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Pay Cut for Payday Lenders?

On March 3, the FDIC blitzkrieged the payday lending industry by introducing new guidelines governing how these lending services are provided. The entire sector -- which includes such companies as First Cash Financial Services (Nasdaq: FCFS  ) , ACE Cash Express (Nasdaq: AACE  ) , Cash America International (NYSE: CSH  ) , EZ Corporation (Nasdaq: EZPW  ) , Dollar Financial Corporation (Nasdaq: DLLR  ) , QC Holdings (Nasdaq: QCCO  ) , and Advance America (NYSE: AEA  ) -- sold off 15% in response. Before I continue, you might want to check out some earlier articles on this industry, so you can get a feel for how the business works and see why I am very high on payday lenders and pawnbrokers.

So why the panic? Here's the deal: Payday lenders work under one of two types of regulations. Individual states determine which regulatory model will apply to lenders operating within their boundaries. The first model is state law, under which the lenders are subject to whatever rules the state has imposed on them. These rules are usually far less restrictive than those of the second option, the bank model, in which FDIC-chartered banks provide the payday lenders with money to fund their loans. Despite their name, "payday lenders" aren't always allowed to make loans in bank-model states -- they act more as conduits for the banks, which ultimately make (and own) the loans. But ironically, these banks may subsequently sell these loans to the payday lenders, along with the loans' servicing rights, collections rights, and advertising rights, and the ability to solicit applications.

The FDIC became concerned that these arrangements, when not properly managed, significantly increase the banks' transaction, legal, and reputation risks. That concerns the FDIC because it doesn't want to be holding the bag if a chartered bank runs into a financial crisis. So it stepped in to rein in the payday loans, including:

  • Limiting the number and frequency of extensions, deferrals, renewals, and rewrites.
  • Prohibiting additional advances to finance unpaid interest and fees and simultaneous loans to the same customer.
  • Establishing waiting periods between the time a payday loan is repaid and another application is made.
  • Establishing the maximum number of loans per customer allowed in a year.
  • Limiting one outstanding payday loan per borrower per bank.
  • Ensuring that payday loans are not provided to customers who had payday loans outstanding at any lender for a total of three months during the previous 12 months.

That stuff is pretty darn restrictive, and that's one reason why payday lenders sold off. But hold the phone. All is not lost. These restrictions apply only to those lenders who operate under the bank model. How many of the above companies do? And of the ones that do, how much revenue exposure do they have?

Let's take Texas-based First Cash Financial Services, which I'm using because I own the company and I'm pretty concerned about how all this is going to play out. The only state where First Cash operates under the bank model is Texas. My first thought before running any numbers was whether there might be anything in Texas law that will either blunt the FDIC guidelines or make them irrelevant. The answer: Yes.

Texas State Rep. Dan Flynn introduced H.B. 846 in the Texas Legislature, which would change the current law requiring payday lenders to use the bank model and instead subject them to the less restrictive state law. If that happens, it would mean that the FDIC guidelines won't apply to First Cash's business in Texas.

The bill's chances look very good for a number of reasons. Several Democrats have co-authored and co-sponsored it. I called around to a few of the Texas lawmakers' offices, and the word is that House politicos think of it as a nonpartisan bill that will easily pass both houses. That would probably happen anyway, even if some Dems weren't aboard, because this is business-friendly legislation that the Republican-controlled legislature would pass and the Republican governor would sign.

"OK," some of you say, "First Cash appears to be in the clear with regard to its Texas business -- the only business that might be affected by this recent buzz. But what about all those other companies? How do I know whether any of their revenue is exposed to the FDIC guidelines?" Here's how:

  1. Choose your company of interest.
  2. Look at its 10-K. It should disclose the number of payday stores that it has and the states where its stores are located. From that, you can figure out how many stores are in states that use the bank model.
  3. Divide the number of bank-model payday stores by the total number of payday stores. Making a rough assumption that all stores generate about the same revenue, this number approximates the percentage of payday store revenue that's exposed to the FDIC guidelines. For First Cash, I estimate that 16% of revenues come from Texas, the only bank-model state in which it operates.
  4. Take that percentage, and multiply it by the latest full-fiscal-year revenue number to find the total revenue that will be affected.

Does that mean that all that revenue will be lost and therefore must be subtracted from the bottom line? Well, at this point, you can't tell. The FDIC is giving banks 45 days to come up with alternative products for customers whose payday loans have exceeded the restrictions. Maybe those products will have high interest rates as well. Maybe not. This is the other reason payday lenders sold off -- uncertainty. The market hates uncertainty. But remember, uncertainty can create opportunity.

"But Larry, don't leave me hanging! I'm invested in another payday lender! Tell me the answers!" Nope. That's your homework. In an upcoming article, I'll analyze the entire industry to find the top players, and I'll offer up the answers as to who is most vulnerable. (Hint: Most payday lenders are headquartered in Texas.)

There are two big lessons here, folks. First, all the information I just related is available to the general public. The FDIC guidelines and the text and status of H.B. 846 are online. So is the company's 10-K. Don't let the market shake you out of an investment; the information is there if you look for it.

The other lesson -- to toot the Fool's horn -- is that the mainstream press offered none of the analysis I just presented. There's news on the sell-off, and how the analysts "weighed in" with their opinion. That opinion, by the way, basically amounted to a repeat of the payday lenders' press releases that stated: "We don't know yet how these guidelines will affect us."

Bottom line? There's no reason to rely on the Wise. There's magic in doing your own research. And when bad news hits your stock, don't panic! At least not until you're sure there's reason to.

For related coverage, see:

Fool contributor Lawrence Meyers owns shares of First Cash Financial Services and is closely studying other payday lenders. But check his facts for yourself, or you may end up needing a short-term payday loan.

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