In this post, we profile the payday lending industry. We discuss how payday lenders make money and the regulatory landscapes that have evolved in Canada, the United States and Australia. This discussion is meant to be read in conjunction with our posts on CSF and AUC.
Payday loans are small-value short-term, unsecured personal loans to borrowers requiring short-term funds until their next payday. Neither assets nor credit ratings are taken into account when determining a borrower's creditworthiness. The borrower must have a job, a bank account, picture identification, a permanent address, and several references. A recent bank statement, pay stub, and proof of address (such as a current utility bill) are required as verification. Normally, upwards of 33-50% of the person's paycheck is loaned for up to 15 days. The borrower writes a post-dated check for the repayment of the loan. The lender / broker will charge a fee, or several fees, for making the loan, as well as interest that the loan will accrue. Annualized interest rates can exceed 500%, but because much of that "interest rate" comes in the form of a $20 or so fee for each $100 borrowed (keep in mind that these are typically 2-week loans), many borrowers don't view that they're paying 500% interest rates on their loans.
Payday locations can be open seven days a week, with longer hours of operations than typically provided by banks. Loans can be approved relatively quickly, in 30 minutes to 45 minutes in many cases. The level of convenience offered by payday lenders is one of their competitive advantages over traditional banks, and many payday borrowers cite ease and convenience as their main reason for taking out payday loans.
If the borrower cannot repay the loan on time, the payday lender works with the borrower to work out a repayment schedule. Typically, if the loan is not repaid within 90 days, the lender sends the outstanding loan to a collection agency.
Payday lenders also provide ancillary services, like check cashing services, Western Union money transfers, title loans (whereby loans secured by the asset value of customers' cars are issued for terms up to one year), etc.
Some payday lenders lend their own capital, while others act as brokers for 3rd party lenders. To some extent, the brokers take capital risk because they typically make extra payments to their 3rd party lenders to compensate lenders for high default rates. CSF, for instance, makes "retention" payments to its lenders to help 3rd party lenders (like Assistive Financial Corp.) hit their target 20%+ rates of return. The broker model is mainly used to bypass older regulations that cap interest rates but don't include fees in interest calculations.
Consumer advocates argue that companies like CSF are predatory lenders who are incentivized to drive low-income, financially unsophisticated borrowers into vicious debt cycles. They're correct. It's less clear that payday lending should be banned. The compelling arguments for keeping payday lending legalized, despite its obviously unsavory features, typically centers around the belief that banning it would make society even worse off, in the form of: fostering criminal loan-shark mafias; cutting off the last form of capital available to individuals with poor credit histories; shifting payday borrowing from regulated storefront lenders to unregulated internet lenders; punishing borrowers who use payday lending responsibly for the sins of those who engage in payday loans irresponsibly; and subjecting low-income, financially unsophisticated consumers to even higher annualized interest rates due to bank overdraft fees, late fees on utilities, etc.
As I mention in my AUC writeup, I'm going to refrain from casting my own moral judgment on the issue. The legalization of payday lending faces many of the same dilemmas as the legalization of marijuana, prostitution, alcohol and cigarettes. But regardless of whether one views payday lending as right or wrong, there are two rational government legislative responses to the practice: ban it or regulate it. Governments in both Canada and the United States have come to the conclusion that an unregulated payday lending environment is not a viable scenario.
In this chart, I've shown how each 50 states in the U.S., and 7 Canadian provinces have chosen to regulate payday lending.
In Canada, the federal government transferred legislative jurisdiction over payday loans to the provinces in 2007. In the following two years, most provinces held public hearings; commissioned studies; and otherwise debated how best to regulate the industry. Their conclusions, by and large, were favorable to companies like CSF. Their rate caps were as follows:
Alberta: $23 of fees per $100 of loans (598% APR)
British Columbia: $23 of fees per $100 of loans (598% APR)
Manitoba: $17 of fees per $100 of loans (442% APR)
Nova Scotia: $31 of fees per $100 of loans (806% APR)
Saskatchewan: $23 of fees per $100 of loans (598% APR)
In many cases, the maximum permitted fees are higher than what leading payday lenders like Money Mart and Cash Store Financial were charging prior the rate caps. As well, regulations have generally prohibited rollover loans; have mandated a 1- or 2-day window whereby borrowers can change their minds; have limited companies' abilities to harass borrowers during their collection efforts; have mandated province-wide databases to track payday borrowers and prevent lenders from lending to a borrower who is simply rolling a payday loan at one lender to a new loan at another; and have implemented other regulations to protect consumers and prevent abuses by lenders.
The only province where payday lending is effectively prohibited is Quebec, where a longstanding usury law caps all loans to 35% APR, far lower than the 500%+ APR in most other provinces. At 35% annual rates, payday lendors' all-in interest rates don't compensate them for the higher default rates amongst payday borrowers.
In the United States, the legislative landscape varies widely by state, and continues to evolve on a state-by-state basis. Fifteen states have effectively banned payday lending. States like New York, New Jersey, and Connecticut have long prohibited payday lending by maintaining maximum all-in interest rates of 30% to 40%. Other states, like Georgia or Oregon, have banned payday lending more recently, implementing legislation in the past 5 years that have brought rates down to New York or Connecticut levels. In these states, incumbent payday lenders have closed stores and exited the states. In other states like Nevada or Utah, payday lenders can charge as much as they'd like, unrestricted by any regulation or interest rate caps whatsoever.
As a general rule, Canada has adopted a legalize-and-regulate approach, whereas the United States has followed a more unpredictable trend of legalizing the practice in some states and banning it in others.
Why have Canada and the U.S. followed such different paths to regulation? Here are a few reasons:
1. The Canadian payday lenders created an industry group in the mid-2000s to try to self-regulate the industry and take a more cooperative, proactive stance towards regulation, rather than the reactive stance taken by the U.S. payday lenders. The group required members to abide by a code of conduct: see http://www.cpla-acps.ca/english/consumercode.php. Money Mart and Cash Store Financial, two of the dominant players in Canada, spearheaded efforts to end rollovers, cap default interest rates, allow borrowers to change their mind for 24 hours, require appropriate disclosure, etc. These measures hurt profitability in the short-term (CSF saw a decline in revenue and profitability in 2007 as a result of ending rollovers), but helped develop a cooperative relationship with legislators. In the United States, dissension within the ranks in the industry, and the difficulty of coordinating common policies across the nation's numerous lenders, prevented a similar coordinated response from developing in the US.
2. The anti-payday loan lobby is stronger in the US than Canada. Payday lending acts as competition to banks and subprime lenders, and the banking lobby has funded some of the anti-payday loan lobbying efforts in the US. The most powerful anti-payday lobbyist group in the U.S. is the Center for Responsible Lending, which was founded by Herb and Marion Sandler, the founders of Golden West Financial, one of California's most egregious subprime lenders (Golden West was bought by Wachovia prior to the credit crunch, and was the source of much of the bad loans which rendered Wachovia basically insolvent). Other groups that want to see payday lending banned have also traditionally been stronger in the United States than in Canada.
3. Canadian regulatory reform followed a more orderly process than in the United States, and therefore resulted in less politicized and more studies-oriented legislative deliberations. In Canada, the federal government initially drafted broad legislation legalizing payday lending in 2007, and then told provinces to come up with the particulars. As a result, the provinces adopted a common timeline in debating and drafting payday legislation, spending much of 2007 to 2009 deciding on rate caps and the most appropriate regulatory framework for monitoring the practice. In the U.S., the regulatory landscaped has evolved in a more arbitrary manner. Some states enacted legislation in 2003; others in 2007; others are waiting until 2012. There is less cooperation amongst states in sharing research, studies, etc. As well, Canada is a smaller country with 12 provinces, while the Unites States is a much larger country with 50 states. The political spectrum is narrower in Canada than in the United States, and provincial regulations tend to be more similar across provinces than in the United States. These factors have all helped make Canadian regulatory reform a much more deliberative, dispassionate process than American regulatory reform.
4. Canadians tend to be more tolerant of individual transgressions and less moralistic than the American populace. As we discussed above, payday lending faces many of the same moral dilemmas as prostitution, drugs, alcohol, etc. Canada's more liberal approach towards legalizing individual sins (a prime example is the decriminalization of marijuana) has led it to take a less moralistic, and more research-focused, approach to the issue of legalizing payday lending.
An additional note to keep in mind is that regulatory outcomes with respect to payday lending are often binary. Few states have 200% APRs. Payday lending is either tolerated, and lenders are allowed to charge 350%+ annualized rates, or payday lending is banned, limiting annual rates to under 50%. Therein lies the risk for any payday lender operating in an environment where the regulatory environment remains unresolved, like AUC in Australia. Conceivably, payday lending could be effectively banned, and the entire business model of a payday lender can be deemed unviable.
That said, the Australian demographics, government and regulatory environment is far more similar to Canada than the United States. Australia has a more liberal demographic than the U.S. It's a smaller country with fewer provinces / states. AUC is spearheading an industry group that is establishing a code of conduct aimed at self-regulating the industry and at taking a proactive approach towards regulation. The Federal government is taking a more active initial role in regulatory reform than was the case in the United States.
For our purposes of analyzing AUC, i's key to determine how penetrated the Australian market is. One way to do that is by comparing payday stores per capita in Australia versus Canada, the U.K. and the United States. CSF management estimates stores per capita in the four countries to be:
USA: 10,000 residents per store
Canada: 25,000 residents per store
UK: 50,000 residents per store
Australia: 75,000 residents per store
The population demographics of Australia are fairly similar to Canada. As a result, the Australian payday loan market appears quite underpenetrated. With AUC already as the leading payday lender with 44 stores, and no major competitor trying to develop a dominant national footprint, the growth opportunity seems exceptional. AUC provides a good background on the Australian competitive landscape on page 11 and 12 of Exhibit B of its original going-public proxy.
Now, let's provide a bit of commentary on the historical development of the payday lending sector in the United States and Canada. Payday lending developed into a real subsector of the financial services industry in the 1990s, initially in the United States. Growth in payday lenders was rapid, as many companies initially benefited from the same high returns on capital that CSF experienced in Canada. Consumer demand was abundant for the product, whether because payday lenders were luring unsuspecting borrowers into cycles of debt as consumer advocates claim or because subprime borrowers viewed payday lending as a better alternative to overdraft and late fees as the industry claims.
By 2005, there were 7 publicly traded payday lenders in the United States, comprised of 4 pure play pay day lenders and 3 hybrid payday lender / pawnshops. The three largest U.S.-listed companies were Advance America, with 2,600 stores; Ace Cash Express, with 1,400 stores; and Dollar Financial, with 1,300 stores.
Then, in the mid 2000s, the twin forces of regulation and competition began to undermine the industry. Over the past few years, virtually all American payday lenders have been reducing stores as opposed to opening new ones, primarily in response to new legislation, or potential adverse legislative changes on the horizon.
In Canada, given the more promising regulatory environment, the sector has continued to grow. Both Money Mart and Cash Store Financial are aggressively expanding their store base, and certain American companies have announced intentions to expand into Canada.
In both Canada and the United States, there have been numerous class action lawsuits prior to legislation. Essentially, both countries had vague usury legislation that ostensibly prevented lenders from charging interest rates above a certain amount. Payday lenders attempted to bypass these laws in certain ways that exploited the unclear manner in which the laws were written. For instance, in Canada, CSF argued that it was merely acting as a broker of loans and receiving a simple fee for matching lenders and borrowers. The lenders were the parties charging the interest rates, and their rates were under the legal caps. However, when one blended the 3rd party lenders' rates and CSF's fees, one achieved the 500%+ APRs that consumer advocates argue is usurious. For the most part, the lawsuits resulted in modest settlements that were fairly negligible to the companies' bottom lines, and acted as a backdrop to the more important legislative decisions being made in state parliaments and senates. In Australia, the lawsuits have yet to begin, but it's reasonable to expect them to hit the tape in the not so distant future.
THIS COMMUNICATION IS FOR INFORMATIONAL AND EDUCATIONAL PURPOSES ONLY AND SHALL NOT BE CONSTRUED TO CONSTITUTE INVESTMENT ADVICE. NOTHING CONTAINED HEREIN SHALL CONSTITUTE A SOLICITATION, RECOMMENDATION OR ENDORSEMENT TO BUY OR SELL ANY SECURITY OR OTHER FINANCIAL INSTRUMENT OR TO BUY ANY INTERESTS IN ANY INVESTMENT FUNDS OR OTHER ACCOUNTS. THE AUTHOR HAS NO OBLIGATION TO UPDATE THE INFORMATION CONTAINED HEREIN AND MAY MAKE INVESTMENT DECISIONS THAT ARE INCONSISTENT WITH THE VIEWS EXPRESSED IN THIS COMMUNICATION. THE AUTHOR MAKES NO REPRESENTATIONS OR WARRANTIES AS TO THE ACCURACY, COMPLETENESS OR TIMELINESS OF THE INFORMATION, TEXT, GRAPHICS OR OTHER ITEMS CONTAINED IN THIS COMMUNICATION. KERRISDALE CAPITAL MANAGEMENT, LLC OR AFFILIATED ENTITIES MAY OWN SECURITIES OF OR OTHERWISE HAVE AN INVESTMENT RELATED TO ANY COMPANIES MENTIONED IN THIS COMMUNICATION. THE SENDER EXPRESSLY DISCLAIMS ALL LIABILITY FOR ERRORS OR OMISSIONS IN, OR THE MISUSE OR MISINTERPRETATION OF, ANY INFORMATION CONTAINED IN THIS COMMUNICATION.