Payday Lenders are Subject to Increased Regulatory Risk

By Hoang Nguyen, Senior Research Analyst

On February 23, 2013, The New York Times published a report detailing how major U.S. banks are aiding internet-based payday lenders that offer short-term loans with very high interest rates, and how they allow the lenders to operate from abroad to avoid state laws. According to the report, the banks, including giants such as JPMorgan Chase, Bank of America and Wells Fargo, allow the lenders to withdraw payments automatically from a borrower’s account, even in states where these loans have been banned entirely and even after customers have instructed the banks to stop the withdrawals.

By processing these transactions, banks benefit from potential additional revenue generated from overdraft fees. According to the Pew Charitable Trusts, 27% of payday loan borrowers say that the loans caused them to overdraw their accounts. With current federal regulations limiting fees on debit and credit cards, banks are relying more on these fees to make up for lost revenue.

Once obtained, payday loans are difficult for customers to get rid of. Customers who want to repay in full must contact the online lender at least three days before the next withdrawal or else the lender automatically renews the loans monthly and withdraws only the interest owed. While federal law allows customers to stop any withdrawals from their account, banks often do not facilitate the process.

State and federal officials have now focused on the banks’ role in their effort to clamp down on payday lending. Lawmakers introduced a bill in July 2012 forcing the lenders to abide by the laws of the state where the borrower lives instead of where the lender resides as well as to let borrowers cancel automatic withdrawals more easily. This will clearly make it harder for payday lenders to withdraw money from borrower bank accounts. In states where these loans are restricted, prosecutors have been trying to keep online lenders from illegally making loans to residents. While the lenders can currently move their offices offshore to bypass state laws, pending legislation will probably make it harder for payday lenders to operate in this manner.

In January 2013, GMI Ratings wrote a report on payday lenders. GMI has rated a number of these companies poorly and will continue to do so. This group includes firms such as EZCORP Inc., First Cash Financial Services (FCFS), and Cash American International, Inc. (CSH) – all three of which currently receive a “D” ESG rating.

In examining EZCORP’s most recent 10-K, we observed that the interest rates and fees for payday loans are not unlike those that would be charged by illegal loan sharks. For example, on multiple-payment unsecured loans, total interest and fees over the entire loan term can range from approximately 45% to 130% of the original principal amount of the loan. For line of credit loans, which operate similarly to a typical credit card, the company typically charges an annual fee of $30 per account and a stiff monthly fee of about 52% of the amount borrowed.

Overall governance is poor at all three companies, and is indicative of the insular boards that typically have difficulty adapting business models to a changing market or regulatory conditions. EZCORP suffers from a CEO with control of all the voting power via a dual-class stock arrangement, related party transactions, board independence concerns, and executive remuneration insufficiently linked to company performance. FCFS’s governance profile is marked by having a classified board consisting of only four directors, poor committee structures, lack of incentive-based compensation tied to long-term performance, and discretionary cash bonuses. CSH’s governance profile presents a high level of risk due to an entrenched board and poorly-structured compensation policies.

The issue of predatory lending is a problematic not only for borrowers, but for the companies who engage in the practice. While it is easy to simply label these firms as high risk because of the social stigma associated with payday loans, the problem runs deeper. Investors have to ask how long before the threshold of public and government tolerance is surpassed and results in substantive regulation that closes loopholes and restricts the space in which these companies operate. The process of increased regulation seems to have already begun in the US, and in the end will provide ample opportunity for state and federal regulators to make use of new laws to justify penalizing these firms. It would appear that these companies are ill equipped to adapt to the changing reality.