When CompuCredit Corp. last year acquired two payday lending chains, it startled many industry observers. After all, some consider payday lenders in the same league as pawnshops, loan sharks and other types of predatory lenders. That is not an image most issuers would care to cultivate.
But CompuCredit has a different opinion. The Atlanta-based subprime issuer sees payday lending as a good fit with its core card business, giving it access to consumers it might not otherwise reach.
"We have found that a lot of our customers wanted this kind of service offering, and it complements our core business of subprime credit card lending," says Jay Putnam, director of finance. CompuCredit's lower-tiered card products are marketed to consumers with credit scores below 600.
CompuCredit, like other issuers, is looking for additional sources of revenue. Buying payday loan operations not only gives CompuCredit a new product to offer, the storefront offices typically used by such lenders give the issuer a new venue to market such other products as credit, debit and stored-value cards, Putnam says.
CompuCredit expects the return on investment generated by the payday loan business to be between 20% and 25%, Putnam says. "We're going to have some fluctuations obviously, but that's the benchmark we set when we invest money," he says.
The two payday lending chains bought by CompuCredit-First American Cash Advance (including First Southern Cash) and Venture Services of Kentucky Inc.-operate a combined 470 stores in 14 states.
Payday lending, also known as micro-lending, has been around for more than a decade, offered primarily by small, independent check-cashing outlets and pawnshops. However, it has grown at a breakneck pace over the past few years, fueled by the demand from cash-strapped consumers for short-term, small-denomination credit. Consumers who use payday loans often have no other access to credit.
In 2004, there were about 22,000 payday loan outlets nationwide that combined generated more than $40 billion in loans, according to Community Financial Services of America, an industry trade group.
Payday loans usually are in the $100-to-$500 range for a period of about two weeks. To obtain a loan, the borrower gives the lender a post-dated check or debit authorization for the amount of the loan, plus a finance charge. The lender agrees not to deposit the check until the borrower's next payday.
On payday, a customer can redeem the check by paying the loan amount plus interest, or the lender can cash the check. Some borrowers may extend the loan by paying only the finance charge and writing a new check.
A well-managed payday advance operation can be profitable. That is because micro-lenders typically charge finance fees that translate into annual percentage rates of 100% or more.
The largest payday lender, Advance America, Cash Advance Centers Inc., reported net income of $68.8 million at year-end 2004. As of Sept. 30, 2004, the Spartanburg, S.C.-based company operated 2,290 payday cash advance centers in 34 states.
Another publicly traded payday lender, Kansas City, Kan.-based QCHoldings Inc., reported net income of $4.5 million for the three months ended Sept. 30, 2004, and $13.6 million for the nine months ended Sept. 30. As of Sept. 30, QCHoldings operated 322 stores in about 21 states.
Fees play a major role in a payday lender's profits. QCHoldings says fees accounted for 89.6% of revenues in the nine months ended Sept. 30, up from 86.4% a year earlier. The average payday loan fee increased 6.7%.
So it should be no surprise that a card issuer in search of new revenue sources would cast an eye toward the payday lending industry. Thus far, CompuCredit appears to be the only major issuer entering the payday lending market. But there is a long, and often sordid, history of banks working with payday lenders.
Ironically, it is the fees that make payday loans so profitable that have prompted regulators and lawmakers to crack down on the industry. One of the most frequent rates charged by payday lenders-$25 per $100 for a two-week period-translates into a 650% rate, according to the Consumer Federation of America. That is well beyond the top limit set by states' usury laws.
As of March 2004, 15 states prohibited payday lending through usury or loan laws, and a growing number of states prohibit retailers from brokering loans for out-of-state banks.
Payday lenders work under two models. In states with laws enabling micro-lending, the lender makes payday cash advances directly to the consumer. Under that model, the lender typically determines the terms of the loan agreement in accordance with state and federal laws. The lender uses operating cash or its revolving credit facility to fund the loans. The lender typically receives 100% of the revenue but also is responsible for all losses.
As of March 2004, 33 states and the District of Columbia authorized payday loans by law or regulation, according to the Consumer Federation of America. Two additional states have no usury limits for small loans by licensed lenders.
About 75% of CompuCredit's payday loan business is done under the state model, and CompuCredit will rely on that model for organic growth, Richard Gilbert, vice chairman and chief operating officer, said in November during a conference call discussing the issuer's third-quarter results.
In the second model, in states where there is no enabling legislation, payday lenders must form partnerships with financial institutions. The bank typically establishes the underwriting criteria and decides whether to approve the loan. The bank also sets all the terms of the loan agreement in accordance with state and federal laws and Federal Deposit Insurance Corp. guidelines.
Critics say that under the state model, payday loan operations are simply "renting" bank charters to front for loans that would violate state law if made directly by the payday lenders.
Regulators also were alarmed by banks' involvement in payday loans, saying the loans expose national banks and thrifts to unacceptable safety and soundness risk and undermine consumer protections. Over the past two years, the U.S. Office of the Comptroller of the Currency signed consent orders that halted payday lending activity with third parties by federally chartered banks.
In one case, the OCC ordered Paris, Texas-based Peoples National Bank to terminate its payday loan arrangement with Advance America because of safety and soundness concerns. The OCC alleged that Peoples failed to ensure that the payday lender, which held itself out as agent for the bank, complied with federal consumer-protection laws and regulations.
The OCC said the bank, through Advance America, routinely failed to make disclosures required under the Truth-in-Lending Act by failing to verbally disclose the annual interest rate, and repeatedly violated the disclosure and record-keeping requirements of the Equal Credit Opportunity Act. The OCC also found that as of October 2001, 60% or more of assets were delinquent payday loans, yet the bank failed to classify the loans as substandard.
The FDIC also has clamped down on payday lenders. In February it ordered Cash Now Corp. of Fort Lauderdale, Fla., to stop advertising that its FDIC banking services program can set up payday lenders as a branch of an FDIC-chartered bank. The FDIC does not issue charters, and payday lenders cannot become bank branches, an FDIC spokesperson says.
Cash Now's Web site also states that the payday lender would assume no risk for defaulted loans and could set its own underwriting standards. That position violates the FDIC's guidance, the FDIC spokesperson says. That means a bank that "hooked up with Cash Now or a Cash Now client" must come into compliance with the FDIC guidance" or face "appropriate action" from the FDIC, he says. The FDIC has not determined which banks are working with Cash Now.
Bank partnerships with micro-lenders also have come under fire at the state level. In a recent case, New York Attorney General Eliot Spitzer charged that payday lenders NetCash and Telecash rented the name of County Bank of Rehoboth Beach, Del., so they could operate in New York.
"We take the position that it's Telecash and Cashnet that are providing the loans," says a spokesperson for the attorney general. "It's Cashnet and Telecash that carry the loans, do all of the paperwork associated with the loans, and they are the true companies engaging in payday lending."
CompuCredit downplays the risk inherent in the payday loan business. "Our view there is our bank partner has been through Federal Deposit Insurance Corp. reviews and is explicitly following the FDIC guidelines on micro-lending," Putnam says.
"We've done a lot of due diligence in this area," he adds. "We're very aware of the regulatory risk and the perception that's out there. The reality is that over 90% of the people who use this source really like it."
The consumers using payday lenders "couldn't go to another traditional financial institution and get a short-term $300 loan," Putnam says. "If they bounce a check, if they have their utilities cut off, that is far more expensive than paying a fee to get a $300 loan."
CompuCredit also believes it can handle the credit risk posed by payday lending operations.
Payday lenders typically check for proof of employment and hold consumers' post-dated checks as collateral for loans, a practice that should keep chargeoff rates manageable, proponents say. "We know (the consumer has) a job, obviously," Putnam says. "You're lending to somebody who has a stable income. (The chargeoff rate) is not really that high."
However, Advance America reported that about 79% of customer checks deposited by Advance America's stores were returned unpaid because of non-sufficient funds or because of closed accounts or stop-payment orders. In 2003, Advance America deposited about 4.4% of all customer checks it received. In the remainder of the cases, the borrowers came in to pay off the loan and redeem their checks.
Total chargeoffs, net of recoveries, for the nine months ended Sept. 30, 2004, and the year ended Dec. 31, 2003, were approximately $54.7 million and $60 million respectively.
At QCHoldings, losses totaled $7.8 million for the three months ended Sept. 30. On an annual basis, QCHoldings expects losses of between 20% and 22% of revenues.
But during a conference call on third-quarter results, QCHoldings Chief Financial Officer Douglas Nickerson said when losses are calculated as a percentage of volume, the company's loss rates are "fairly competitive, if not a little better" than those of other consumer-finance firms. "A lot of people... are very surprised to find that between 2% and 4% of volume is where our losses end up being," he said.
In contrast, CompuCredit reported a chargeoff rate of 13% of receivables for the third quarter.
It is too early to tell whether CompuCredit will be able to wend its way through the perilous world of payday lending. But it's certain that many credit card issuers,especially subprime issuers, will be watching closely.
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