Digging into finance's pay dirt: The risky business of payday loans and more

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By Ezra Klein
Sunday, July 25, 2010

Sometime this spring, Democrats stopped calling Sen. Chris Dodd's bill "financial reform" and started calling it "Wall Street reform." Most of the headlines and news releases on the sweeping legislation focused on the well-heeled, white-collar, upper crust of finance -- investment banks, private-equity firms and hedge funds. But the bill President Obama signed into law Thursday will have a lot to say about payday lenders and check cashers and rent-to-own furniture stores -- the blue-collar, far-off-Main Street joints.

That's to its credit. Michael Lewis's "The Big Short" is considered by many to be the definitive history of the financial crisis. (Dodd himself told his staffers and friends to read it.) But to understand American finance, you need to understand Ace Cash Express as much as you need to understand Goldman Sachs. Which is why Gary Rivlin's "Broke, USA" is a necessary companion. Where Lewis tells the story of mortgage-backed assets and the bankers who flogged them, Rivlin tells the story of the underlying mortgages and the folks who bought them.

The two are intertwined, and Rivlin shows there is nothing fringe about "fringe finance." Welders looking for an advance on a paycheck became unwitting cash cows for big banks, such as Bank of America. Small-town schoolteachers taking out home loans became the collateral for massive leveraged bets on housing worked out in London and Greenwich. But before they were Wall Street grist, the working poor were good business.

"To me, it was so counterintuitive," Rivlin says. "People with no money in their pockets are good for business?"

But they were profitable. And fringe finance bloomed. By 1996, there were more payday lenders than all the McDonald's and Burger Kings in the land combined.

It was also a different sort of business. Unlike traditional banking, it wasn't about finding good credit risks who could repay their loans promptly. Quite the opposite, actually. The central insight was that you wanted people who couldn't quite stay ahead of the loan. Then you could hit them with late fees and try to get them to refinance with more fees and catches, and generally bleed them and bleed them and bleed them.

Consider, for instance, the "yield-spread premium." It's an anodyne name for a real bit of financial villainy. If the person selling you your loan could lock you into a higher interest rate than what your credit score would qualify you for, the lender would give the seller a kickback. You might think locking people into loans that would be harder for them to repay would be bad for banks. And you'd be right.

The size of the fraud, though, is a bit difficult to wrap your mind around. An analysis by First American Loan Performance, a San Francisco-based research firm, found that 41 percent of the subprime mortgages sold in 2004 went to borrowers who qualified for prime-rate loans. A Wall Street Journal analysis found that in 2005, 55 percent of subprime borrowers were sold subprime when they qualified for prime. That same First American study found that 61 percent of the subprime mortgages issued in 2006 went to borrowers who qualified for prime-rate mortgages. In 2007, of course, the housing market crashed, and then the financial system crashed with it.

Or take payday loans. Rivlin says that when he started his book, he believed they were an important, useful financial innovation. Sometimes people need money, and quick.

"What really turned my opinion on the payday loan was how aggressively they pushed them," Rivlin says. "This is a dangerous financial product" -- the annual interest rate was typically around 300 percent -- "and yet the industry marketed it like a soft drink or candy. Every chain I came across offered $20 off your next payday loan if you brought a friend, family member or co-worker. At least a couple of the big chains would call people who had not been in the store in a month or two to convince them to come back.

"Then there's the up-sell. A customer comes in and asks for $200 but could qualify for $500. The store managers were instructed to point out no less than three times that they could qualify for $500. And they were giving these salesmen bonuses based on volume."

And it's only gotten worse since the financial crisis. Businesses that thrive on people needing access to emergency funds boom when unemployment skyrockets and wages dip and millions find themselves struggling to make rent each month. So what happens next?

"Congress got that financial reform was largely about protecting consumers, even if most pundits were talking about too-big-to-fail and derivatives," Rivlin says. "They banned yield-spread premiums and added a common-sense provision to the law that says a lender must take into account a borrower's ability to pay. They created an independent, well-funded Consumer Financial Protection Bureau with teeth. It's only a start, as its powers are limited. But it's also exactly what consumer lobbyists and lawyers for the poor have been clamoring for for years: an agency overseeing the financial system that puts the consumer, and not the safety and soundness of the banks, first."

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