Payday Loans: Why This Lender of Last Resort Isn’t the Bad Guy.
Did ex-Barclay’s CEO Bob Diamond really know more about the LIBOR scandal?
Does his decision to give up a 20 million pound bonus signal guilt?
And should you even care about it?
As we indicated on Monday, we find it hard to get angry about the LIBOR scandal when the real crooks (central bankers) manipulate interest rates all the time.
As we see it, it’s like giving a life sentence to a petty vandal while at the same time handing matches to a mass arsonist.
But this isn’t about whether a bank told a few porkies four years ago. It’s about the manipulation of interest rates and the damage it does to the economy and the wealth of savers.
But there is one line of business that has resisted the urge to fiddle with interest rates. And not surprisingly, in a world where credit and debt have become dirty words, this line of business is doing very nicely indeed…
We say this line of business is doing nicely, but it’s not without effort. And it’s not without bullying from lawmakers and lobby groups who insist on rewriting the rules on interest rates and risk.
Take these headlines as examples:
‘Revised payday lending bill puts profits before people’ – debttrap.org.au
‘Payday lenders charge up to 60 times more than true cost of loan’ – The Guardian
‘City should regulate lenders because state won’t’ – San Antonio Express
In the June issue of Australian Small-Cap Investigator we explained how many don’t understand the role of payday lending and how these lenders price risk.
In fact, we devoted two pages of the issue to knocking down a few of the myths about the payday loans industry. One of the biggest myths is that payday lenders charge rip-off interest rates.
In the June issue we wrote:
‘I mentioned that XXXXX has a customer default rate of 6%. That means – in simple terms – 6% of all the money it lends isn’t repaid.
‘So let’s say XXXXX loaned $1 million to a range of customers and charged a low interest rate of say, 6%. But if 6% of borrowers don’t repay the loan, the interest earned is offset by the bad debts…meaning the company won’t make a profit. That would be a bad business model.
‘That’s why payday lenders charge higher interest rates. It helps ensure they cover any bad debts, plus it leaves them with a worthwhile profit to account for taking the higher risk.’
It’s because of the higher risk of default that payday lenders charge higher interest rates. The high interest rate simply reflects the fact that the borrower is high risk.
But that’s not good enough for the lobby groups. They assume high interest rates are screwing the customer.
So, what’s the alternative?
The alternative is that the lobby groups will get their way and lobby for payday lending regulation.
Of course, what they don’t appear to get is that this will cut off the last chance many people have to stay out of poverty. Banks have a central bank as a lender of last resort. For many a payday lender is their lender of last resort.
In 2010 the UK government boasted a grand new plan to beat the payday lenders. It worked with the Royal Bank of Scotland (three-quarters government owned) and the National Housing Federation to set up a business called ‘My Home Finance’.
The plan was for ‘My Home Finance’ to offer payday loans at a much lower interest rate (69.9%), compared to private payday lenders (over 4,000%). They would offer this through 10 street-front outlets.
The venture had a target of making 150,000 loans over 10 years – 15,000 loans per year. With the difference in interest rates, meeting that target should be child’s play, right?
Two years later, ‘My Home Finance’ has made just 8,000 loans (4,000 per year), and has closed four of its 10 shops.
But how can that be right? According to a Guardian report in 2010:
‘Around 2.5 million people borrow from doorstep lenders at rates often in the region of 272% for new customers. A further 200,000 are estimated to borrow from loan sharks. A majority of those financially excluded are social housing tenants.’
Something is amiss. If we include all payday lending operations (including doorstep and loan shark lenders), we’ll guess that 3-4 million people in the UK use these services.
And yet, ‘My Home Finance’ has dished out just 8,000 loans in two years…That’s just 0.2% of the potential market.
Why is this? The reason is simple…
Why it Excludes Those Who Need it Most
When interest rates are artificially lowered for high risk loans – either the lender raises their lending criteria to exclude high risk borrowers (therefore excluding those who most need the cash) or they offer much smaller loans (which means the borrower has to go elsewhere).
A third option, as seen in the US subprime mortgage market, is that lending standards drop. More on that in a moment.
But you shouldn’t forget that payday lenders don’t charge high interest rates just so they can force people into more debt. Payday lenders charge high interest rates to cover the risk of lending to high risk lenders.
But ultimately, whatever the popular press says, payday lenders provide loans in the full belief that people will repay the loan.
Because if they don’t repay it, that’s bad news for the lender, because they’ll soon go out of business…and bad news for the customer who won’t get access to the payday lending service.
In effect, by restricting the interest rate charged by payday lenders, governments are creating price controls. In this case it’s the price of money.
And price controls always have an unintended outcome. As Henry Hazlitt wrote in Man vs. The Welfare State:
‘What governments never realize is that, so far as any individual commodity is concerned, the cure for high prices is high prices. High prices lead to economy in consumption and stimulate and increase production. Both of these results increase supply and tend to bring prices down again.’
The fiddling of interest rates in the United States is a perfect example of low prices causing increased consumption. In that case it was the subprime housing market.
Banks couldn’t discriminate against people based on their ability to repay a loan, so high risk borrowers borrowed the same amount of money and paid the same interest rate as low risk borrowers.
And because the banks didn’t have the buffer of high interest rates to cover the cost of high defaults, many banks went bust, the US housing market collapsed, and the entire US economy went into a recession that it’s still suffering from.
Add to that the knowledge that banks would get bailed out if they got into trouble; it was a disaster waiting to happen.
Payday lenders don’t have the guarantee of a government or central bank bailout. That’s why they price risk according to the market.
The fault of people going into debt and poverty isn’t payday lenders. The payday lender provides a valuable service to those who need it.
The fault is with the pen-pushers in government and the central banks. It’s their fiddling with the economy (minimum wages, red-tape, taxes, import and export restrictions, etc.) and interest rates that mean many have no choice but to rely on a lender of last resort.
This article is contributed by Money Morning. Click Here to Subscribe to their free newsletter.