In my previous article, I described how Broke, USA, Gary Rivlin's book on the alternative finance industry, shows why regulation is the industry's most prominent risk. Regulation is the industry's best known risk because it can totally eliminate parts of the alternative finance business, especially payday lending. Moreover, the book also shows why such regulation is popular, describing many people's visceral response to an industry that profits largely through high interest lending to the poor and middle class. As a result, support for the restriction or even illegalization of the industry is widespread and bipartisan.
However, in my opinion, Rivlin's book also shows why regulation is not necessarily the threat to investors in the alternative finance industry that many believe it is. As I described in my previous article, the industry has consistently found ways to work around regulation, with the larger companies in the industry even turning regulation into a competitive advantage. Not only can the largest companies diversify from its riskiest parts, such as payday lending, but they can also gain market share from smaller operators, who are disproportionately affected by regulation related compliance costs. One company that has done this is DFC Global, whose strategy was vindicated in June 2014 when it was acquired for $1.3 billion.
Instead of regulation, I believe that one of the most serious risks to investors in the alternative finance industry is actually corporate misbehavior. Corporate misbehavior encompasses everything from letting customers use alternative finance products in harmful ways to actively breaking the law. The threat from this sort of misbehavior is related to, but is different from the threat from regulation. Regulation seeks to restrict the characteristics of the industry that generate its high returns, such as its high interest rates. In contrast, corporate misbehavior is behavior which is not inherently necessary for the industry to generate its high returns, but which may be common nevertheless. That said, regulations may be passed in response to misbehavior, and previously normal industry practices may overlap with and become labeled as misbehavior.
Through the stories of many industry participants, Broke, USA illustrates the threat posed by such misbehavior, as well as why such misbehavior may be an unavoidable result of the industry's incentive structures,
The Temptations of Misbehavior-The Instant Tax Service Story
Few stories illustrate both the high returns and perils offered to investors in the alternative finance industry like that of Fesum Ogbazion, the founder of tax preparation company Instant Tax Service. As I described in one of my previous articles, Broke, USA tells the story of how Ogbazion, an Eritrean immigrant, first entered the tax preparation business when he realized how lucrative it was to combine tax preparation services with high interest refund anticipation loans, or RALs. Such loans allowed filers to receive tax refunds immediately after tax preparation, at the expense of steep fees and/or interest charges. They were appealing to tax preparation companies because they offer high returns for little risk, given that the loan is collateralized by the filer's expected refund. Despite having almost no startup capital, Ogbazion used this strategy of combining RALs with tax preparation to build ITS into the fourth largest tax preparation company in the US, with over 1200 locations in 39 states as of 2009. In doing so, he illustrated the high returns available in the alternative finance space.
Unfortunately, in November 2013, ITS also illustrated corporate misbehavior's threat to alternative finance investors when the company was shut down for a variety of misconduct. Among other things, the company allowed felons to become tax preparers, included up to a thousand dollars of hidden fees in customers' tax costs, and encouraged customers to lie to the IRS. The company's actions potentially cost the US government-and by extension, taxpayers-tens of millions of dollars. As a result, Judge Timothy Black shuttered the business to, in his words, "protect the public and the Treasury."
Though ITS was a privately held company and its failure thus did not impact any public investors, the fall of such a prominent alternative finance company shows the perils of investing in the industry. By its very nature, the industry draws its customers from those with few other options. As a result, there is a persistent risk that companies in the industry will take advantage of that lack of alternatives by exploiting such customers, especially since many of those customers are poorly educated about their finances. The shuttering of ITS shows how this temptation to exploit vulnerable customers can affect even the largest operators in the alternative finance space.
Moreover, this temptation is especially strong because many alternative finance industry customers are willing, even eager, to abuse its products. Here, abuse can be defined as customers using alternative finance products in ways that harm themselves. The most obvious example of this is the borrower who takes out too many payday loans and becomes trapped in a debt spiral.
By facilitating this sort of abuse, alternative finance companies create long-term risks for their investors. After all, while letting customers abuse its products might help a company's bottom line in the short run, it has dangerous consequences in the long run. For one thing, alternative finance customers who abuse the industry's products are probably poor prospects for paying back their loans. Moreover, if companies consistently exploit their customers by encouraging them to take out loans that they won't be able to pay back, they run the risk of drawing regulatory attention and public wrath.
Despite this, Broke, USA shows how easy it can be for an alternative finance company to misbehave by allowing its customers to abuse its products. The book does so through the story of Chris Browning, a former manager at payday lending chain Check n' Go.
A Local Perspective on Misbehavior-The Chris Browning Story
Broke, USA describes how Browning was once one of Check n' Go's top branch managers. As the manager of one of the company's first stores in Ohio, Browning helped develop the company's early training procedures. Rivlin describes how her store consistently brought in above average revenues and how her tenure as a store manager was significantly longer than the norm-ten years, as opposed to the usual two.
During that tenure, Browning engaged in many practices which could be considered helping customers abuse her products. One such practice was letting people take out payday loans not just for emergencies, but on a regular basis. Browning illustrates this with the story of a GM pensioner who took out payday loans for 115 months straight-nearly ten years, almost the entirety of her tenure with the company-in order to gamble. Such behavior contradicts the guidelines of the Community Financial Services Association of America, or CFSA, a payday industry group, which describes payday loans on its website as "short-term financial assistance… intended to cover small, often unexpected, expenses."
Another questionable practice which Browning facilitated was lending money to borrowers who already had multiple payday loans. In her words, she often saw customers "borrow money from [her] and walk straight…across the street to the Advance America…[and] then…walk to the next store and then finish up by walking across the street to Cashland." Similarly, David, the aforementioned GM pensioner, told Browning that he was "juggling loans at seven stores." Such customers would use one payday loan to pay off another, while sinking ever deeper into a debt spiral.
Of course, it is necessary to view Browning's account with some skepticism. After all, Rivlin's book notes that Chris Browning was dismissed from Check n' Go after being accused of mishandling a large sum of cash. Even Rivlin's account describes as "too facile an explanation" Browning's story that she was fired because she opposed how "[the company's] policy became, if a body walks in the door, you loan 'em money." However, it seems clear that Chris Browning's behavior, which helped customers abuse payday loans, was tolerated or even encouraged at Check n'Go.
Ironically, this is made clear by the response of Check n' Go founder Jared Davis to Browning's account. In Rivlin's book, Davis rhetorically asks "how good a manager could [Browning] really have been if she was lending out money to people owing money to all these other stores?" Davis notes that "that made a person a greater credit risk-and you weren't doing that person any favors in the long run." Davis also asks "If [they] abuse a customer, is that customer coming back?" He makes good points-it's certainly possible that Browning's behavior was an outlier, and her account just the story of a disgruntled employee.
If so, though, that raises another question. If Browning's behavior was against company policy, why was it not caught during her ten year tenure there? Certainly, the tendency of borrowers to roll over their loans month to month could have been detected by a simple look at borrower files. Indeed, even Davis admits that the company had a policy of contacting customers who had not visited its stores for more than sixty days to try and persuade them to take out additional loans-behavior which seems to belie the CFSA's description of payday loans as a tool for rare emergencies. In Rivlin's account, Davis argues that such tactics were necessary because they needed to "do what [they] can to find an edge" as a result of growing competition. Given that the rest of Browning's behavior was ignored during her ten-year tenure at Check n' Go, it seems likely that such behavior was, if not encouraged, at least condoned because of that competition..
If so, this brings up the question as to whether there are characteristics intrinsic to the alternative finance industry that encourage corporate misbehavior. In the case of Check n' Go, it appears that Browning's behavior may have been influenced by her bonus structure.
Rivlin's book notes that though Chris Browning only made $21,000 in salary, she could earn up to $6000 in bonuses. In the book, Browning notes that one driver of such bonuses was the rate at which customers who hadn't taken out loans in sixty days returned for new loans. The book also notes elsewhere that bonuses in the payday lending industry are largely driven by loan volume.
Given such incentives, it is rather unsurprising that some store managers might give up long term prudence for short term profits (and accompanying bonuses). This is especially likely given that most such managers, as mentioned above, would only be staying in their posts for less than two years. In contrast, owners like Jared Davis are incentivized by their large stakes in the company's stock to think long term, while other high ranking managers would at least be concerned about their long term careers.
Thus, one explanation for misbehavior in the alternative finance industry might be diverging incentives between lower ranking employees versus upper management.
An Explanation for Misbehavior-Divergent Incentives, As Shown By Several Stories
Broke, USA supports such a theory that much of the misbehavior that occurs in the alternative finance industry occurs because of a divergence between the short term incentives of lower ranking employees and the long term goals of upper management. Perhaps the book's most egregious example of such a divergence is the "couch payment." The couch payment is, in Rivlin's words, "when the repo man accepts sex in lieu of a payment." Broke, USA goes on to say that "of the twenty-eight former Rent-A-Center (RAC) managers interviewed for [a 1993 Wall Street Journal article], six admitted that couch payments had occurred in their territory." The book notes that the article's revelation of such behavior helped scuttle the IPO of a rent-to-own company owned by Toby McKenzie, who would later go on to found payday lending chain National Cash Advance, now a subsidiary of the Mexican firm Grupo Elektra (OTC:GLEKY).
It would hardly be fair to use one article about one company from 1993 to criticize the entire alternative finance industry. However, this story does illustrate the risk that corporate misbehavior poses to investors in the industry. Not only did the improprieties of a few repo men help derail a company's 15 million dollar IPO, but the improprieties weren't even committed by individuals of that company! In this way, it is easy to imagine how misbehavior by a single alternative finance company's employees might cause harsher regulation or other consequences for the entire industry. Even reputational damage caused by one bad actor might seriously affect the rest of the industry. One example of such a ripple effect has occurred in the for-profit school industry, where enrollment has crumbled across the board because of accusations that such schools exploit students, even though some such schools genuinely offer good outcomes.
Beyond that, the "couch payments" story is perhaps the clearest example of how incentives can diverge between lower ranking employees and upper management. After all, couch payments offer zero benefit to shareholders, management, or anyone else except for the specific employee they're offered to. And yet, they have the opportunity to harm all of those individuals. Similarly, irresponsible lending may harm the long term goals of shareholders and executives, but it is still tempting to a store manager who wants to hit his or her monthly bonus.
One such manager who understands the temptations of the business is Tom Kirk, whose testimony to a 2007 Ohio Attorney General hearing on payday lending is related in Broke, USA. The book describes how Kirk argued that "the payday lenders were generally responsible citizens." He notes that "there were in fact rules at the company where he worked against lending to a customer carrying loans at multiple stores, and there were policies to protect borrowers from overzealous collections."
However, Kirk goes on to describe the divergence of incentives that Broke, USA implies is the cause of much misbehavior in the alternative finance industry. In Rivlin's words, Kirk described how "the rub was that employee bonuses were based largely on volume." As a result, Kirk noted, even though "The policy manual of the company I worked for was good…The problem is that the district manager and the store managers and the store personnel don't always follow it."
Such a disconnect between the genuinely good intentions of higher management and the more shortsighted incentives of local employees can also explain many of the other incidents of misbehavior related in Broke, USA. One such incident that also appeared during the Ohio payday lending fight came from a man named Charles Mormino. Rivlin's book describes how Mormino had a relative with psychiatric problems who was nevertheless a customer of several payday lending companies. In Rivlin's words, Mormino "sent a certified letter to each alerting them to the family member's problem. But all three…continued to do business with her. "
Such a willingness by those companies to do business with someone with a possibly impaired ability to make good financial choices would be consistent with employees who are more concerned with short term volume incentives than long term risk.
And yet, Rivlin's book also argues that it would be wrong to blame all misbehavior in the alternative finance industry on a disconnect between the ideals of top executives and the incentives of local employees. Such incentives come, after all, from the policies of those executives. Rivlin describes how Allan Jones, the founder of payday lending chain Check Into Cash, established a system designed so that "the only thing that was required was obedience by all those replaceable parts residing in the lower reaches of the organizational chart." In Rivlin's words, the company's high ranking vice presidents were incentivized this way:
Bonuses were granted based on the performance of those directly below them on the organizational chart. If the stores under a regional or district manager saw an increase in fees collected-assuming those financial gains were not washed out by bad debts-they would receive a bonus for that month. If not, well, the disappointed divisional managers chewed out their regional managers, who in turn dressed down the laggards among their store managers, who also were paid bonuses only if their numbers rose.
Rivlin's description implies how such an incentive system might promote misbehavior. After all, there is nothing here to keep managers from promoting excessive borrowing, and every incentive to encourage it. Even including the risk of bad debts in the incentive structure would not necessarily prevent misbehavior. After all, turnover in the lower echelons of management in the payday lending industry is very high. Because of that, managers might be tempted to engage in misbehavior knowing that they would be gone by the time the consequences occurred a year or two later. Such a practice would, of course, be exacerbated by the fact that bonuses were awarded monthly, giving very little time for the consequences of misbehavior to be noticed.
Moreover, Rivlin's account argues that there is another reason why upper management cannot be entirely exempted from responsibility for misbehavior in the alternative finance industry. The book notes that there is data that much of the industry's revenues comes from behavior considered questionable by the industry's own associations, such as the CFSA.
As I have mentioned, industry groups like the CFSA emphasize the payday loan's role as a short term tool for emergencies. In Rivlin's words, "From the start, the payday lenders have said theirs is an occasional emergency product used by the rational consumer facing the prospect of a bounced check." Rivlin continues, however, by noting that "those in the business of following the industry [seem] to come to precisely the opposite conclusion." He cites one analyst who is "convinced the business just doesn't work without [regular borrowers]." Another notes that "the survival of payday loan operators depends on establishing and maintaining a substantial repeat customer business because that's really where the profitability is." Rivlin also cites a similar quote from Dan Feehan, the CEO of Cash America, a national pawn and payday lending chain. Rivlin quotes Feehan as saying "The theory in the business…is you've got to get that customer, work to turn him into a repetitive customer, long-term customer, because that's really where the profitability is."
Rivlin backs up such quotes in Broke, USA with data. Rivlin notes that according to a 2007 study by the Center for Responsible Lending, or CRL, in states such as Colorado, Florida, Oklahoma, and Washington, somewhere between 56 percent and 65 percent of payday industry revenues come from borrowers taking out more than twelve loans in a year. He describes how the study describes how "at least one in five borrowers in each of those four states had taken out twenty-one or more loans in a year." In Rivlin's words, based on that study's results, "the APR no longer seemed an imprecise measurement of what was in fact a fee but a close approximation of the interest a good portion of the industry's customer base was paying for its short-term cash needs."
Such studies by an opponent of payday lending do need to be taken with a grain of salt, of course. Rivlin himself notes problems with some of the CRL's definitions in that study. Rivlin's implication is if such data is even partially true, it seems unlikely that top management in the payday lending industry is unaware that much of their profits come from behavior their industry association criticizes.
Thus, in many ways, the question what causes misbehavior in the alternative finance industry is reminiscent of the question of what causes misbehavior in the finance industry as a whole. Anecdotes of low ranking alternative finance employees engaging in misbehavior to earn bonuses remind the reader of bank employees doing things like rigging markets and misleading customers for similar reasons. Similarly, the willingness of alternative finance employees to violate corporate risk mitigation rules to meet performance incentives is reminiscent of the various trading scandals that have occurred in the past several years.
Along those lines, the argument over who is to blame for misbehavior in the alternative finance industry is also reminiscent of the argument over who is to blame for misbehavior in the mainstream finance industry. On the one hand, there are those who blame lower ranking employees who allow their greed to override the sensible directions of upper management. On the other hand, there those like Rivlin who imply that upper management also has a hand in the misbehavior.
In summary, misbehavior in the alternative finance industry is probably caused by many of the same reasons why misbehavior occurs in the financial industry as a whole. A common cause of misbehavior is likely divergence between the short term incentives of low ranking industry employees and the longer term goals of high ranking industry executives. However, authors like Rivlin argue that it is not possible to totally ignore the role of such executives in incentivizing misbehavior.
Conclusion-Investing In the Alternative Finance Industry Despite The Risk of Misbehavior
In this article, the examination of misbehavior in the alternative finance industry as seen in Gary Rivlin's Broke, USA began with egregious illegality in the story of Instant Tax Service. It continued through Chris Browning's anecdotes about facilitating customer abuse as a payday lending store manager, and continued to by showing why such managers might facilitate such abuse. In doing so, this article has shown how much of this misbehavior may be caused by the divergence of incentives between low ranking store employees and upper management.
Such a divergence of incentives will probably continue in the alternative finance industry. After all, it seems likely that local managers still continue to receive bonuses based on volume and most of them will continue to leave their jobs after a year or two. Moreover, such managers will probably continue to have the opportunity to engage in misbehavior. After all, alternative finance customers will continue to have no alternatives and be willing, even eager to abuse the industry's profits.
Thus, an obvious question seems to be whether the alternative finance industry is investible at all, given such structural tendencies towards making misbehavior possible.
In my personal opinion, even if the tendency towards misbehavior is inherent to the alternative finance industry, that doesn't mean that the industry is necessarily un-investible for the public equity investor. After all, despite this risk of corporate misbehavior, many companies in the industry have delivered extraordinary returns for investors, as can be seen in the chart below:
Source: Yahoo! Finance
Despite the fact that both World Acceptance Corporation (NASDAQ:WRLD) and Cash America International (NYSE:CSH) have been tarnished by scandal over many years of misbehavior, their stocks have still trounced the S&P 500 over those same years.
That said, if corporate misbehavior is a risk inherent to the alternative finance industry, that does mean that any investor in the industry will always have to worry about such misbehavior's effects. Such effects could range from a small fine, such as that borne by Cash America International in November 2013, to a potentially catastrophic loss, such as that now facing investors in World Acceptance Corporation according to many of its detractors. This means that investors will always have to view investments in the alternative finance industry as inherently riskier than investments in most other industries.
In this way, the alternative finance industry is just like the mainstream financial industry. Both industries offer services and products that are important, even critical to their customers. However, both industries have incentive structures that create a persistent risk of corporate misbehavior, a risk greater than that of most industries.
Despite that risk, in my opinion, both industries remain investible. After all, as my previous article showed, the alternative finance industry is a resilient one. More importantly, it is true that the alternative finance industry may have incentive problems similar to those of the mainstream finance industry. However, it is also true that many talented investors still invest in the mainstream finance industry. Even Charlie Munger, who has spoken extensively on the role of incentives in causing misbehavior, is still a major owner of such financial companies as Goldman Sachs (NYSE:GS) and Wells Fargo (NYSE:WFC) through Berkshire Hathaway (NYSE:BRK.A) (NYSE:BRK.B). If he thinks that such companies can generate high returns despite the risk of mismatched incentives, is seems reasonable to think that the alternative finance industry will also be able to generate high returns despite similar incentive problems and the accompanying risk of misbehavior.
This is true even though the alternative finance industry does have some weaknesses that the mainstream finance industry does not. It is true that society can live without payday lending or pawn shops more than it can live without, say, banking. However, it is also true that the alternative finance industry has some inherent competitive advantages that the mainstream finance industry does not, as I outlined in my first article about Broke, USA. It is reasonable to believe that such advantages adequately compensate the alternative finance investor for the risk of misbehavior.
Of course, corporate misbehavior isn't the only risk threatening investors in the alternative finance industry. There can be reasonable doubt as to whether misbehavior is truly endemic to the industry, or simply the product of a few "bad apples." However, there is little doubt that competition is a systemic threat to the industry, one that threatens to permanently reduce investor returns. Conversely, I believe that another threat to the industry that has been prominent in the past couple of years, the falling price of gold, is actually no real threat at all.
These threats, one true, one false, will be profiled in the next article in this series, "Understanding The Alternative Finance Sector Through Gary Rivlin's Broke, USA, Pt. 4: Competition and the Price of Gold."
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