Payday lending is illegal in 15 U.S. states. But thanks to the Internet, almost anyone can get a high-interest consumer loan, even if it's illegal in the state in which they reside. Fly-by-night operators make it so.
The Department of Justice isn't happy with nonbank lenders skirting state laws. So, what will it do to kill the trend? It's going after the banks -- not the payday loan companies.
"Operation Choke Point"
Banks are ultimately the enablers of all commerce, legal and illegal. The banks that house accounts for payday loan operators are the subject of a new lawsuit from the Department of Commerce for their "involvement" in predatory lending.
This isn't the first warning sign from federal regulators. The FDIC warned banks to reevaluate their relationship with high-interest lenders. The Comptroller of Currency suggests it has regulatory authority to oversee bank's relationships with nonbank financiers.
As investors, there are several issues worth watching. First, this is a clear sign that legal issues in banking are only getting bigger. If a bank can be sued for simply processing payments on behalf of a payday lender, it's obvious that there's really no end to what a bank can be sued for. An article in The Wall Street Journal goes so far as to say banks could be on the hook for customers who pay for work-at-home programs that don't lead to jobs. Really?
Secondly, banks should be really careful about their connection to consumer loan companies. Some have a clear financial interest. Prospect Capital (NASDAQ:PSEC), a business development company, owns an umbrella of consumer-lending companies. It finances part of its loan books with low-interest "wholesale" credit lines from Bank of America (NYSE:BAC) and Wells Fargo (NYSE:WFC)
Wells Fargo and Bank of America might not issue loans with 80% annual interest rates like Prospect Capital's First Tower company does, but they have a clear financial interest in its success, seeing as loans provided by First Tower are, in part, financed from a Wells Fargo and Bank of America credit line. Is that lawsuit-worthy? It's tough to say, but there is a much clearer connection between bank and nonbank when the bank is funding the subprime lender.
Regulatory risk is bubbling
Recent headlines in consumer lending follow a change in the regulatory environment. Recently, subprime auto financier Santander Consumer USA Holdings went public. General Electric has a plan to spin off its consumer-credit business. Prospect Capital agreed to buy another subprime auto financier, Nicholas Financial, at a paltry multiple of just 10 times earnings. AIG's former subprime darling, Springleaf Financial, is now a publicly traded company with its own ticker.
All of the above happened in just the last few months.
Consumer lenders are changing hands more frequently. Sure, the economy is doing well; loan losses are much lower than their recessionary levels, and valuation multiples are higher now than in the past. That makes for a perfect storm for a highly priced IPO. But there has to be something more compelling -- perhaps regulatory risk that makes selling a highly profitable consumer loan segment more attractive now than in recent history.
There's more to the success of consumer lending spinoffs and IPOs than meets the eye. There's regulatory risk, which is seemingly growing bigger, day after day, week after week. If there's a clear trend in play for 2014, its the division of big banking from controversial, borderline predatory lending.
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Fool contributor Jordan Wathen has no position in any stocks mentioned. The Motley Fool recommends Bank of America and Wells Fargo. The Motley Fool owns shares of Bank of America, General Electric Company, and Wells Fargo. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.