- CFPB rules will deliver major revenue cuts.
- Banks cutting off payday lender operations accounts.
- Limited remedies could kill the companies.
The news out of the payday lending sector is grim. Without warning, banks that hold depository, ACH, and operational accounts for payday lenders began telling those clients to take their business elsewhere.
Cash America International (NYSE:CSH), First Cash Financial Services (NASDAQ:FCFS), EZCORP (NASDAQ:EZPW), DFC Global (NASDAQ:DLLR), QC Holdings (NASDAQ:QCCO), and all privately-held companies are in a world of trouble.
Although no official reasons are being provided by the banks for this sudden change in policy, the action appears linked to the Department of Justice's ongoing Operation Choke Point, which is designed to kill the payday loan industry.
The problem is there is nowhere else for payday lenders to take their business. They engage in over 100 million consumer transactions annually, and only large banks like Bank of America (NYSE:BAC), Wells Fargo (NYSE:WFC), Fifth Third (FITD), and JP Morgan Chase (NYSE:JPM) can handle this volume and complexity. Without a banking relationship, a cash-intensive transactional business like payday lending cannot survive.
To make matters worse, the Consumer Financial Protection Bureau surprised the industry on March 25 by announcing it was in the late stages of its rulemaking process. The bureau held a hearing in Nashville and simultaneously released a paper excoriating the repeat usage of the product by consumers. Despite not having or presenting any evidence that such repeat usage definitively harmed consumers, the CFPB seems content to issue rules that will likely result in a significant revenue haircut for the industry.
The CFPB cannot institute rate caps. However, the bureau's focus on repeat usage suggests it will institute rules that severely restrict industry revenue. The most likely changes will be any or all of the following: limit the number of loans an individual may take out in a given time period; require a lengthy "cooling off" period between loans, perhaps as much as 30 days; require a 3 to 6 month repayment period. Any of these would materially impact industry revenue.
Yet CFPB action would appear to be moot if there is no payday lending business.
Operation Choke Point hit the industry in waves, beginning last year. The first wave consisted of the FDIC and OCC creating a de facto ban on banks providing "deposit advances" - their own version of payday loans. Particularly notable is that these loans were 33% to 50% cheaper than most storefront payday loans, and 66% to 75% cheaper than online loans. The act sent a chilling message: offering a vastly cheaper product means nothing. Clearly the federal government wants to kill consumer lending.
This became even more evident in Choke Point's second wave, when third-party payment processors were prohibited from handing online lending transactions. The ostensible legal reasoning was that certain lenders were making loans into states where such loans were prohibited by law. These lenders were either sovereign Indian tribes, operated offshore, or operated under "choice of law" models, in which the lender was located in a state without a usury cap such as Utah, and the consumer agreed that Utah law was how their transaction was governed. With ACH processing now cut off, there could be no transactions. The only online lenders left standing were those operating legally under the laws of the 30 states that permitted payday lending.
With the elimination of payday lender bank accounts, the remaining online lenders and the nationwide footprint of storefronts are being choked off. The fact that this third wave has come in such close proximity to the initial attack on bank deposit advances, and the imminent rule-making by the CFPB, gives credence to the notion that there is ideological intent behind the killing of payday lenders.
I spent much of this week on phone calls and engaging in correspondence with my many contacts in the payday loan industry, and in trying to solicit comment from the banks. Other than stock language from the banks, nobody would go on record, insisting that they would only speak on background. Here is a smattering of the comments I collected:
From the spokesman of a large lending company:
"I think that it is timely and relevant that you are looking into this. I would gather that our experience is substantively no different than others you have spoken with. We have lost some long-term relationships with no warning or real explanation. It is certainly a challenge to operating a business. I am not sure where the program originates…it is ostensibly focusing on a number of "risky' industries, but so far I am not aware of any others besides ours that has been targeted. [Emphasis added]
From a large lender's service provider:
"Operation Chokepoint left unfettered is going to cripple this industry. My bank accounts are being closed. Not just ACH, and not just transactional, but operating accounts because we're in this space. A friend of mine operates a pawn business. He opened a new pawn store, went to the local bank to open an account, and because he operates a payday loan business elsewhere, the bank said they wouldn't open the account - even though the payday lending operation is in another state, and had nothing to do with that account."
From a lobbyist:
"[I can ] confirm that I was told by a prominent banker at a large bank located in a Midwestern town that they've been threatened with fines for even as much as opening an account for us."
From a banker:
"That space has become even more challenging for my institution, and I don't think I'd even be able to get accounts opened."
From another industry service provider:
"Yes, they [the DOJ] are trying to cut off the checking accounts of legitimate payday business and other types in the money service area."
It's not just the big players. Even small chains are being told to walk. One lender in the western U.S. tells me, "We're not getting any more than evasive, general language from Wells Fargo. We've been with them for ten years. They make a lot of money on us. It's shocking. There's no rational business reason for this. It's a non-issue from a banking perspective. With all the fees banks can charge us, they should be falling over themselves for us. Instead, we've exited the payday space."
Senior management at a midsized chain told me, "every lender is having problems. One bank, which has serviced the industry for many years, told its clients they had 30 days to move their accounts elsewhere."
The sudden announcements from the bank and the short time frames to abandon the accounts lends further credence to the notion that the DoJ is, at a minimum, pressuring banks to comply.
In response to request for comment on the situation, Bank of America spokesman Jefferson George said, "At Bank of America Merrill Lynch, we routinely evaluate our business practices and the services we provide to clients in various industry sectors. Over the last several years, we have not pursued new credit relationships in the payday lending industry, and over time many clients have moved their banking relationships. In 2013, we made the decision to ultimately discontinue providing extensions of credit to payday lenders. In addition to not pursuing any new business opportunities in this sector, we are also exiting our existing relationships over time."
Fifth Third Bank's spokesman Larry Magnesen said almost the same exact thing. When I asked if there was a specific threat from the DoJ delivered to the bank, he demurred, saying, "As a matter of policy, we do not discuss regulatory issues." This was the same policy stated to me by Wells Fargo spokesman Alanson Van Fleet.
How is this actionable?
In a word: short.
It is entirely possible that payday lenders find other entities that will bank them. It is entirely possible that the CFPB's rules will not materially harm revenue. The payday loan industry has shown tremendous resiliency and resourcefulness over the years. However, as with any investment, the question is one of risk vs. reward.
As it is, the secular environment for payday lenders -- even those diversified into pawn and other services -- has been abysmal. The country was saturated years ago. Store count has drastically contracted. Same-store revenue has been flat to negative as employment has gradually improved. On the pawn side, gold prices cratered, taking scrap revenue down with it. Pawn secular growth is 2-3%. The only bright spots were online lending - now killed by Choke Point - and Mexican pawn, which is still going strong.
So when one adds in a downright hostile federal regulatory environment, I see absolutely no upside to buying or holding any stock in the sector at this time. I would sell any holdings you have.
I consider the situation to be so grim that I have shorted Cash America, First Cash, EZCORP, and hold puts on them as well.
The debt of many companies, both public and private, can be traded. There may be temptation to scoop up the debt of these companies at distressed prices and high yields, but I would avoid that move. You can find those yields in less-risky vehicles.
Disclosure: I am short CSH, FCFS, EZPW. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.
Additional disclosure: I hold puts on CSH, FCFS, EZPW.
Editor's Note: This article covers one or more stocks trading at less than $1 per share and/or with less than a $100 million market cap. Please be aware of the risks associated with these stocks.