1 Pawnbroker without the Cash Advance Risk

A loan can be hard to get when you don't have a banking relationship, which is where pawn shops come in—but there are hidden risks you should be aware of before you get into this finance niche.

Mar 6, 2014 at 3:08PM

Pawn
Source: Flickr / Taber Andrew Bain.

If you believe everything you see in the movies, you know that you go to a pawnshop if you want to sell stolen goods—right? That can happen, but it's really not the way it works. Pawn shops offer people with poor credit the ability to get loans that banks would never offer. And that's the good and the bad of this growing industry.

What's a pawnbroker do?
Traditionally, a pawnbroker provides secured loans. A customer brings in an item of value, such as jewelry, and the broker provides a loan while keeping the jewelry as collateral. Ideally, the customer pays back the loan with interest and gets the jewelry back. If the loan isn't paid, the pawnbroker gets to sell the collateral.

The loans are for less than the full value of the collateral so there's profit to be made when loans go bad. And since banks generally won't lend to the typical pawnbroker customer, pawn shops can charge relatively high interest rates on their loans. That's a win/win situation, at least for the pawn shop.

First Cash Financial Services' (NASDAQ:FCFS) business is pretty close to this model, with over 90% of its revenues coming from traditional pawn operations. The company's growth has been through the expansion of its footprint. It has 311 U.S. locations and nearly 600 stores in Mexico. While it sees opportunity to grow in the United States where it pegs the "under banked" at 30% of the population, it believes Mexico's "under banked" demographic is much higher at 70%. Clearly, Mexico is a key growth market, with further expansion options in other Central and South American markets down the line.

Reaching further into their pockets
The less than 10% of First Cash's business that isn't pawn related is made up of cash advance loans or payday loans. These are loans made to a customer based only a check they have in their hands. The fee for these types of loans can be very high, making the business highly profitable. That's why Cash America International (NYSE:CSH) and EZCorp (NASDAQ:EZPW) are both in that business as well as pawn lending. However, First Cash is shrinking that operation -- which may make it a less risky pawn play.

In fact, Cash America and EZCorp have taken their loans even further, using the Internet to provide small loans on nothing more than a customer's word that he or she will pay up. Such online lending makes up over 40% of Cash America's business and about 20% at EZCorp.

The problem with payday loans and Internet loans is regulation. Although Cash America and EZCorp may be standup citizens when it comes to unsecured loans, they aren't the entire industry. For example, New York went after over 30 online lenders to stop them from charging interest rates above the state's cap of 16%. Worse, some payday lenders charge what amounts to a 400% interest rate if the charge for a typical two week loan is annualized!

What's usury
The term "usury" means to make unethical loans. It isn't hard to see where a 400% interest rate might raise the ire of regulators, even if customers are happy to partake. Already facing a backlash, payday and Internet lending is a huge regulatory risk. Cash America (with 40% of its business tied to online lending) would be devastated if new rules suddenly made that segment a much less profitable business. EZCorp would be less exposed, but its targeting to grow that very segment to 25% of its operation.

Only First Cash is going the other way. While that may mean growth won't look as impressive, it makes the pawnbroker a much less risky way to invest in loans to the under banked population here and in our southern neighbor.

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Reuben Brewer has no position in any stocks mentioned. The Motley Fool has no position in any of the stocks mentioned. 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.

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