“The clamp down.” “The crackdown.” “The crushing blow.”
Headline writers found no shortage of dramatic ways to characterize the final version of the CFPB’s short-term lending rule that dropped yesterday (Oct. 5).
Reactions to the regulations have run the gamut, as one might have expected after what was an extremely contentious five-year effort to bring federal regulation to an industry that had previously only been state-regulated.
In a narrative fit for a soap opera, that five-year journey has been filled with bold pronouncements, thinly veiled threats, magical thinking, accusations, counter-accusations, confusion, rage, alliances, betrayals and a series of hearings on Capitol Hill that at times seemed likely to erupt into actual fistfights.
Really, it’s a book worth reading for the names in the Congressional hearings alone – and lucky for you, we wrote it.
But today, the journey came to an end as the CFPB has offered its final ruling on the future of the payday and title lending industry in this country.
And it looks like the industry’s future is one that will be smaller – a lot smaller.
By the CFPB’s own estimates, the regulations as written will cut the number of short-term loans in the U.S. by more than half, and industry estimates put that figure closer to 80 percent. Other than perhaps the very largest players in the game, most loan lenders can’t soak that kind of volume loss, since payday lending (contrary to public opinion) is not a high-margin business to start with. The average storefront lender clears about $37,000 in profit – and under the new regulations, that annual profit would become a $28,000 loss, according to an economic study paid for by an industry trade association.
That destruction is necessary, according to CFPB director Richard Cordray. He said those profits (however thin) are made by trapping vulnerable customers in “debt traps” that have them constantly taking out new short-term loans to pay off older ones – a process that can cost them hundreds and thousands of dollars over the course of what was initially a “small-dollar loan.”
“This cycle of piling on new debt to pay back old debt can turn a single unaffordable loan into a long-term debt trap,” he warned. “It is a bit like getting into a taxi for a ride across town, then finding yourself stuck in a ruinously costly cross-country journey, with no exit ramps. With each renewed loan, the consumer pays more fees or interest on the same debt. The consequences are severe.”
But opponents aren’t so sure, arguing that the consequence of not having the money to pay bills is also pretty severe, and that that the majority of payday loans taken in the United States go toward paying off necessary household expenses.
So, what are the new rules, why will they shut down so much of the industry and what comes next?
Payday Lending (And Its New Rules At A Glance)
Payday lending is a big segment in the U.S., as storefront short-term loan lenders outnumber McDonald’s locations, and collectively lend out about $46 billion per year in loans to about 12 million borrowers.
The typical payday lending customer, according to the Pew Charitable Trusts, is a white woman aged 25 to 44. Payday lending is often associated with extremely low-income borrowers, but that is a misconception: Low-income, unbanked consumers don’t take out payday loans for the simple reason that most of them can’t. One needs a checking account to deposit funds into and a paycheck to use as collateral of sorts.
Under the current rules, a borrower looking take out $400 in funds would have one to two weeks to repay (depending on the pay cycle), plus $60 in interest and fees (about 15 percent on average). Costs tend to accrue as borrowers roll over their loans and tie on additional 15 percent of fees, which tend to stack into APRs pushing 300 percent and more. Roughly 22 percent of borrowers renewed their loans at least six times, leading to total fees that amounted to more than the size of the initial loan.
“Lenders actually prefer customers who will re-borrow repeatedly,” Cordray said in his remarks on the new regulations today, noting that rollover customers are the heart of the business model because of the high fees they collect.
Payday lenders do in fact collect a lot of money in fees – about $7 billion as of last year. But they do lose a lot of money to default – an unsurprising outcome given that they are known for lending to borrowers who are unable (due to poor or no credit) to tap into lower-cost mainstream financial alternatives. Default rates are estimated at 20 percent on the low end, while at a mainstream financial institution (FI), that rate is a lot closer to 3 percent on average.
At their center, the new rules go after the lender’s ability to continually net those fees by more tightly controlling how often, and how much, customers can borrow.
“These protections bring needed reform to a market where far too often, lenders have succeeded by setting up borrowers to fail,” Cordray said during a call with the media to discuss the rule.
The most controversial part of the rule change requires short-term lenders to put potential borrowers through a full payment test that confirms their ability to repay the loan and still meet day-to-day costs.
The rules also limit the number of loans that could be made in quick succession to an individual borrower to three.
Consumers and lenders can avoid the more complicated underwriting rules if the loan is less than $500 – and if it is restructured as an installment loan to get out of debt more gradually, such as allowing for payments to go directly to principal. Consumers, however, cannot take out these loans in tandem with other payday loans.
The rules, though considered draconian and punitive by the short-term lending industry, do have two significant concessions. There are no caps on annual interest rates on loans (though some states like California do have them). The CFPB also dropped a proposal it made last year to require strict underwriting on many consumer loans with an annual percentage rate higher than 36 percent.
The rules also make an exemption for community banks, credit unions and any other lenders that have not made such loans a big part of their business.
“Notably, we have no intention of disrupting lending by community banks and credit unions,” Cordray noted. “They have found effective ways to make small-dollar loans that consumers are able to repay without high rates of failure. For instance, the rule exempts loans made by a lender that makes 2,500 or fewer short-term or balloon payment loans per year, and derives no more than 10 percent of its revenue from such loans. These are usually small personal loans made by community banks or credit unions to existing customers or members.”
Interestingly, the CFPB’s regulatory nudge to credit unions was followed up with an unexpected signal boost from the Office of the Comptroller of Currency an hour later, when it formally rescinded Obama-era guidance that made it more difficult for banks to offer a payday loan-like product called deposit advance.
“Today, I approved rescission of the OCC’s guidance regarding deposit advance products, effective immediately,” acting Comptroller of the Currency Keith Noreika said in a press release. The CFPB’s payday rule, he added, “necessitates revisiting the OCC guidance.”
So Now What?
Advocates of the regulatory changes are cheering its passage and looking forward to when it goes into effect in 2019.
“Too many Americans end up sinking deep into a quicksand of debt when they take out expensive, high-cost loans,” said Suzanne Martindale, senior attorney for Consumers Union.
Opponents, on the other hand, note that Isaac Boltansky at the CFPB has made it difficult for consumers to gain access to a product that they truly like (and don’t complain about). As Karen Webster recently noted, consumers have spent the last half decade vociferously complaining about the credit rating agencies – and it was only after a massive data breach that the CFPB took interest. Consumers have offered a fraction of the complaints about short-term lending, and the CFPB has taken an obsessive interest in tightening up regulations.
“The CFPB rule is one where I don’t think it is well thought out, and it is a little offensive to the state system. My line on this rule is that it was written substantively by people who have never needed $500 to cover their costs or repair their cars. So, they prefer to severely limit credit opportunity for those folks, and seem utterly unaware of the social consequence of that.”
That wasn’t industry representative, by the way. That was Illinois Secretary of the Department of Financial and Professional Regulation Bryan Schneider at Innovation Project earlier this year.
The CFPB argues that it is, in fact, aware of consumer need, and noted that it is not trying to take away consumer access entirely, but just prevent it from becoming predatory. CFPB attorney Brian Shearer noted that consumers would be able to get the first loan 94 percent of the time under the new rules.
However, the reality is that some 80 percent of storefronts will be closing because their business model is unsustainable under the new rules. There is no first loan, if there is no first lender to get it from.
The new restrictions “will create credit deserts for many Americans who do not have access to traditional banking,” said Edward D’Alessio, the executive director of Financial Service Centers of America, an industry trade group. Mr. D’Alessio said his group was “exploring every possible avenue” to abolish the rules.
And there are a few avenues.
There is the Congressional Review Act, which could be used to prevent the rules from ever taking effect and to effectively block any new short-term lending regulation. But political experts think that remedy is increasingly unlikely given the current political climate.
“There is already CRA fatigue on the Hill, and moderate Republicans are hesitant to be painted as anti-consumer,” noted Isaac Boltansky, the director of policy research at Compass Point Research & Trading.
There is also the possibility that Cordray’s replacement, who will be appointed by Donald Trump and will take over in July 2018, could effectively block or change the rule before it ever goes into effect.
And there will be lawsuits, as the industry has said it will sue to keep the regulation from going into effect.
The moral for the story.
These final rules are very likely far from the final word to come from the federal government on the payday lending question.