Understanding The Alternative Finance Sector Through Gary Rivlin's 'Broke, USA': Part 5 - Final Thoughts

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Includes: ABMLF, CSH, DLLR, EZPW, FCFS, QCCO, WRLD
by: Xinyun Hang

Summary

In writing my article series about Broke, USA, Gary Rivlin's book on the alternative finance industry, some themes have come up repeatedly.

They include the industry's pricing power and the risk of competition, as well as the strength of the pawnbroking model and the value of analyzing a company's relationships with lenders.

Such themes, I feel, are valuable not only to alternative finance investors, but to investors in general.

In addition, one area which Rivlin discusses in great detail but which I have not written about is the subprime mortgage business.

The similarities and differences between that business and alternative finance businesses such as payday lenders and pawnbrokers is also, in my opinion, useful to investors.

In my article series about Broke, USA, journalist Gary Rivlin's book on the alternative finance industry, I have written about the competitive advantages of an industry that lends money to those with few alternatives. However, I have also written about the risks of investing in such an industry, such as regulation, corporate misbehavior, and competition.

In doing so, some themes have come up again and again. Such themes have been, in my mind, valuable not only for alternative finance investors, but also for investors in general. They include the importance of pricing power and the threat of competition. They also include the strength of the pawnbroking model as well as the value of analyzing a company through its relationships with its lenders.

That said, one area of the alternative finance business, which I have not discussed but which Rivlin goes into in much detail is the subprime mortgage business. I have intentionally not discussed that business, since much has already been written about it and its effects on the global economy in the past few years. That said, Rivlin's book does have some interesting insights on subprime mortgage lending and how it relates to the broader alternative finance business, insights, which I feel are useful for investors.

The Pricing Power Of The Alternative Finance Industry - A Power For Good And Ill

In the course of my article series, a characteristic of the alternative finance industry that I have found striking is its pricing power. As I've noted, Warren Buffett has described deciding whether a company has pricing power - which he defines as "the power to raise prices without losing business to a competitor" - as "[the] single most important decision in evaluating a business."

What's interesting about the alternative finance business is that it doesn't even have to raise its prices anymore. Rather, when businesses such as payday lending and rent-to-own companies first became popular, they raised their prices - in the form of interest rates and fees - as high as needed to earn double digit returns on capital. Those prices have stayed largely unchanged even as competition has intensified in the industry.

This ability of alternative finance businesses to set their fees as high as necessary has come up in all of my articles about Broke, USA. In my first article, I described how the pricing power of the industry could be seen in Rivlin's interview of a pawnshop owner. As Rivlin puts it, that pawnshop, which also has a check cashing business, charges a fee that is five times higher for cashing personal checks versus payroll checks. It does so even though personal checks aren't much riskier than payroll checks. It can do this, seemingly in defiance of the conventional economic principle that greater rewards only come from greater risk, because the business has pricing power.

Though astonishing, this ability to ignore risk in charging almost arbitrary fees comes up again and again in examining the alternative finance industry. In one of my recent articles, I described how Sandy McLean, the CEO of installment lender World Acceptance Corporation (NASDAQ:WRLD), explicitly denied in a conference call that his company used risk-based pricing. In other words, the company does not set its interest rates for individual loans based on the risk of the borrower defaulting on the loan. For a lender, the risk of default is equivalent to the "cost of goods sold" for a retail or manufacturing company. Thus, this statement is equivalent to a retailer saying that they set their prices without considering the cost of the products they sell. Rather, this hypothetical retailer would be able to set prices as high as necessary to earn its desired returns.

This pricing power influences the industry's risks, such as regulation. In my article about regulation and Broke, USA, I noted that interest rate caps are one of the most commonly advocated ways to regulate payday lending, one subset of the alternative finance industry. The Center for Responsible Lending, or CRL, an anti-payday lending organization prominently featured in Rivlin's book, explicitly argues for "[a] 36% cap on annual interest." As Rivlin has noted, such a cap would make payday lenders uneconomical. However, what I find interesting about the concept of an interest rate cap is how it demonstrates the pricing power of the payday lending business - and that of the alternative finance industry as a whole.

First of all, advocates of such a cap are essentially saying that payday lenders have such strong pricing power that only government action can restrict it. Given that such an argument is usually only made about monopoly businesses like utilities and telecom companies, it is interesting to see it made here about an industry as competitive as the alternative finance industry.

Beyond that, the rate caps that have been put in place in various states demonstrate the industry's pricing power. 36% may be too low of an interest rate for payday lending to be economical, but many states have established higher rate caps under which payday lending can still survive. For example, a Pew Charitable Trusts study noted that the maximum APR for a payday loan in Colorado, Oregon, and Washington states are all under 200%, versus an average APR over 300% in most states. Despite that, payday lenders continue to operate in those states. By doing so, they show that there is no inherent reason why payday lenders have to charge the 300% to 600% APRs they do in most states where the practice is legal - rather, they do so because they have the pricing power to do so.

Such pricing power does come with downsides. First of all, the collective decision of the payday lending business to maximize its interest rates is a source of major criticism of that business. As I noted in my article about misbehavior in the industry as seen through Broke, USA, probably the most common criticism of the industry is that it is usurious because it charges excessive rates. Indeed, the fact that payday lenders charge the maximum rates possible is used by organizations such as the CRL to argue for rate caps.

More importantly, the industry's pricing power may be a crutch in its competitive endeavors. Because companies in the industry have always been able to earn high returns through high prices, they have never figured out how to grow market share through price competition. For example, in the same conference call that I alluded to earlier, Sandy McLean explained that the company would not use risk based pricing because "[it's] never been [its] expertise." In other words, the company doesn't take into account the riskiness of borrowers in setting interest rates not because of some regulatory or competitive problem. Rather, the company simply lacks the technical expertise to do so, and hasn't been willing to invest to gain that expertise.

This issue is not unique to World Acceptance or the installment lending business. The Pew Charitable Trusts report I mentioned earlier notes that states with a lower maximum APR have fewer payday lending stores per capita. However, it also cites two other studies, which indicate that the volume of payday loans in such states do not decrease. Rather, the stores that persist after an interest rate cap is established make up for the lower rates through increased volume.

What's interesting about this is that the converse seems true as well. Payday lenders in high APR states make up for reduced volume (caused by the increased number of payday lenders per capita) through high rates. They seem uninterested in lowering their rates to increase volume.

This sort of pricing discipline might make sense in an oligopoly, but I'm not sure if it is such a good idea in a highly competitive field like the alternative finance industry. For one thing, this unwillingness to allow competition to lower prices seems to violate one of the basic principles of a competitive market - that competition drives down prices. More importantly, it also subjects the industry to criticism and potential regulation. After all, the implicit argument of those who want to regulate the industry is that since normal market pressures won't cause interest rates on alternative finance products to go down, only government action will do so.

Even more importantly, this reluctance to give up pricing power in order to maintain volumes also influences one of the major risks to the alternative finance industry that I wrote about in my article series about Broke, USA - competition.

The Threat of Competition

One of the risks to the alternative finance industry I have written about most consistently is competition. In my first article about Broke, USA, I noted that diversification is a major theme in the alternative finance industry. This diversification is driven in large part by competition, as companies try to compensate for falling volumes by offering more services. In my subsequent articles, I noted that companies have used the ability to deal with regulation as a competitive advantage. Similarly, competition drives much of the misbehavior in the industry.

One interesting characteristic about the industry is the interplay between competition and pricing power. As I noted in my article about competition in the industry as seen in Broke, USA, competition is a threat because it erodes loan volumes. Because of the industry's operating leverage, even a relatively small decline in loan volumes can cause drastic reductions in profits and returns on investment.

Despite that, what is odd is that none of the major alternative finance companies seems to have aspired to boosting loan volumes by being the low cost provider. This doesn't seem to make sense because the alternative finance market is highly competitive and sells a commodity product - one loan being more or less the same as another. In most such competitive markets for commodity products - particularly ones that cater to consumers - there is a low cost provider that competes on the basis of price. For example, Wal-Mart (NYSE:WMT) does so in retail, Southwest (NYSE:LUV) does so in the airline business, and so on and so forth. And yet, in the alternative finance industry, not one has tried to do this and gain a competitive advantage. It's as if Jeff Bezos had created Amazon (NASDAQ:AMZN), but decided to set all of its prices to be the same as those of its competitors, despite the cost advantages of online retail.

Instead, the companies that could be low cost providers in the alternative finance industry seem to prefer lower returns on capital rather than lower interest rates. It seems likely that at least some of the companies should have lower cost structures, allowing them to be low cost providers. For example, the major chains should be able to leverage their efficiencies of scale to do this. Rivlin describes how this strategy should work in describing one private equity firm that sought to "snap up smaller chains…wring out redundancies, and eventually grow into an efficiently run giant of the poverty business." That firm was stymied by the fact that it arrived late on the scene, when most of the best markets had already been saturated and no one was willing to sell. However, Rivlin's description implies that such a low cost strategy should be possible.

Despite that, interest rates in the industry remain stubbornly high, even as growth slows for low and high cost providers alike. It appears that the industry seems intent on holding onto its pricing power, even if it results in falling volume growth and public criticism.

Even the evidence that does exist of interest rate reductions - such as a 2007 New York Fed paper on payday lending - indicates that such reductions are fairly limited. For example, the paper notes that a one standard deviation increase in payday lending locations per capita causes a $0.50 drop in the interest and fees on a payday loan per $100 borrowed. Given that the typical payday loan cited in the article has an interest charge of $15 per $100 borrowed (a 390% APR), this reduction in fees from $15 per $100 to $14.50 per $100 comes out to a movement in APR from 390% to 378%. That is not a huge change in rates.

Indeed, this unwillingness of the alternative finance industry to lower rates seems to be a global phenomenon. In my article about the bankruptcy of UK pawnbroker Albemarle & Bond (OTC:ABMLF), I noted that the company's interest rates fell in the years before it went under. However, what's interesting is that they did not fall much - indeed, at least one media report said they did not fall at all. In contrast, the company's loan volumes and retail turnover fell drastically. This seems to reflect the general trend that alternative finance companies are willing to accept volume declines if it means that they can maintain their high interest rates and fees.

Because the industry has persistently refused to compete on the basis of price, it seems relatively limited in its ability to prevent the kind of loan volume decline that comes with increased competition. As I have noted in my articles, the industry's competitive efforts have largely been focused on diversification and marketing. For example, Rivlin tells the story of a payday loan branch manager whose store went from being one of five stores in town to one of twenty-seven. As a result, in Rivlin's words, "[the] battle…[became] a war of dueling rewards programs and rival marketing campaigns." Similarly, other major alternative finance companies have touted their expansion into online lending and their new marketing programs in their conference calls and annual reports.

However, I am not sure if this is a trend that can continue indefinitely. I believe that eventually a company will arise that uses technology to gain a competitive edge by setting interest rates based on the riskiness of individual borrowers. It doing so, it will lower the cost of borrowing for those who deserve lower rates, giving such a company a strong competitive advantage.

I am perhaps biased on this matter because I have been a long time investor in loans through LendingClub (NYSE:LC). As a result, I am used to the idea that interest rates on loans should be calibrated based on the riskiness of the loan. Certainly, I know that this isn't the case in many areas of lending - such as the credit card business that LendingClub seeks to disrupt.

That said, I feel that the alternative finance industry's unwillingness to take up risk based pricing is a major risk for the industry. It is certainly true that risk based pricing for payday loans - never mind pawn loans, with their varying types of collateral - would be much more difficult than for credit card loans. That said, many of the mechanisms are already there. There is certainly enough competition in the alternative finance space to stimulate a company to effectively implement risk-based pricing. Moreover, the rising popularity of online lending means that a potential disruptor that uses risk-based pricing like LendingClub would not need to build an extensive branch network. Rather, it would just need an effective algorithm, some lending capital, and basic marketing. Indeed, a number of such lenders have already appeared, as described in a recent National Journal article. One of them, LendUp, recently received a $50 million venture capital loan on top of $18 million in venture capital equity.

Based on developments such as this, my personal belief is that the alternative finance industry needs to find a way to compete through risk-based pricing of interest rates, as opposed to purely through volumes. If it does not, the industry's current competitive problems may only be a preview of what's to come. As I have noted in my articles, the US alternative finance sector, particularly the payday lending business, has reached a saturation point, and a number of companies, such as QC Holdings (NASDAQ:QCCO) and World Acceptance Corporation, have seen stagnant or even declining loan volumes. Between the existing problems of saturation that such companies face and the potential of disruptive online rivals, I feel that competition is one of the major risks to the alternative finance industry.

The Strength of the Pawn Model

In the face of competition and other threats to the alternative finance industry, I feel that one of the alternative finance business models that will do best is that of the pawnbroker. I first became aware of the strength of the pawnbroking model from a passage from Broke, USA in which Rivlin interviewed payday and pawn lending chain owner Allan Jones:

"The rule of thumb with pawn is you pledge three times collateral," [Jones] said. So if one of his clerks thinks they can sell a flat-screen TV for $300, they will loan that person $100. That borrower pays a little more than $20 a month in interest on that $100 (Tennessee allows pawnshops to charge a 256 percent APR); meanwhile, the pawned item remains in the shop's back room as long as that customer keeps current with his or her loan. If that customer can't repay the loan or decides not to, the shop puts the item up for sale. "I make money if they can pay off the loan," Jones said. "I make money if they can't pay off the loan."

To be fair, it is not entirely irrelevant to a pawnbroker whether borrowers pay off their loans. As I have noted in several articles, most pawn lenders prefer that their borrowers pay off their loans and redeem their goods. For one thing, this allows that same collateral to be used for future loans.

However, what is interesting is that this practice - offering one's goods as collateral again and again for loans at a pawn shop - does not seem to receive nearly as much criticism as rolling over one's payday loans again and again. This seems odd, since if you think about it, the two practices are fairly similar. It is true that the amount of pawn debt a person can take out is limited by his or her collateral. That said, it still seems strange that repeatedly taking out a pawn loan - which, as noted above, often has a triple digit APR - is not subject to nearly as much criticism as repeatedly taking out a payday loan. For example, Rivlin describes how former Denver Broncos football player Willie Green outlined his family's interactions with a pawn shop when he was a child:

Green's father, a janitor at a movie theater in Athens, Georgia, had raised nine kids on $85 a week. "He used to play golf on Saturdays and Sundays and then go to the pawnshop," Green said. "He'd pawn his clubs and he'd pay for my school, or whatever I needed to succeed in life. And then he'd go get his clubs at the end of the week when he got paid."

What I personally find interesting about this quote is that this experience is not described negatively. Green's father is described as a noble figure for regularly taking out pawn loans, and Green uses his story to advocate for the alternative finance industry. I am not sure if the same story would be considered as positive if Green's father had been taking out payday loans, even if the loan amounts and APRs had been the exact same. At the very least, the Community Financial Services Association of America, an alternative finance industry group, argues that "a payday advance is inappropriate when used as a long-term credit solution for ongoing budget management." In contrast, Green's father is lauded in his story for using pawn loans as precisely that kind of long-term solution, even though it is quite possible that the loans he was taking out had exactly the same kind of high interest rates as modern payday loans.

Thus, I think one of the pawn business's major strengths is that it offers loans under many of the same terms as the payday lending business without being subject to the same criticism. For example, payday lending is outright banned - generally through rate caps - in fourteen states and the District of Columbia, which represent almost 30% of the US population. In contrast, no states ban pawn lending.

It is true that most states do restrict the amount of interest that pawnbrokers can charge, with the lowest interest rate caps at an APR of between 20 and 30 percent. However, such states generally also allow pawn lenders to charge various additional fees. For example, North Carolina, a state where payday lending is banned, allows pawn lenders to charge only 2% a month in interest. However, the state also allows pawnbrokers to charge a wide variety of fees for such services as title investigation, handling, appraisal, and storage, and even "other expenses, including losses of every nature, and all other services." Such fees can total up to 20% of the principal value of a loan per month. Given that North Carolina pawnbrokers can charge fees to cover essentially any expense - including loan losses - it seems likely that they can charge an effective APR similar to those of payday lenders, even with a strict interest rate cap.

The pawn industry's ability to charge interest rates similar to those of payday lenders, even with interest rate caps, is also implied by Rivlin's comment that Tennessee allows pawnbrokers to charge a 256% APR. Tennessee has the same pawnbroking regulations as North Carolina. They limit interest rates to 2% per month, or an APR of about 24%, but also allow additional fees. The fact that Rivlin describes the actual state APR as 256% implies that Tennessee pawnbrokers can earn payday-like interest rates from those fees, even when their nominal interest rates are capped. This certainly makes sense - in my article about alternative finance regulation as seen through Broke, USA, I noted how Rivlin described how payday lenders have circumvented interest rate caps in states such as Ohio through similar strategies. Thus, it is hardly surprising that pawnbrokers would do the same. The only difference is that while those payday lenders have been sharply criticized for exploiting loopholes, pawnbrokers do not seem subject to the same criticism.

In addition to being able to charge payday-like APRs without being subject to similar scrutiny, pawnbrokers have other strengths.

As I've noted, one of the major themes of Rivlin's book is diversification in the alternative finance industry. Companies such as payday lenders and pawnshops have diversified into new lines of business such as installment lending, tax preparation, and check cashing not only to boost volumes, but also to escape regulation.

Beyond this, another theme of the alternative finance industry Rivlin noted in Broke, USA is that alternative finance lenders have to charge their high interest rates because they have high fixed expenses in the form of employee salaries and store costs. Because the number of transactions at a given lending location is fairly low, lenders have to maximize their revenues per transaction to cover their fixed costs.

Pawnbrokers are uniquely suited to take advantage of both of these themes. A pawnbroker does not need to make significant investments in additional facilities to be a payday lender or a check casher. At most, a pawnbroking location might need to invest in some additional staff and software to add most of the other major alternative finance business lines, such as payday lending or check cashing. In contrast, a payday lender or check casher would have to make significant investments in display space and other furnishings to enter pawnbroking. However, when a pawnbroker does add such additional lines of business, it is "an easy way to add rocket fuel to the bottom line," as Rivlin puts it.

Because of this, I feel that pawn companies are uniquely situated to diversify and dominate the alternative finance space. Pawnbrokers have a natural cost advantage in providing additional alternative finance services such as payday lending. The pawn business not only covers all of a pawnbroker's costs, but is highly profitable. Thus, profits from additional lines of business flow directly to the bottom line. This allows pawnbrokers to provide other alternative finance services much more cheaply than pure-plays. In contrast, other alternative finance businesses such as high interest lenders have more limited diversification prospects. Expanding into pawnbroking for them would require large investments and additional training to run what is essentially a retail store business.

In this context, it is perhaps unsurprising that the largest alternative finance companies in the US are predominantly diversified pawnbrokers such as EZCorp (NASDAQ:EZPW), First Cash Financial Services (NASDAQ:FCFS), and Cash America International (NYSE:CSH). I believe that in the long run, such companies may dominate the storefront alternative finance space in the US. After all, such businesses combine pawnbroking - which as I've noted, earns payday-like returns without payday-like regulatory risk - with the ability to be the low cost provider in nearly every other area of the alternative finance business.

Of course, even though pawnbrokers have many strengths, that doesn't mean that they can't fail. As I have noted, diversified pawnbrokers in the future will have to contend with online lenders, which can provide many of the same services at an even lower price point. Even today, a number of pawnbrokers and other diversified alternative finance companies have run into trouble and even gone bankrupt. One tool, which I have found useful in analyzing such troubles, is studying a company's debt covenants and its relationships with its lenders.

Lender Relationships and Covenant Analysis

I was first inspired to write my articles about the Albemarle & Bond bankruptcy and the DFC Global buyout while writing the fourth article in my Broke, USA series, which discussed the themes of competition and gold prices. I initially planned to discuss those two events as examples of the effect of competition on the alternative finance industry. Albemarle & Bond saw volumes collapse in its core pawnbroking business due to rising competition, leaving it without the earnings needed to service its debts. DFC Global (NASDAQ:DLLR) became overleveraged while expanding abroad to escape rising competition, forcing it to accept a buyout.

However, in the course of writing about those events, I realized that each of them was compelling enough to deserve its own article. One reason for this is because both of those events alluded to an idea, which I have come to believe is important in analyzing not only alternative finance companies, but also companies in general. That idea is the analysis of a company's relationships with its lenders in studying the company as a prospective investment.

The idea of studying companies through their relationships with its lenders is actually one that appears in Broke, USA. In telling the early history of the alternative finance industry, Rivlin describes the industry's relationships with its bankers, both those who lent to the industry in its early days and the investment bankers who helped take some of the first alternative finance companies public. Indeed, these stories help illustrate the alternative finance industry's growth from an early startup sector to a major part of the US consumer finance market.

One story described by Rivlin about the industry's early days is that of Jerry Robinson, who begins Rivlin's tale as a low ranking banker at a subsidiary of Transamerica, now a subsidiary of Aegon (NYSE:AEG), which was focused on lending to businesses serving the subprime market. Robinson comes to work for rent-to-own business owner Toby McKenzie, helping him enter the payday business in the mid 1990s. In Robinson's words, at the time "he wondered if he and McKenzie weren't the two stupidest people on the planet" because the payday model was unproven. Similarly, Rivlin describes how other bankers were unwilling to lend money to Check Into Cash founder Allan Jones when he first began his company around the same time, forcing him to go to a private equity firm for a loan.

Of course, this wariness of the major banks towards the alternative finance industry did not last. Only a couple of years after Jones could not get a loan, he was shopping through major investment banks to see who might underwrite an IPO. CIBC Oppenheimer (NYSE:OPY) agreed to take the assignment. As Rivlin describes it, it was a sign of the growing legitimacy of the industry:

"CIBC wasn't Goldman or Morgan but it was a large bank, respectable and legitimate…'I must have arrived,' Jones would say mockingly, 'because now I have me a real-life lawyer with a Park Avenue address.'"

Even when the IPO was cancelled, Jones was able to get a loan for the same amount as he had planned to raise from National City Bank, now a part of PNC (NYSE:PNC).

By 2004, when Advance America went through its IPO, it was indeed "Goldman or Morgan" that was the lead underwriter - Morgan Stanley (NYSE:MS), whose decision to take on the assignment, in Rivlin's words, showed that "[the] issue of whether Wall Street could fully embrace payday lending was put to rest."

This progression of the payday lending business from one to which even specialty lenders were reluctant to lend to a business, which could draw the services of the top banks in the nation, reflects the mainstreaming of the alternative finance industry. As Rivlin puts it, the willingness of top tier banks to work with the industry was an endorsement of its business model.

Though this story is interesting from a historical perspective, I discovered while studying Albemarle & Bond and DFC Global that such relationships between the industry and its bankers remain useful in analyzing the industry today. Even today, bankers' willingness to extend credit to companies in the industry is still an endorsement of those companies. Conversely, the desire to withdraw credit is an indicator of trouble.

Few examples illustrate this better than the slide of UK pawnbroker Albemarle & Bond into administration in early 2014. The company first announced that it was having trouble with its loan covenants in late 2013. It is true that the exact nature of the company's covenant troubles could not have been predicted beforehand, since the company never detailed its covenants in its annual reports. However, the fact that the company announced covenant troubles without any offsetting good news - such as an equity injection to cure its covenant problems or even a simple amendment to its covenants to bring the company back into compliance - in retrospect spoke volumes about the company's health at the time. It meant that the company's bankers weren't willing to be flexible on its loans, beyond some short-term waivers, and that no one was willing to make an investment to save it from bankruptcy. Given that a company's bankers often know a company best outside of management, this was a sign that shareholders should sell immediately. Shareholders who did so at that time would have salvaged at least a small part of their investment.

Similarly, I have noted in my article about the DFC Global buyout that the company's covenants became drastically more restrictive before the company's bargain price buyout by private equity firm Lone Star Partners. This occurred even as the company's management was protesting that the company's financial situation was sound and that its issues were temporary. The company's problems may have been temporary, but the signal being given by its bankers was that they were losing faith in the company's financial health. Shareholders who responded to that signal and sold their shares would have salvaged an additional 10% of their investment over those who waited for the buyout.

Thus, a company's relationship with its bankers is often a useful indicator of the company's financial health. This indicator is often useful outside of the alternative finance space as well. A recent CFA Institute Magazine article interviewed C. Thomas Howard, the head of Athena Investment Services, whose portfolio strategy has earned a 25% annual return over the past 12 years. Howard advocates investing in "companies with as much debt as possible." He argues that "debt is attractive is because the underwriter or the bank worked closely with the company and decided they could make the loan and the firm would repay it." Obviously, this might be going a little far - banks have made many loans over the years to companies that ended up going bankrupt - but it does show how useful a company's relationship with its bankers can be in evaluating the company. That is why I emphasized World Acceptance Corporation's deteriorating debt covenant terms heavily in my most recent article about the company. That article noted that those deteriorating covenants might indicate deteriorating fundamentals with the company's operations.

Of course, the judgment of banks is hardly infallible. One example of this was the recent subprime mortgage bubble, in which banks made large numbers of subprime loans that could not be repaid. In my article series about Broke, USA, I have not discussed subprime mortgages, even though Rivlin's book goes into much detail on the subject. However, what Rivlin writes about the subject does have relevance to investors.

Subprime Mortgage Lending

It is somewhat ironic that in reviewing Gary Rivlin's Broke, USA, I have barely mentioned the subprime mortgage business. After all, much of the book is actually devoted to that subject. In part, this is because I feel that plenty of ink has already been spilled about it and my contribution would not add much to the discussion. In part, it is also because most of the major subprime lenders went bankrupt during the financial crisis and the major banks divested themselves of their subprime operations. Thus, there doesn't seem to be much point in analyzing the investment prospects of subprime lenders as seen in Rivlin's book.

However, what is interesting to me is that the subprime lenders profiled in Broke, USA shared many of the same characteristics as the alternative finance industry. Obviously, both groups of businesses have many of the same customers, but the similarity goes beyond that.

Like alternative finance companies, subprime mortgage lenders were targeted by regulation in the 2000s, and like those companies, subprime mortgage lenders largely managed to escape the effects of such regulation. It goes without saying that the subprime mortgage industry saw accusations of misbehavior just like the alternative finance industry, and the reasons for this misbehavior were also similar - a drive for volume that caused lenders to cut corners, as well as growing competition that saturated the market and drove down returns. Even the strengths of the subprime mortgage business in the mid-2000s that can be inferred from Rivlin's book are similar to those I described in my first article about the alternative finance industry. Rivlin argues that many subprime mortgage lenders overcharged borrowers unnecessarily, thus implying they had pricing power. After all, only a company with pricing power could do so without losing business. Moreover, as we know, such lenders also had strong growth in the mid-2000s and high returns on capital, the same qualities I described in my article about the alternative finance industry's competitive advantages.

Because of this, one wonders - why did the alternative finance industry do so much better than the subprime mortgage industry in the financial crisis? One would think that the customers of a subprime mortgage lender would actually be stronger financially than those of a payday lender or pawnshop. After all, someone who took out a subprime mortgage before the financial crisis had to own a home and thus probably had some equity in that home - or at least did before the housing collapse.

One difference presented by Broke, USA is securitization, or the process of turning loans into securities and selling them. Perhaps unsurprisingly, Rivlin spends much of the book criticizing subprime lenders that made loans without considering the ability of borrowers to pay in order to sell those loans to investment banks for securitization. In contrast, the alternative finance industry generally does not securitize and sell its loans. Payday lenders, high interest installment lenders, and pawn lenders generally keep their loans. Thus, they are incentivized to only make loans that can be repaid.

It is certainly appealing to argue that this was the key difference between the two industries. After all, such an argument is based on one of the most common explanations of the financial crisis - that subprime mortgage executives made an endless stream of reckless loans to feed Wall Street's securitization machine, which eventually brought down the economy. In contrast, one can argue, alternative finance lenders were not so reckless, since they had to endure the consequences of bad lending.

However, I believe this explanation is too simple. Rivlin's own account shows that even subprime mortgage lenders that made subprime loans only for their own balance sheets ran into trouble. He illustrates this with the example of World Savings, a subsidiary of Golden West Financial, which not only did not sell the mortgages it originated, but even avoided many of the most dangerous types of subprime mortgages. Despite that, after Golden West Financial was sold to Wachovia, problems with the World Savings portfolio helped bring down that bank. Thus, it seems clear that securitization was not the only reason for the differing fates of the subprime mortgage and alternative finance industries.

Rather, my theory is that there are many possible reasons for the difference in outcomes between the two industries. One potential reason is that mortgage loans are obviously much larger than payday or installment loans. As a result, the kind of pricing power that allows the alternative finance industry to earn such high returns may have actually harmed the subprime mortgage industry. After all, the ability to set arbitrarily high interest rates on a payday loan may earn a payday lender much higher returns, but the difference in interest amounts is unlikely to cripple the finances of a borrower in of itself. The difference between a 150% APR and a 450% APR for a $100, 14-day payday loan is, after all, about $12 in interest. In contrast, the pricing power of the subprime mortgage industry may have actually harmed the industry. Subprime mortgage lenders' ability to use their pricing power to put borrowers into loans with higher interest rates than required, as Rivlin describes them doing, may have increased default rates on those loans. After all, a $200,000 subprime loan with an APR of 8% versus 6% would have an extra $250 in monthly payments - an increased burden far more likely to drive a borrower, particularly a marginal one, into default.

This size difference also means that the small dollar loans made by the alternative finance industry are simply easier to repay. Payday and pawn loans are usually only a few hundred dollars at most. Even installment loans are usually only a few thousand dollars, if that. Because of this, it seems likely that when the financial crisis hit, many alternative finance borrowers who ran into trouble were able to find alternative ways of paying their loans, such as cutting costs, selling assets, finding help from family and friends, or other types of borrowing. Such measures likely helped default rates in the alternative finance industry stay manageable. In contrast, subprime mortgage borrowers would have had far more difficulty finding help to keep up their mortgage payments because those payments were so much larger.

Of course, one obvious hypothesis for the divergent fates of the two industries is that one went under because the Great Recession uniquely affected its area of business. After all, the Great Recession was in large part a housing crisis, and thus it unsurprisingly affected the mortgage industry particularly strongly. This is certainly the simplest explanation to explain why the two industries had such divergent fates.

My argument is not that these hypotheses, either individually or in combination, necessarily fully answer the question of why the Great Recession affected the alternative finance and subprime mortgage industries so differently. Rather, what I believe is that Rivlin's book shows that the subprime mortgage business of the mid-2000s had many of the same characteristics as the alternative finance industry. The fact that one was crushed by the financial crisis and the other passed with flying colors offers an important lesson, in my mind. This lesson is that investing is hard and can involve more moving parts than one can possibly imagine. Even two superficially very similar industries can behave very differently in a crisis. As a result, it is important to maintain a margin of safety in one's investments, since there will always be unknown risks that can torpedo one's portfolio if one isn't careful.

Conclusions

I feel that Gary Rivlin's Broke, USA offers much to teach investors, even those who aren't interested in investing in the alternative finance industry. Despite all that I have written about the book, I still feel that I haven't discussed all of the lessons offered in it.

As Warren Buffett puts it, the first rule of investing is "don't lose money." Rivlin's book discusses an industry in which the fear of losing money is an everyday proposition. As a result, I feel that the book's lessons about the various methods that a business might use to avoid losing money - such as diversification and pricing power - are valuable to any investor. Similarly, the book's warnings about the risks of government regulation of those methods, and the misbehavior that might accompany those methods, are also timely lessons. Finally, I think the book's theme of the risk of competition is valuable to anyone interested in business.

Disclaimer: The content here is not meant as investment advice. Do not rely on it in making an investment decision. Do your own research. The content here reflects only the author's opinions. Those opinions might be wrong. This content is meant solely for the entertainment of the reader and its author.

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

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.

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