargaining question of who has more power.

Likewise I suspect a cap on payday fees wouldn't result in fewer loans but less money going to capture the 'monopoly' position. The people harmed the most probably wouldn't be payday borrowers, not even payday lenders but landlords in strip malls who will find the payday lenders a bit more willing to locate an extra block away from the prime shopping areas where rents are a tad less.

Boonton,

A monopoly is not a market with a (as in one) dominant seller. It's a market with one seller, period. And even there, as Rothbard pointed out in M,E&S, the term monopoly should be confined to State-granted monopolies (such as patents, etc.). IOW there's no such thing as a monopoly on the free market.
Your other points are presented contentiously, and in a manner like "look what I learned" that you haven't figured out--like the commonplace knowledge that every four year old knows about payday loan firms locating in strip malls, etc., because (your "hypotesis") that's where the customers are. Imagine that! Thanks for filling us in on this earth-shattering insight.
Who knew?
Re: point 6, just because you have a "monopoly" doesn't mean high profits. Again, who knew?
Certainly not those of us who rejected the mainstream textbook view of monopoly the minute we read Rothbard (or Armentano).

And thanks for the earth-shaking insight that an ATM inside a strip club has a higher fee than one outside.

I would recommend ditching the textbooks you mention, and reading Rothbard, M,E&S (skip the part about money, and read Selgin's Theory of Free Banking, and skip the part on copyright and read Boldrin and Levine, Against Intellectual Monopoly).


Bill,

A lot of snide comments from you but little of substance. Yes many economic observations do sound like common sense, but they are relevant to make. The purpose of the strip club ATM is not to yield insights about them but to use them as an analogy to think about Payday loans and the implications of regulation in a more productive manner. I notice you haven't even addressed the biggest point which seems to be that the claim that payday lenders suffer from horrible default rates appears to be false.

In terms of taking a fundamentalist stance on monopoly, I don't find it very useful. Even in the case where gov't grants a monopoly by law, the market rarely has a single supplier (are there not street vendors in big cities now hawking DVDs of movies that are supposedly only showing in theaters?) A market where one supplier has 99% of the business is very much like one where the supplier has 100%. That some strip club patrons will leave, walk three blocks and return in order to avoid a $5 service charge doesn't alter the ATM's monopoly aspects.

Interesting post! Just to defend them a little bit - Yes, payday lenders prey on the desperate, but they are short term and high risk, so the APR is understandably high. While critics of the short term loan industry are well meaning. They do miss the point, that one way or another people who have no access to prime credit will turn to short term lenders- I think you have also pointed this out. For me, everything goes well when you are using it right, there’s no bad or good on it. It’s a choice that once you decided to have it; you will have to be responsible enough to pay for it on time for you not to be in a deep depth.

Short terms make a loan less risky, not more risky. But a small dollar loan would have higher transaction fees relative to their size than a larger one.

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