Watch Out! Governments Are Cracking Down on This Banking Niche

Making loans is generally the province of banks, but there's a growing niche in providing loans outside of banks—and governments around the world don't like it.

Apr 10, 2014 at 7:24AM

If you have a bank account, you've probably never heard of a pay day loan. But, there are millions of people without bank accounts that use these loans all the time. Although companies like Cash America International (NYSE:CSH) and EZCORP (NASDAQ:EZPW) are generally upstanding citizens, there are so many unscrupulous players, that governments around the world are coming down hard on this industry. There's a big opportunity in serving the underbanked, but you should probably stay away from pay day lenders until the smoke clears.

Where the growth has been
Cash America and EZCorp are pawnbrokers. They make loans based on physical collateral like jewelry and musical instruments. The loan is always for less than the value of the collateral, so the pawn shop can make a profit on the loan even if it doesn't get repaid. And because customers who use pawn loans generally can't get a loan from a bank, rates are relatively high for those loans that do get repaid.

Thumb

(Source: Public domain, via Wikimedia Commons).

It's a pretty interesting niche in the underbanked segment. However, Cash America and EZCORP have been growing more quickly in the payday and unsecured loan area. In this space, loans are provided based on future earnings -- or nothing more than a customers word that he or she will repay. That increasingly includes loans made over the Internet -- such online lending makes up over 40% of Cash America's business and about 20% at EZCORP. Pawnbrokers have been around for centuries, but online lending didn't exist before the Internet.

Exploiting a new industry opportunity is great, but the problem here is that the U.S. government is increasingly cracking down on such loans. New rules, however, don't seem to be enough. Tom Feltner, director of financial services at the Consumer Federation of America, recently told The New York Times, "We have seen in a number of states considerable creativity on behalf of lenders in exploiting definitional weaknesses in existing payday consumer protections." The United Kingdom has also signaled that it's looking at the space more closely. In other words, more regulation is on the way.

Steering clear
That makes payday lending a risky endeavor, even for upstanding lenders. That's why investing in the underbanked theme is probably better achieved through other means. For example, First Cash Financial Services (NASDAQ:FCFS) is a pawnbroker, but over 90% of its revenue comes from traditional pawn operations. In fact it's specifically exiting the payday area.

Payday

(Source: Gregory F. Maxwell, via Wikimedia Commons).

It has 311 domestic locations and nearly 600 in Mexico. Look for the company's future growth to be driven by its south of the border operations, where it estimates the underbanked make up as much as 70% of the population.

But you don't need to go that far afield to invest in the underbank niche. For example, Green Dot (NYSE:GDOT) allows people to buy pre-paid credit cards that can be replenished with cash. However, its customers can also have their paychecks or government support checks sent directly to their Green Dot card. Those are clearly bank-like services.

It also has a deal with Wal-Mart (NYSE:WMT) that allows Green Dot customers to bring in physical checks to be cashed and deposited to their cards. Green Dot gets paid for this and so does Wal-Mart for cashing a physical check. This is a perfect marriage of convenience and opportunity for both Wal-Mart and Green Dot, and, so long as the fees don't bother you, Green Dot could easily replace a traditional banking relationship.

Collateral damage
There are times when just being associated with the wrong type of business is enough to tank a company's stock. With the heat being put on payday lenders, Cash America and EZCORP could easily get thrown out with the bathwater. Look instead at companies like Green Dot and First Cash if you want to invest in the underbanked arena.

This isn't the only way the banking industry is changing today
There's a brand-new company that's revolutionizing banking, and is poised to kill the hated traditional brick-and-mortar banks. That's bad for them, but great for investors. And amazingly, despite its rapid growth, this company is still flying under the radar of Wall Street. To learn about about this company, click here to access our new special free report.

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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