Costly Cash: The Great Recession Is Paying Off for Pawnshops and Payday Lenders

Millions of Americans today are facing the worst money problems imaginable, but these same conditions are creating flush times for pawn shops and so-called payday lenders. As banks slashed their lending and jacked up fees on overdrafts and bounced checks and as credit card issuers made credit harder and more expensive to get, the number of people walking into a pawnshop or a payday-loan store has skyrocketed.

Borrowers get short-term loans at these stores using some asset as collateral -- their paycheck for example, or a car, or jewelry. The most common transaction is the payday loan, where a borrower usually writes a check that's post-dated to the next payday, usually two weeks out. Typically, a borrower writes a $300 check dated for two weeks later and receives cash totaling $255. The money store will cash in the entire amount two weeks later, pocketing the $45 difference as fees and interest on the loan.

Given the rising numbers of people who've been shut out of traditional forms of borrowing and credit, it's no surprise that profits at companies that run these stores and provide loans to the cash-strapped have accelerated. And for the bigger, publicly held companies, their stocks are going gangbusters. They've been helped by a confluence of factors, including an increasingly underemployed and income-constrained population, tighter credit and increased fees at mainstream lenders, and record gold prices.

A Rare Alignment

Despite the threat of increased regulation on these alternative lenders, investors continue to see them as good bets. First Cash Financial Services (FCFS) is trading around $22, EZ Corp. (EZPW) around $21, Cash America International (CSH) around $40 and Advance America Cash Advance Centers (AEA) is around $6 -- all at or close to 52-week highs.

"The moons don't often align for all business units on a diversified portfolio like ours, but everything did come together," said Daniel Feehan, CEO of Cash America, in a conference call after reporting that his company's profits more than doubled to $33.7 million in the fourth quarter. Cash America owns 500 pawn shops, where it provides check-cashing and makes short-term loans.

The payday lending industry (as it's often called, though most of these stores make other kinds of loans, too)has grown dramatically from just 500 locations in 1990 to over 22,000 today. The ranks of cash-strapped people swelled further during the Great Recession, with over 8 millionnewly unemployed as the U.S. jobless rate reached a multi-decade high. The cash crunch is also moving up the income brackets, with more middle-income families turning to these avenues for emergency funds.

"The median annual income of an Advance America customer has increased to approximately $50,000, and nearly 20% of our customers earn more than $75,000 annually," says Advance America CEO Ken Compton. Advance America is the country's leading payday lender with 2,700 stores nationwide. In the previous year, the average income of an Advance America customer was $41,000.

"A shift in Advance America's customer demographics over the past 12 months offers evidence that a broader range of Americans have chosen the cash-advance option to meet their financial needs," he says. Advance America's fourth-quarter profit more than tripled to $19.8 million on the back of growth in its online cash-advance business.

An Effort to Be More Appealing

There's little mystery about the booming popularity of alternative lenders. "The real driver is that people don't have access to cash -- nobody is providing credit. Banks aren't lending to regular people -- forget lending to the lower-income or credit-challenged," borrowers, says David Burtzlaff, an analyst at investment bank Stephens Inc., who follows the industry.

And the lenders have worked to make their stores more welcoming. They're open longer hours to accommodate people who can't get away from work, and the store layouts are more open and inviting, without the usual glass window between a loan officer and the borrower.

Pawnshops in particular have made an effort to lure in buyers who have previously shunned such stores. Some Cash America stores, for instance, have been upgraded to attract regular shoppers browsing for jewelry. The stores have been "elevated in terms of aesthetics, where it looks like a mall-based jewelry store with beautiful casing and nice lighting," says Elizabeth Pierce, senior research analyst at Roth Partners, an investment banking firm in Newport Beach, Calif. "Cash America sends jewelry to be refurbished and cleaned, and their stores get exposure to a whole new level of customers interested in buying watches and gold chains, and gold earnings and diamonds."

Debit Cards for the Unbanked

Of course, not even money stores will lend to everyone. The jobless aren't normally eligible for payday loans, though some lenders, like Ace Cash Express in California, are writing loans against unemployment checks, according to a recent Los Angeles Times report. However, the increased jobless rate has crimped business at some companies, so they're exploring newer and more innovative avenues.

Advance America, for instance, has already had success in attracting customers online. And Advance America and others are offering prepaid cards targeted at the unbanked population. People can bring in their cash into the stores, buy a debit card for $9.95 and load the cash for a fee of $2 every time. "Society is increasingly becoming cashless, and...there's a good potential for income [for lenders]. Every time a customer loadsit, they can collect a fee," says Pierce. Lenders market these cards as convenience for the unbanked, allowing them to be used where only debit cards are accepted or for online shopping.

Despite all the success the industry has had during the economic downturn (or, perhaps, because of that success), the threat of regulation looms large. Consumer advocates say these short-term lenders prey on the most vulnerable parts of society who have the least access to credit. For instance, the Center for Labor Market Studies at Northeastern University in a study released in February found that the unemployment rate among people with incomes below $12,499 was 30.8% in the U.S. in the fourth quarter of 2009.

Putting Rate Caps on Payday Lending

Leading the charge against the industry is the Center for Responsible Lending, a consumer advocacy group, which calls payday lenders "legal loan sharks" because of the high annual interest rates on their loans. For instance, in the $300 payday loan with a $45 fee, the annual interest rate would be 459%.

The industry defends its practices, saying payday lenders fulfill a need no other lenders are meeting. "People may need cash to pay for a medical emergency, make a car payment, or a medical bill, and banks don't make these sorts of short-term loans," says Steven Schlein, spokesman for the Community Financial Services Association, the trade group that represents payday lenders and lobbies state and federal government officials on behalf of the industry.

Still, at least 16 states have interest rate caps on payday lending ranging from 17% to 60%, according to the Center for Responsible Lending. And more states are likely to join in. Recently, rating agency Standard & Poor's reduced its debt rating on ACE Cash Express,to B+, from BB-, because of potential legislative actions in Arizona, Washington State and Ohio. ACE, owned by private equity firm JLL Partners, is the largest check-cashing operator in the U.S.

And the industry is bracing for a tougher regulatory environment in Washington. Last year, two bills were introduced in Congress to curb payday lending. Additionally, if the proposed Consumer Financial Protection Agency gets established, it's likely to put restrictions on how these companies price their loans.

Nevertheless, despite attracting some very vocal critics and the prospect for increased regulation, these businesses continue to thrive because they satisfy the need for something that's in short supply in many homes these days: cash.

Editor's Note: This is the first in a series of stories about money stores and payday lending that DailyFinance has published from March 9-12. On Tuesday, the first two stories concerned the payday lending industry's growth during the Great Recession and how a Texas retiree wound up with a 375% loan for $4,000. On Wednesday, we looked at how several cities in Texas are restricting the spread of money stores in their towns. Thursday's story examined Congress's lost zeal for regulating payday lenders. And Friday's final installment reviews some alternatives to payday loans for folks who find themselves strapped for cash.