Predatory Lending: Easy Money

Subprime lenders make a killing catering to poorer Americans. Now Wall Street is getting in on the act

It's a drizzly morning on Bankhead Highway, a hardscrabble stretch of Atlanta pocked by industrial parks and housing projects, but the miserable weather isn't enough to slow business at Title Brokers. For Title Brokers, a small pawnshop that lends money to borrowers willing to hock the title to their car for a few hundred bucks--and up to 25% a month in interest--Mondays and Fridays are without fail the busiest days. "Monday's for folks broke from the weekend, and Friday's when they get paid and stop by to make a payment," says the shop's tough-as-nails manager, Betty Autry.

At Title Brokers, loan reviews take 10 minutes. Autry gives the car a quick lookover and makes two calls to verify employment and address. She then cuts a check that she hands over in return for the car title and a second set of keys--just in case she has to send out a repo man. Shortly before noon, a young black male in his late 20s drives up in a rusting minivan in dire need of a new muffler. A repeat customer, Isaac quickly gets a check for $600--plus a reminder from Autry that he'll owe $750 in a month and $1,172 if the loan goes to 90 days. Even though he got his loan, he feels little relief. "If I wasn't in such a desperate situation, I wouldn't have come back," fumes Isaac, who asked that his last name be withheld. "I'm embarrassed to be here because these guys rip people off. This is $150 I should be investing for my children."

LOAN EXPLOSION. High-interest loans to the poor and hard pressed are hardly novel. But what is new is the invasion of mainstream financiers into what was once the sole province of check cashers, pawnshops, and the like. Wall Street and banks are financing a growing number of paycheck and car-title lenders like Title Brokers that help many Americans to survive from week to week. Over the past decade, the number of such subprime lenders--a catch-all term for lenders who cater to customers with poor credit--has exploded (table). The growth is echoed in the well-established second-mortgage and car-loan businesses that cater to individuals who can't get bank loans.

The boom in easy money has unleashed a storm of criticism by activists. "We've created a financial apartheid within society," says William Brennan, an attorney with Atlanta Legal Aid. "Lenders claim the reason that the cost of these financial services is so high is because the risks are so tremendous. This whole shadow banking industry is riddled with abuses that have nothing to do with credit risks."

Since the easy-money lenders are loosely regulated, they charge interest rates running anywhere between 300% and 2,000% on an annualized basis. Jerry L. Robinson, an Atlanta-based investment banker at brokerage Stephens Inc., calculates that payday lenders earn an annual 23.8% return on investment, vs. 13% to 18% for traditional consumer lenders.

More and more big-name banks and Wall Street firms are moving into subprime lending at the quick-cash end. Wells Fargo & Co., for example, started a joint venture with Cash America International Inc. last year that will allow Cash America's customers to cash their paychecks at special ATMs for a fee equal to 2% to 5% of the checks, with a $2 minimum. Since 1998, the bank has also arranged more than $700 million in loans to three of the largest check cashers: Ace Cash Express, EZCorp, and Cash America. What's more, leading Wall Street firms packaged and resold to investors nearly $60 billion of subprime mortgage loans alone last year, vs. less than $3 billion in 1995. The list of the top underwriters of such debt reads like a directory of the Street's white-shoe names, from Lehman Bros. to Merrill Lynch and Salomon Smith Barney (table).

Major banks have been quietly active in traditional subprime lending for years, too. And business is booming. Citigroup's CitiFinancial, for example, recorded a 77% increase in net income, to $390 million, in 1999. The unit, formerly called Commercial Credit, makes home-equity, personal, and consumer-goods loans through 1,170 special branches to customers who don't qualify for traditional bank loans.

Banking the unbanked is indeed big business--and growing fast. If they were a single financial institution, the subprime lenders would be one of the nation's largest banks, with more than $400 billion in assets, vs. $183.2 billion in consumer loans for the largest retail bank, Bank of America Corp. Given demographic trends, experts believe the market will top $1 trillion within a decade. As mainstream banks have raised the cost of checking, many low-income individuals have been left out in the cold. About 10% of households don't have a checking account, and 40% lack a credit card. Another 15% of Americans have no savings and live from paycheck to paycheck.

New lenders are only too willing to jump in and serve this lucrative market. More than 9,000 payday lenders, who typically provide two-week loans for a 15% fee, have sprung up in the past five years. A few, such as Ace Cash Express Inc., trade as public companies. And in cities such as Atlanta, some car-title lenders such as Cash 4 Titles have boldly moved into branch locations cast off by regular banks following mergers.

Entrepreneurs moving into the industry think that sprucing up the subprime business' image and practices is the way to go. George Johnson Jr., a former president of Blockbuster Inc.'s consumer-products group, is now applying the same formula that Blockbuster brought to the video-rental business, widely considered to be seedy at the time, to build a private venture of his own: Advance America, a nationwide chain of 1,300 payday advance offices. Johnson's partner, Billy Webster, a former head of scheduling and advance in the Clinton White House, says: "We're trying to professionalize this business, clean it up, change the way it works." Unlike payday lenders that let borrowers renew loans for a year or more and amass interest rates in the triple or quadruple digits, Advance America caps loan rollovers at three months. Then it tries to work out repayment schedules. Another firm, Checks into Cash, has spiffy designer furniture in its clean, well-lit offices and a dress code requiring office managers to wear dress shirts and ties.

POOR PREY. Even so, unscrupulous practices are still extensive. Among the worst offenders: Mortgage lenders who goad low-income homeowners into refinancing their existing mortgages with new loans that carry such high rates, high fees, and hidden balloon payments that they virtually guarantee default--and foreclosure. North Carolina community activists say they have found lenders who refinance the poor out of zero-interest loans on homes built by the nonprofit Habitat for Humanity and into new double-digit loans that they often can't repay. "There is a racial element to subprime lenders and whom they target," contends Russell C. Wirbicki, executive director of Chicago's Horizon Legal Center, a nonprofit group that helps homeowners avoid foreclosure. "I see the poorest of the poor being preyed upon. It's the opposite of redlining."

Consider the plight of Rodney Foster, a 51-year-old truck driver who lives in a small row house in North Philadelphia. After an injury left him unable to work, Foster slipped behind on his $30,000 Veterans Administration mortgage and other bills. Foster answered an ad offering "loan consolidations" and discovered--to his surprise--that a loan broker who was peddling his application to Equicredit, now a division of Bank of America Corp., had paid off his VA loan without his approval. Then the broker showed up at his door with loan documents for him to sign, Foster says. "They were in a big hurry because they had to get to another borrower's house," he recalls. "They said we could go ahead and sign the papers and read them later because [by law] we had three days to cancel the loan."

"BE A MAN." But when Foster studied the fine print, he realized he had exchanged his 9.5% VA note for a $43,200 loan at 12.05%--and roughly 13 points in fees rolled into the loans. When he called the next day to cancel the loan, "the man I talked to told me I couldn't, because I'd already signed," Foster says. "He told me to be a man and pay what I owed." Within months, Foster was behind on his payments once again. And when Equicredit moved to foreclose, Foster retained a Community Legal Services lawyer to fight the move. "Lord knows if I'd known all the things they were doing, I'd have never left the VA," he sighs. "The VA tries to help you keep your house. Equicredit's goal is to get you out." Foster's lawyer says that the lender recently offered to settle. An attorney for Equicredit declined to comment on the suit. A Bank of America spokeswoman says the loan was purchased from an independent mortgage broker. "All of our loans are brought to us through loan brokers, who are supposed to be acting in the interest of the borrower," adds the spokeswoman, Jerri Franz. "We believe ourselves to be a responsible lender. We don't condone unfair and fraudulent practices."

Subprime lenders argue that they are filling the credit needs of their customers by providing emergency loans that often were not available at any price before. And they dismiss any perception that they exploit the poor and vulnerable. "Our average consumer is a female schoolteacher with a car repair," says Allan Jones, founder of Cleveland (Tenn.) Check into Cash Inc., one of the pioneers of payday lending, which operates more than 470 stores in 15 states.

What's more, Jones argues that his 15% charge on two-week payday loans isn't interest but a service fee--and a cheaper alternative to the bounced-check charges banks impose, which he says can approach $60 for each check. "It's as much a service as a loan," says Jones. "It's quick, easy, and confidential. You can go to Wal-Mart Stores Inc. and overspend and then go to one of our stores and you're out in 15 minutes."

Even if their fees seem high, some lenders say credit risks justify the rates they levy. "I don't need to defend what we charge," says Todd Meislahn, founder of Oregon's Reconex Inc., which markets $49-a-month prepaid local phone service through 50,000 locations to consumers who had their phones cut off. "[Reconex is] serving the undisciplined credit-challenged in a way that suits their behavioral patterns," says Meislahn, who at age 12 was helping repossess cars and furniture for his father's rent-to-own business. "As a ratepayer, I don't want to be subsidizing people who don't want to pay their bill."

Activists counter that there isn't always as much risk as the lenders suggest--particularly on mortgages and for car-title lending. Typically creditors advance up to a quarter of a car's value. "Where's the risk if you're holding the title to a car?" asks Melissa Burkholder, executive director of the Consumer Law Center of the South. "Even if the car is a real junker, it's worth more than the loan." While banks that repossess and then sell a car are required by law to return any proceeds above the outstanding loan balance, car-title lenders are under no such obligation. Michael Darby, a computer-systems installer from Powder Spring, Ga., discovered that the hard way when he was a day late on a $700 title loan he'd guaranteed with his 1994 Nissan truck. When Darby balked, the lender offered to sell it back to him--for $4,000. The lender, Chaim Oami, disputes Darby's account and says: "He was more than 30 days late."

Most critics of subprime lenders don't view the borrowers as deadbeats who don't want to pay their bills--just working-class people who can't make ends meet. Monsignor John Egan, a Catholic priest at Chicago's Holy Name Cathedral, grew alarmed after hearing confessions from parishioners who borrowed from fringe lenders and found themselves drowning in the debt. After talking with one of them, P.J. (who asked that her real name be withheld), Father Egan scraped together $720 and took the 47-year-old single mother of two to pay off the loan. "Here was a family with no money for food, no money to recreate, no money for insurance, and she's paying $80 every payday on a $400 loan and $40 on a $200 loan," says Egan. But even after promising Father Egan she wouldn't visit the payday lenders again, P.J. admits she returned just a month later to pay for her daughters' school uniforms. "Father Egan came to my rescue, and I wasn't supposed to take out another [loan]," admits P.J. "But it's hard to say `no' to [the children] when what they're asking for are things they need--new coats, new shoes, new clothes."

HEAVY HINT. When borrowers fall behind in their repayments, the more aggressive lenders don't hesitate to resort to hardball tactics. After Norvin and Bernita Lee, a young Navajo couple in Littlewater, N.M., fell behind $705 on a 24%-per-year car loan, they received a notice from the lender that grabbed their attention: a drawing of two burly repo men, one holding a sledgehammer and the other a gun, standing over a borrower lying in a garbage can. When two repo men showed up weeks later, the Lees didn't hesitate to hand over their keys. Later the Lees won a $500,000 judgment against Gallup Auto Sales. Owner Jerry Egeland insists that the letter was sent out unbeknownst to him by a 19-year-old former employee. "She thought it was cute, it was a joke." And he said the Lees' truck was left abandoned 100 miles from their home. "It was completely stripped out. There was nothing left to the truck."

In some states, police officers unwittingly find themselves running debtors' prisons for payday lenders who file felony bad-check charges against delinquent borrowers. While most police departments now refuse to pursue such charges--viewing them as civil disputes--that didn't help Jamie Knight, a 19-year-old mother from Hanceville, Ala., who was thrown in jail after missing a payment on a payday loan. After taking out a $200 two-week loan from a local pawnbroker, which she backed with a $240 postdated check, Knight later asked the broker to give her a few days more to repay. "He agreed," she says, "but then deposited the check anyway"--and when it bounced, sent the local sheriff for her. "I never thought something like this would happen." An attorney for the lender did not return calls.

Federal regulators acknowledge that there are rampant abuses in fringe lending. "Predatory lending is a high enforcement priority," says Robert Pitofsky, Chairman of the Federal Trade Commission, which has brought eight major cases against home-equity lenders since last July for deceptive advertising and unfair credit terms "These cases involve some of the worst frauds I've ever seen in the consumer market. You have very vulnerable populations preyed upon by lenders whose goal is to foreclose."

NEW RULES. But short of legal action against the most egregious abusers, regulators and state officials concede there is little they can do to rein in predatory lending. "The federal legal system is very disclosure-oriented. If you disclose, you can do almost anything," sighs Ellen Seidman, director of the Office of Thrift Supervision, a federal agency. Seidman believes regulators' best weapon is to use their mandate to ensure the "safety and soundness" of banks to limit their ability to fund subprime activities. Indeed, the Federal Deposit Insurance Corp. recently circulated a proposal that would impose capital requirements that are several times the current 8% for subprime loans.

Some 19 states have usury laws to discourage abuses. But some banks get around them by using a 1996 U.S. Supreme Court ruling that prevents states from applying their rate ceilings on credit cards to out-of-state banks. A handful of banks, including Utah's Web Bank and Eagle National Bank of Pennsylvania, have exploited the loophole to partner with check cashers in other states. In Texas, for instance, Chicago-based Banco Popular has joined with two local check cashers, enabling them to skirt a 48% state cap on payday loans and charge annualized rates of 456%. The bank plans to exit payday lending in late April because of negative publicity. "We value our reputation too much to be caught in the middle of a misinformed debate," says North American Chief Operating Officer Roberto Herencia.

With so few restraints, some lenders are intent on moving into even more controversial areas. Reconex's Meislahn, for instance, envisions offering prepaid electricity and natural gas to consumers who have had those services disconnected. "To keep their rates low, utilities will want to disenfranchise customers who don't want to pay," he predicts. If he's right, that means that the good times for subprime lenders are likely to keep rolling for some time to come.