There is an interesting dynamic in Japan between consumer lenders operated by Acom, Aiful, Promise, Takefuji, General Electric (NYSE: GE), and Citigroup (NYSE: C) and the banks Mitsubishi UFJ Financial Group (NYSE: MTU), Mizuho Financial Group (NYSE: MFG), and Sumitomo Mitsui Financial Group.
The banks were very busy for more than 10 years cleaning up their balance sheets and didn't focus on the consumer lending market. Meanwhile, the consumer lenders issued bonds and took out loans at relatively low interest rates and serviced the consumer market. Because of what was known as a gray area in Japan's lending laws, the consumer lenders were able to charge an interest rate of up to 29.2% in some cases, provided the consumer was aware and received documentation of exactly what they were agreeing to pay. Not surprisingly, the consumer lenders were very profitable for a time, but this appears set to change because the banks are now stronger than they have been in more than a decade, interest rates are rising, and the laws surrounding maximum interest rates have changed.
The item getting the most media coverage lately is the lowering of the maximum interest rate that can be charged to borrowers to 20% . There are some fine points to the original law, but along with the lower maximum rate, companies must recognize interest charges above the maximum threshold in their financial statements that they need to repay to borrowers if the loan agreement and receipts of payment did not clearly spell out what the customer was being charged. In this case, that means the interest rate, the total amount to be paid over the life of the loan, and any receipts of payments must clearly specify what is being paid toward principal and interest. In many cases, contracts did not contain all of the data, and that is leading to a lot of loan writedowns and charges for repayment of interest.
That's a big hit for these companies, and it comes at a time when they're dealing with a couple of other factors. The first is that the banks now have stronger balance sheets than they have had in more than a decade, and they are interested in getting into the profitable consumer lending business, and the banks have an advantage in their access to cheap funds in the form of deposits. The other factor in play is that interest rates in Japan are slowly beginning to rise, which also increases the cost of funding for the consumer lenders.
All these events happening together not only affect the profitability of the consumer lenders now, but also put a dent in their competitive position going forward. Some of the consumer lenders such as Promise and Acom are slightly ahead of the curve and partnered with banks. The partnering is attractive to the banks, because the consumer lenders have a history of handling small consumer loans and evaluating creditworthiness of consumers. It is not as profitable as doing loans at rates above 20% interest, but it does allow the partners to evaluate loans and decide which party will write the loan, with the riskier business generally falling to the consumer lenders.
Some of the consumer lenders have also become credit card issuers. In the end, this may allow the strong operators to prosper, and if all goes well have a part of their business become like Capital One (NYSE: COF) and a part of it be expert in evaluating loans for banks. The consumer lenders that have aligned themselves with banks -- or in the case of GE and Citigroup's operations, have access to cheap funds -- and have moved toward cards are probably in the best position to survive, though they are ultimately less profitable then they have been in recent memory. Depending on the valuations these companies are assigned the next couple of years and how they execute, this could create some intriguing opportunities.
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At the time of publication, Nathan Parmelee had no financial position in any of the companies mentioned. He is ranked 43rd out of 20,585 players in Motley Fool CAPS.
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