Biweekly View: How to See Which Payday Lenders Regulators Should Hate

By Sonja Ryst, Research Analyst

Ryan Detrick, senior technical strategist at Schaeffer’s Investment Research Inc., has staked his reputation on Fifth Third Bancorp (FITB). He said in a Business Courier article on January 20, 2012 that the stock had bottomed after declining 13% the previous year, and he recommended it as an investment. So far, Fifth Third prices gained around 19.5% in 2012.

But a cloud is hanging over the Cincinnati financial services firm’s future. The National Consumer Law Center (NCLC) has protested that Fifth Third is among a growing number of banks offering payday loan-like “account advances” that “exploit the struggles of American families living paycheck to paycheck.” For example, the nonprofit said in August 2011 that Fifth Third would charge a 365% annual percentage rate for a 10-day, $400 loan and then seize up to half the borrower’s next wages toward repayment, ignoring laws in Ohio that restrict payday lending. Fifth Third declined to comment.

The regulatory risk surrounding payday lenders is “a big concern, and the wild card out there,” Mr. Detrick says. His team is betting that it’s already factored into Fifth Third’s stock price.

Investors have more reason now than ever to consider which payday lenders the regulators are likely to punish the most severely. For example, the U.K.’s government is weighing a proposal that includes a component intended to grant its new regulator, the Financial Conduct Authority, the ability to cap interest rates charged on payday loans. And while payday lenders in the U.S. have historically answered mainly to state regulators, Richard Cordray, director of the U.S. government’s new watchdog the Consumer Financial Protection Bureau, has in recent months promised federal supervision.

Bob Ramsey, a research analyst at FBR Capital Markets Corp. in Arlington, Va., said some people think the CFPB could find a way to end payday lending altogether. “You have to think about (the regulatory risk) and understand the moving pieces,” he said. He believes there will most likely be rules around disclosure to ensure that consumers understand the terms, costs and implications of payday loans, and possibly also limitations on usage, but he hopes to get more clarity from the CFPB on such matters by year end 2013.

So how do investors figure out which lenders are most likely to have the biggest regulatory issues? To be sure, many critics will point to borrowers’ harrowing experiences and say that all payday lenders have exposed themselves to significant risk. For example, the Center for Responsible Lending, in partnership with the advocacy the California Reinvestment Coalition, describes on its website how a lawyer in her late 30’s borrowed $500 using her bank’s direct deposit advance program, hoping to cover expenses before she got her first paycheck from a new job. Since she was paid weekly, the loan was due in one week, with a $50 fee. This put her behind on her next check. After enduring this cycle for a year, she ended up paying $2,600 in fees for one $500 loan, renewed every payday, the nonprofit said.

“Any lenders that aren’t following the law we would consider bad,” said Amy Cantu, director of communications and research at the Community Financial Services Association of America, which represents the payday lending industry. “All CFSAA members are state and federally regulated, and adhere to a set of best practices.” These include providing full disclosure, using truthful advertising and working with customers to extend the amount of time they have for repaying loans, she said.

Some payday lenders have more exposure than others to areas where politicians are arguing that the laws need improvement. For example, DFC Global Corp. (DLLR), formerly Dollar Financial Corp., said in its most recent annual filing with the Securities and Exchange Commission that nearly half its consolidated revenue came from the United Kingdom during fiscal 2012.

Investors can also examine the kinds of loans banks are offering, and to what extent they have shown the willingness to involve themselves in controversial practices. Tom Feltner, director of financial services at the Consumer Federation of America, said his advocacy organization looks at how well consumer credit providers match credit opportunity with a realistic expectation that a buyer can make repayments. High cost loans are one red flag, but another important criterion is whether the lender ties loan repayment to a borrower’s paycheck, effectively putting itself ahead of all other creditors regardless of the impact on the borrower. Finally, his team also takes into account whether the lender did effective underwriting and investigated the borrower’s entire financial picture before agreeing to a deal, he said.

“A large public company that has payday lending segments is probably less vulnerable (to regulatory risk) than the small private companies,” said John Hecht, a research analyst at San Francisco-based Stephens Inc. He explained that the larger companies would have more resources available to devote to their compliance efforts.

Fifth Third is an example of a large capitalization company that is rated “B” on its environmental, social and governance (ESG) risk despite its involvement in payday lending. That said, other major banks that consumer advocates have accused of selling payday lending-like products continue to have abysmal ratings, particularly as regulatory fallout continues in the wake of the financial crisis. Wells Fargo & Co. (WFC), for example, is rated “F” on its ESG risk.

Investors can also examine the extent to which a payday lender has incorporated checks and balances intended to prevent the abuse of power. For example, Nasdaq-listed companies typically provide stock that includes enough rights for shareholders to be able to elect the people who will supervise the senior managers. But all of the voting stock in the payday lender EZCORP, Inc. is owned by a single individual, Phillip E. Cohen, via his ownership of MS Pawn Corp, which is the sole general partner of MS Pawn Limited Partnership. As a result Mr. Cohen controls the outcome of all EZCORP issues requiring a vote of stockholders, including the election of board directors – even though institutional and mutual fund owners own most of EZCORP’s shares outstanding (including those with and without voting rights.) More detail about EZCORP’s governance is available in the following GMI Ratings report published in October 2011.

Tom Welch, general counsel at EZCORP, said in an e-mail that Mr. Cohen has as much interest as any other shareholder in preventing staffers from abusing their powers. He also noted that traditional payday loans constitute a relatively small portion of EZCORP’s overall business.

Some investors have learned the hard way to take such risks more seriously. Sahm Adrangi, the portfolio manager of New York-based Kerrisdale Capital Management, posted an article on the website Seeking Alpha in June 2010 that talked up The Cash Store Australia Holdings Inc (AUC.) He said at the time that “regulatory risks notwithstanding,” the Canadian Venture Exchange-listed payday lender was “fast-growing” and “well-run.” Noting that Cash Store Australia was spearheading an industry group establishing a code of conduct aimed at self-regulation, Mr. Adrangi predicted that Australia would follow in the footsteps of Canada, which he said had made legislative changes in 2007 that ultimately resulted in final rate caps largely above those charged by Cash Store Australia’s Canadian parent The Cash Store Financial Services Inc (CSF.)

Australia’s parliament ended up passing a bill in August 2012 that said the maximum any payday lender could charge was an establishment fee of 20 per cent of the amount of credit upfront and 4 per cent for each month of the loan. While local advocates such as the Consumer Action Law Centre protested that the new regulation had no teeth, the Cash Store came under fire nonetheless for its marketing practices, and the company’s sales declined in recent months as it revised loan contracts, strengthened disclosure policies and tightened its lending criteria to ensure compliance with regulations. Meanwhile its Canadian parent said in December that it needed to restate financial results in connection with its acquisition of a portfolio of consumer loans from third-party lenders. Cash Store Australia stock prices have plunged since June 2010 from around $3 per share to 14 cents a share.

Luckily, Mr. Adrangi did so well in his other investments, the money he lost on his Cash Store Australia bet never amounted to anything material for him in the end. But he said in recent weeks that he will never buy shares in another payday lender. “Basically, God is punishing me for screwing over uneducated borrowers,” he said in a half-joking tone. “That’s my lesson. No more vice stocks.”

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