Spitzer Helps Loan Sharks

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While following the ongoing New York Attorney General Office investigation of the insurance industry, I noticed something interesting: Eliot Spitzer's office shut down a Nevada-based company that had been making payday loans to New Yorkers charging upwards of 400% interest, its third such action in the past year.

The laws in question here have to do with "usury," or making loans with exorbitant rates of interest. In the case of Cashback Payday Loans, customers agreed to pay what amounted to interest rates exceeding 400% per year. In other words, if you were to borrow $1 from Cashback on Jan. 1 and repay it at the end of the year, you would roughly owe the company $5. According to the State of New York, such rates of interest are usurious, so the state in its infinite wisdom placed a cap on the interest rate such companies can charge at 16%.

The intrepid among you will immediately recognize that 16% annual interest is well below what most credit card companies charge. Why isn't this an issue in New York? Maybe because payday loan companies have a tawdrier reputation and are easier marks for the crusading Mr. Spitzer.

While it may seem to be a really good idea to limit the amount of interest a company can charge borrowers, it completely misses the point of charging interest in the first place. Payday loan companies lend money to consumers who have almost no assets. If they weren't so hard up for cash, they wouldn't be borrowing against their next paychecks. They tend to have awful credit, be deeply in debt, and are among the worst credit risks imaginable. And yet New York says that the highest rate of interest they may be charged is below that of many credit cards.

Payday loans are big business -- there are four rather sizable publicly traded pawn and payday loan companies: Cash America International (NYSE: CSH), First Cash (Nasdaq: FCFS), EZCorp (Nasdaq: EZPW), and Ace Cash Express (Nasdaq: AACE). My colleague Lawrence Meyers recently wrote an excellent article describing the economics of the business, and notes that most states have statutory ceilings on interest rates. No state listed has a rate lower than New York's.

Not coincidentally, none of these reputable companies has any operations in the state of New York. That's because what ought to be a market defined by competition in the state is hamstrung by limits on interest rates that make it impossible for the owners of this capital to adequately protect themselves from the risk of default, which is extraordinarily high in this particular market segment. Lend out cash to a class of lender with 50%-plus default rates charging only 16%? That's not business, that's charity. State mandated charity. Leave the market alone, and competition will define the interest rate. It's not like there is some special branding cache among payday lenders -- one charges too much interest and borrowers will take their business elsewhere.

So what happens? Do these borrowers simply walk into their nearest banks and get loans there? No -- most of them would be laughed out of the building; banks aren't in the business of making high-risk, uncollateralized loans to people who lack assets. And their need for cash doesn't disappear, either. The market exists. And where it exists is underground. If companies aren't allowed to legally meet their costs of capital by law, laws will be broken. For every Cashback Payday Loans that charges interest rates 20 times the legal limit, there are certainly dozens of illegal, unregulated black market payday lenders, whose terms of repayment and collection may be substantially more Draconian than those employed by the EZCorps of the world.

That's the way I see it, if you're so broke that you need to take out a payday loan, you're going to pay an enormous level of interest to compensate your lender for the risk that you'll default. State limitations on this natural relationship show a blithe oblivion to the time value of money and the notion of risk capital. Sure, Cashback broke the law, but don't you think that it built in the fact it was taking such a risk into the rates charged, sending them even higher?

See also:

• Seth Jayson's "First Cash Bash"
• Bill Mann's "Not So EZ"

Bill Mann owns none of the companies mentioned in this column. He dearly loves the business models of pawnbroking and debt collection, though he hopes never to come across either.