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Don't Try to Pawn your Movado (But Your Rolex is OK):

A few weeks back I noted that the retrenchment of consumer lending had led to the revival of layaway as a form of consumer credit, which consumers had abandoned over the past decade or so as an inferior option to credit cards.

Yesterday's WSJ brings tale of the growth of pawn shop borrowing by middle and upper-middle class consumers and small businesses as another response to the drying up of consumer credit:

Typically, pawnshop customers have a household income of about $29,000, according to Dave Adelman, president of the 2,400-member National Pawnbrokers Association. But operators around the country say they are seeing a surge in new activity fueled in part by a different clientele: middle- and upper-middle-class customers facing ravaged stock portfolios, tightened bank credit and unexpected layoffs. In areas dogged by high unemployment and foreclosure rates, the pawn business is especially robust.

Rick LaChappelle, owner of four pawnshops in Maine, calculates he has lent about 33% more money this year than last. "The banking industry is not giving out any money right now," he said. "So people are relying on second-tier lending institutions."

While some pawnshops -- like Beverly Loan Co. in Beverly Hills -- have discreetly served the wealthy for decades, more stores, such as Society Hill, are newly awash with furs, diamonds and other baubles from the bubble. At places like Society Hill, transactions are up by as much as 40% in recent months.

Even Beverly Loan has seen a shift in customer patterns. "We have had so many $50,000-plus loans and more businesses [as clients] than ever before," said Chief Executive Officer Jordan Tabach-Bank. Many business clients, he said, are "getting loans to meet payroll or other obligations because their lines of credit are frozen."

The more general policy lesson here is to recognize the substitution of consumeres among different types of consumer credit and that adopting policies that make it more difficult for consumers to gain access to certain types of consumer credit (credit cards or installment loans) will often force consumers to rely on inferior forms of consumer credit (pawn shops and layaway plans). Restricting the supply of credit (or some types of credit) does not eliminate demand (or the nead) for consumer credit.

I expect we'll see more stories like this if better forms of consumer lending continue to be dry and especially if new regulations are imposed that raise the cost of consumer lending. The Federal Reserve has just issued new regulations that will raise the cost of credit cards and restrict supply, but at least won't go into effect for some time. But as consumers are relying more on fringe-lending products as a substitute to the drying of good credit options, the boom in pawn shops and other fringe-lending operations may lead to further regulation of these products that will reduce their usefulness and availability as well. Many states, for instance, seem to be considering new regulations on payday lending. The biggest concern of all is that if all of these options get snuffed out we may see consumers pushed right out of the legal market completely, leading to a rise in illegal loan-sharking activity, both for consumers and small businesses. Although some growth in illegal lending is probably inevitable as a result of the combination of problems in the credit markets and poorly-conceived regulations, let's hope that this effect will be small.

alkali (mail):
I don't disagree with the proposition that some regulatory changes could impose costs that would affect the availability of consumer credit, but that hardly seems to be the "general policy lesson" of the current crisis. I might instead draw the conclusion that the most important determinants of access to consumer credit are not costs imposed by regulation, but rather (i) the prevailing business practices of the consumer credit industry and (ii) economic conditions generally. Certainly the night-and-day change in the availability of consumer credit over the last months can't be attributed to any regulatory change.
12.31.2008 9:53am
KenB (mail):
". . . the night-and-day change in the availability of consumer credit over the last months can't be attributed to any regulatory change."
I agree, but regulatory changes can have adverse effects. In our case, the road to deeper economic Hell may be paved with ill-considered consumer protection schemes.
12.31.2008 10:02am
Jessie (mail):
I would disagree that pawn shops are "inferior" forms of credit. One major problem with your "superior" forms of loans is that they trap the poor in a never ending cycle of interest payments and more loans to pay off previous loans. With most pawn shops, the client gives them the collateral and gets the loan, then if repayment becomes too onerous, they can simply walk away and start fresh. No collection notices, no eternal hounding by credit card sharks. I just don't see how traditional credit cards and payday loans could possibly be superior considering the longer term consequences for those who hit financial hard times.
12.31.2008 10:04am
Prof. S. (mail):
Restricting credit doesn't "[b]force[/b] consumers to rely on inferior forms of consumer credit (pawn shops and layaway plans)." Rather, restricting consumer credit means that the cost to some people who insist on using consumer credit increases.

This is not necessarily a bad thing, particularly if it means some marginal people don't use the credit in the first place. I mean, isn't this [i]exactly[/i] what should have happened with mortgages. Had they restricted access to credit, many sub-prime borrowers wouldn't have invested in housing. Sure, we could do a story about how there is an increase in contracts for deeds or loan sharking (both of which are inferior types of credit), but it would have been a net benefit.

The root of the problem is the attempt to use consumer credit to live beyond one's means. For example, the WSJ story talked about a parent who went to the pawn shop to get a loan to buy private school uniforms. The fact that she was at the pawn shop is not a story about credit, but a story about bad priorities and living beyond her means.
12.31.2008 10:09am
Crust (mail):
the revival of layaway as a form of consumer credit
Layaway isn't a form of consumer credit. If anything, it's a form of "retailer credit" in which a consumer lends money to the retailer in advance of a purchase at which time the retailer will deliver the good.
12.31.2008 10:19am
Crust (mail):
Here's a brief summary of the regulatory changes that trouble Todd:
[Banks would be] forced to give up practices like universal default (jacking up your rates to default levels if you miss a payment from some other grantor but are current with them) and double cycle billing. The changes pending also require banks to be less punitive about late payment (you'd need to be a full 30 days late to get in trouble).
Those sound like reasonable changes to me. It's true that they would have at least some adverse effect on bank profits and thereby the availability of credit cards and credit generally, but that doesn't show that on balance they're a bad idea.
12.31.2008 10:24am
Patrick216:
The biggest concern of all is that if all of these options get snuffed out we may see consumers pushed right out of the legal market completely, leading to a rise in illegal loan-sharking activity, both for consumers and small businesses.

I'm as red blooded of a conservative as anyone, but come on. Payday lenders allegedly need to charge some ludicrous figure like 200% per year interest in order to make money. In Ohio, where I live, a lot of payday lenders have left the state because their rates were capped at 29% APR.

I don't mean to sound like an elitist, but usury laws are among the oldest lending laws in the world, with the first usury law being passed by the First Council of Nicaea in 325 A.D. (That usury law limited interest to 1% per month). They exist for a reason. There comes a point where a credit is so risky that you can't reasonably price it in the market. 200% interest is not "reasonable;" neither, in my view, is 29% interest, but it doesn't shock the conscience like 200% interest does.

While libertarians would argue that free market participants should be allowed to price a loan product at whatever price they want, as this financial crisis has taught us, there are major economic and social impacts to these kinds of schemes. Thus, the wisened judgment of the past 1700-ish years has taught us that there comes a time when you must say "no mas" and not give people money.

Sadly, we're in that boat now.
12.31.2008 10:37am
Yankev (mail):

There comes a point where a credit is so risky that you can't reasonably price it in the market. 200% interest is not "reasonable;" neither, in my view, is 29% interest, but it doesn't shock the conscience like 200% interest does.
I live in Ohio, too. Overdraft fees are one of the most common alternatives to payday lenders; those fees can amount to much more than the payday lender charges. Does this also shock the conscience?

In our compassion for the poor, we have cut off access to a product they need. As you point out, despite the posturing of our legislators and self-appointed advocates for the poor, this product cannot be provided at a lower price. Now we have driven them to costlier products such as overdraft fees. And when the banks terminate their checking accounts for excessive overdrafts, they can go to loan sharks, who will charge much much more and use threats of violence to collect their loans. Some compassion.

If anyone could profitably offer payday loans for 29% instead of 200%, some enterprising business would have come along and made a fortune by offering them at 75% -- less than half of what the competition charged, and more than double the amount necessary (in the legislature's fantasy world) to make a profit. The other payday lenders would have dropped their prices or gone out of business. Instead, they are all going out of business, and we have "helped" their customers into the arms of illegal, violent, unregulated and much costlier alternatives.
12.31.2008 10:51am
Dick King:
I'm not sure I see the problem with universal default.

Suppose you're Megabank and you see a customer starting to be late on other loans. Doesn't that kinda make you wonder whether you're next?

Of course you could be an evil capitalist, looking to pounce on any excuse to jack up the rates on this hapless consumer. If that's the case, if your default rate is bigger than it was when you signed up for the credit card in the first place but reasonably safe but you jack up the price unconscionably anyway, then other banks -- and there are many -- will be eager for your business at a rate higher than when you first signed up but lower than Megabank wants to charge. Furthermore, the consumer doesn't have to do hir own research on this. BofA has enough information to trigger an offer to you with a balance transfer option.

What you [Crust] seem to be advocating is forcing a bank to stay with a newly risky consumer who is learning the fine art of payment juggling until they, themselves, are affected. Furthermore, you would force the bank to ride the problem for an extra thirty days with no compensation for the increased risk.

I'm of two minds about double cycle billing. I don't think a law against it would be terrible.

-dk
12.31.2008 11:05am
some dude:

Jessie (mail):
With most pawn shops, the client gives them the collateral and gets the loan, then if repayment becomes too onerous, they can simply walk away and start fresh.

The same should be said for mortgages, IMO. If the mortgage becomes too onerous, there should be no stigma attached from walking away. The bank gets the house like the pawn shop gets the watch.
12.31.2008 11:10am
Zed:
Patrick216, 200% interest rate is reasonable when the term of most payday loans are much less than one year. Let's say someone wants to borrow $50 for two weeks. How much interest should you charge? $2 sounds reasonable, right? That's roughly 200% interest rate compounded. Does paying back $52 for a $50 loan for two weeks really "shock the conscience"?

At 29% interest rate, that $50 loan will net you a whopping 40 cents. Is that worthwhile for the lender to stay in business considering all the transaction costs?
The consumer wants a small loan for a short period of time (i.e., until his next paycheck). The banks aren't offering these loans (at their 20% interest rates) because it is not profitable. That need will be met either by the payday lender or the loanshark.
12.31.2008 11:41am
Soronel Haetir (mail):

The same should be said for mortgages, IMO. If the mortgage becomes too onerous, there should be no stigma attached from walking away. The bank gets the
house like the pawn shop gets the watch.



It works with pawn because there is a large value discount, you aren't going to get anywhere close to the full value of the pawned item as a loan. A store knows it, the borrower knows it. Non-recourse has been discussed on the VC sveral times already.

Perhaps some sort of differentiation up front between investment loans and home (opposed to house) purchase loans would be in order.
12.31.2008 11:42am
markm (mail):
Patrick: That "200%" isn't comparable to interest on a bank loan. Banks charge hundreds to thousands of dollars for loan processing fees, to cover the costs of credit reports, paperwork, etc. When you figure these as an increase in interest rate, it's hardly noticeable on a 30 year $150,000 mortgage. But your payroll lender has to recoup his time to do the paperwork on a loan running just a week or two, usually for only a few hundred dollars. 29% APR on a one-week $300 loan is just $1.67, but the payroll costs for the clerk who sees the loan forms are filled in properly are going to be at least $10. So rather than helping poor workers, your state just drove out the least toxic form of credit available to them - so when they come up short a week before payday, now their alternatives are:

- Leave bills unpaid and incur penalties, generally at a higher effective APR.
- overdraw the checking account. The penalties on that are MUCH higher than the costs of a payroll loan.
- Pawn shops, IF they have portable collateral.
-
12.31.2008 11:46am
markm (mail):
Err, somehow the submit button was triggered early when it wasn't even visible on the screen. The final credit alternative is a loan shark - with even higher rates, plus the option of breaking your leg...
12.31.2008 11:50am
A.C.:
The problem with universal default is that it might tip someone in temporarily messy circumstances over the edge into permanently messy circumstances and bankruptcy. Not all cash shortfalls are a downward spiral. Many result from one-time illnesses, hurricane damage, or totalling a car, and the person cleans up the mess when he recovers or the insurance comes through. But if every loan he has is now at double the former interest rate, he may start into a downward spiral that he can't come out of.

Of course it's rational for any given bank to up its rates in such circumstances, because doing so puts that bank to the front of the line in terms of collecting from the person in question. But if they all do it, chances are good that no one will collect.
12.31.2008 11:54am
deathsinger:
markm,

loan sharks prefer to break knuckles or fingers on the non-writing hand (pinky, ring, or middle) as opposed to legs. Many people find it hard to work with a broken leg.
12.31.2008 11:59am
Crust (mail):
Dick King, what A.C. said in response re universal default.

That said, my point was not to advocate for these regulations (though I suspect they'd on balance be a good thing, I'd want to research the details further first). My claim is that they sound like reasonable (if perhaps arguable) regulations, not (to caricature) the bogeyman Todd seems to think they are.
12.31.2008 12:20pm
David M. Nieporent (www):
I would disagree that pawn shops are "inferior" forms of credit. One major problem with your "superior" forms of loans is that they trap the poor in a never ending cycle of interest payments and more loans to pay off previous loans. With most pawn shops, the client gives them the collateral and gets the loan, then if repayment becomes too onerous, they can simply walk away and start fresh. No collection notices, no eternal hounding by credit card sharks. I just don't see how traditional credit cards and payday loans could possibly be superior considering the longer term consequences for those who hit financial hard times.
Repeat after me: revealed preference.
12.31.2008 12:21pm
bobfromfresno (mail):
Anyone who thinks that lawaway is a form of credit, lacks a basic understanding of the word "credit."
12.31.2008 12:27pm
ReaderY:
I've always had the view that both the 13th Amendment and the Contract Clause prohibit an arrangement in which one and only one side of an agreement has a right to change the terms at any time (and often without notice). I've been shocked that nobody seems to have gone to court with the sauce-for-the-goose-is-sauce-for-the-gander claim that the since their credit agreement says in plain terms that the bank reserves the right to change any term at any time, the bank never actually obligated itself to do anything, and hence the agreement doesn't obligate them to do anything either (such as, for example, paying at any specific time.)

The only reason I can think of why this hasn't happened is that the Truth in Lending Act, which permits collecting attorney's fees, only applies to obligations. This gives lawyers representing consumers suing banks over credit disputes an enormous incentive to allege the existence of an obligation in order to be entitled to invoke the TILA and claim attorney's fees under it. Since the amounts involved are small and wouldn't ordinarily be worth paying an attorney over, a case where somebody would be willing to sue a blank and claim non-obligation might be rare because of this aspect of the legal landscape.

I also realize that in the absence of an agreement most states make loans payable on demand. Nonetheless, I would expect there would be cases where a bank would charge huge fees and/or trash a consumer's credit rating where it would nonetheless be advantageous, despite these issues, for a consumer or perhaps a bankruptcy trustee to make the sauce-for-the-goose-is-sauce-for-the-gander argument and challenge the enforcibility of credit agreements containing credit-issuer-can-change-any-term-at-any-time clauses.

I continue to find it astonishing that Professor Zywicki would protest about the unfairness of requiring banks to make contracts of the sort that requires them to actually follow what they promise and seek the other party's agreement to change it, just like everyone else has to do. The right to make and enforce contracts and the sauce-for-the-goose-is-sauce-for-the-gander principle are basic to what it means to be a free person with some measure of equality of rights, now as in the 1860s.
12.31.2008 12:50pm
some dude:
Soronel Haetir:

The same should be said for mortgages, IMO. If the mortgage becomes too onerous, there should be no stigma attached from walking away. The bank gets the
house like the pawn shop gets the watch.

It works with pawn because there is a large value discount, you aren't going to get anywhere close to the full value of the pawned item as a loan. A store knows it, the borrower knows it.


That's because the pawn shop has sound business practices. Should it be my problem or the government's problem to bail out banks because they don't?
12.31.2008 12:55pm
Patrick216:
A few thoughts regarding topics raised on this thread:

1. Universal Defaults. As a practical matter, if a consumer is insolvent, these don't matter because the consumer can't pay regardless of the interest rate. So the consumer files his/her 7 and the debt is discharged. Who cares if the accrued interest is $1,000 or $10,000?

The question is, does the universal default rule actually harm consumers? If the banks institute the universal default primarily in cases like I identified above, then I imagine the debate is academic. I'd be more concerned if the banks were instituting a default rate of interest on a $3,000 credit card balance because of a reported default on, say, a $50 utility bill or something.

2. Payday lending

Some have criticized my position on payday lending as being anti-poor, and have suggested that by banning payday lending, all I'm doing is encouraging illegal behavior.

My credit card allows me to withdraw roughly $1,000 as a "cash advance" at an interest rate of 16%. I can do so at any ATM. In other words, the market allows credit-worthy customers to have short-term loans of relatively small amounts.

Payday lenders need to charge 200%+ interest on these loans because their customers relatively rarely pay them back. All that debt creates a vicious cycle of poverty, both for the non-performing customers (who now have additional debt accruing at 200%) and for the performing customers (who must pay 200% to cross-subsidize the non-performing customers). I fail to see how, in the long run, any of this benefits poor people. If you don't have money, then go get a job or cut your expenses back. Establish credit. Yes, that's "hard" to do, but nothing worth having is ever easy to get.
12.31.2008 1:19pm
Steve:
The debate always seems to be between those who recognize the concept of predatory behavior and those who don't.
12.31.2008 1:24pm
Crunchy Frog:
Patrick216:


Payday lenders need to charge 200%+ interest on these loans because their customers relatively rarely pay them back.

Uh, no. Having been in the regrettable position of having to make use of these services, let me tell you how it works. You go in, fill out the paperwork, give them copies of your last two pay stubs (so that they know you have steady income), and ask to borrow, say, $100. They give you the $100, in cash (typically, their customers are already overdrawn), and you write them a check for $115, post-dated to the date on your next paycheck. There is no non-payment option that doesn't result in a) inability to ever maintain another checking account, and b) having charges brought against you for writing bad checks.
12.31.2008 1:51pm
A.C.:
Sure, once a person is in bankruptcy, the interest rate doesn't matter. But suppose that person has some debts and can afford to make the total monthly payment of $500 (except for that 6-week period when he broke his arm and couldn't work and therefore missed one payment on one account). If a lot of that goes to principal, the debt will go away eventually. If it's mostly interest, the debt won't.

That's why the interest rate matters. It can be the tipping point.
12.31.2008 1:52pm
JoeSixpack (mail):
Patrick - Most credit card companies will charge you a hefty initial fee for cash advnaces on top of that 16%. If you factor in the fee and assume that you will only keep the loan for 2 weeks, the APR could easily be over 100%.
12.31.2008 2:02pm
Harry Eagar (mail):
Good but somewhat dated discussion in
Fringe Banking: Check-Cashing Outlets, Pawnshops and the Poor
by John P. Caskey.

Most pawn customers don't have access to other bank services, so if they are regulated away from pawn, they won't be going to any 'legitimate' (if we can still use that word in the context of American banking) bank.

A friend of mine runs a pawn shop. He called the real estate downturn months before most people saw it, because lawyers and real estate agents were coming in for loans.

Patrick, payday loans cannot become perpetual if there is as regulation (as there is in Hawaii) that they can be renewed only once (or, even better, not at all).

Some payday lenders ignore the regulation and there is no effort at enforcement.
12.31.2008 2:44pm
Zed:
Patrick216, I don't think you actually read any of the payday lending responses to you. The 200% interest rate is due to the fact that the loan terms are very short (i.e., two week pay periods), not because most loans are not paid back. If you want to start your own 20% interest lending service, and charge people $1 for a two-week $100 loan, nothing is stopping you except the fact that you'll go out of business after paying expenses.

Furthermore, while your credit card gives you a cash advance of $1000 at 16% interest rate, you conveniently forgot to mention that almost all credit cards charge a 3% cash advance fee. That 3% is $30. If you pay back the loan in two weeks, your annualized interest rate if you include the fee is about 200%. What a coincidence that short-term loans for "credit-worthy" customers have the same overall cost as payday loans for poor customers. Long-term loans from payday lenders have lower interest rates.
12.31.2008 3:13pm
jmo (mail):
To add to what Zed says - if we're talking about the typical PayDay loan of $250 - if you used a BofA ATM machine that charges you $3 to withdraw cash and you paid back the loan in 2 weeks, that would equate to an effective interest rate of 30% - just on the ATM fee alone!
12.31.2008 3:56pm
jmo (mail):
Funny to think. I usually take out $100 at a time so a payday loan place would have to charge 75% interest just to compete with an ATM machine.
12.31.2008 3:59pm
Adam B. (www):
Pawnbroker: Burnt my fingers, man.
Louis: I beg your pardon?
Pawnbroker: Man, that watch is so hot, it's smokin'.
Louis: Hot? Do you mean to imply stolen?
Pawnbroker: I'll give you 50 bucks for it.
Louis: Fifty bucks? No, no, no. This is a Rouchefoucauld. The thinnest water-resistant watch in the world. Singularly unique, sculptured in design, hand-crafted in Switzerland, and water resistant to three atmospheres. This is the sports watch of the '80s. Six thousand, nine hundred and fifty five dollars retail!
Pawnbroker: You got a receipt?
Louis: Look, it tells time simultaneously in Monte Carlo, Beverly Hills, London, Paris, Rome, and Gstaad.
Pawnbroker: In Philadelphia, it's worth 50 bucks.
Louis: Just give me the money. [looking in display case] How much for the gun?
12.31.2008 4:44pm
Barbara Skolaut (mail):
So if everyone's selling to the pawnbrokers, who's buying?

The pawnbrokers have to sell their stuff or they go broke fast (but with a store full of stuff, which they can't eat or use to pay the mortgage).
12.31.2008 5:46pm
A. Zarkov (mail):
"So if everyone's selling to the pawnbrokers, who's buying?"

Excellent question. Do people flush with cash and without debt shop at pawnshops? I doubt it. Pawnshops tend to cluster in poor communities, the very ones without money. I was thinking of investing in Cash America, and I thought I would check out one of their stores. Using their store locater, I found that they have none in California, but lots in Nevada. What gives here? CA does have pawnshops. It must have something to do with regulation.
1.1.2009 10:47am
Harry Eagar (mail):
Bingo.

Just because pawnshops cluster in poorer neighborhoods does not mean that wealthy people do not know how to find them.

I hang out sometimes at my friend's shop. It is not unusual to have someone come in with $50K in gold coins to sell, or with money to buy a like amount. It doesn't happen every day but often enough.

People who like bargains and old jewelry also visit pawnshops.

I don't know if Cash America gets involved in mortgages, but my friend's independent shop does. I once watched while he made a loan of about $40K secured by a first mortgage on as $3M property. Lawyers should love pawnshops, they generate a lot of legal business, and not on collections.
1.1.2009 8:33pm
Soronel Haetir (mail):
I would figure lawyers would love pawn shops because they enjoy getting paid.
1.2.2009 12:51am
A. Zarkov (mail):
"It is not unusual to have someone come in with $50K in gold coins to sell, or with money to buy a like amount."

Why would someone go to a pawnshop with $50k in gold coins? Why not go to a coin or gold dealer who should give a much better price? Unless of course they want those particular coins back. I think of gold coins as another form of money. Indeed we might one day find that people only take gold coins for money after US dollars become worthless because of hyper inflation.
1.2.2009 1:45am
Yankev (mail):
Adam B, I know a few pawn brokers and either your state has incredibly lax regulation or you have been watching too many bad movies. They are subject to frequent police inspection. They turn in weekly reports of every item they receive in pawn. If they take in stolen property, they can be stuck for the entire amount they loaned on it. (A few insurance companies are willing to pay a recovery fee.) If they knowingly take in stolen property (including property listed on the reports they get from the police), they can lose their licenses, go to jail of both. And they cannot take in or sell firearms without holding an FFL and going thru the same steps as any other FFL holder.

Loved The Public Enemy, though. I'll bet the character Putty Nose is as close as you've ever come to a pawn shop.
1.2.2009 1:57pm
Yankev (mail):

The debate always seems to be between those who recognize the concept of predatory behavior and those who don't.
Or between those who fantasize that good intentions are enough and those who recognize the concept that certain economic costs cannot be legislated out of existence. The well founded concern of the first group often results in policies that make the disadvantages even worse, while the sponsors, who do not have to live with the real world consequences of their actions, can pat themselves on the back for their superior moral insight.
1.2.2009 2:02pm

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