The bad business of payday loans

In an effort to curb abusive lending practices, the US government has finally issued guidelines – long overdue – on short-term bank loans tied to consumers’ income. The new federal limits will help to protect consumers and, surprisingly, the banks who make such loans.

The benefit for consumers is obvious. These deposit advance loans (which are really just payday loans offered by legitimate banks rather than shady neighborhood dealers or online outlets) hit consumers with a myriad of expensive fees and charge up to 120 percent in interest. The new guidelines, issued last month by the Office of the Comptroller of the Currency and the Federal Deposit Insurance Corp., rein in the interest rates that banks can charge and the balloon payments they require.

Here is how the loans work: A bank advances money to existing customers against their paycheck, Social Security, or other benefit that is due to be deposited into their accounts. When the expected deposit hits, the bank withdraws its principal plus interest directly from the account.

So far, such an advance could be construed as a valuable service for cash-strapped consumers. Deposit advance lending exists because some people cannot meet their near-term financial obligations and need a little extra time to round up the necessary funds.

The problems start, however, when the deposit cannot cover the full amount of what the customer has borrowed. The bank takes its money anyway, and socks the borrower with overdraft fees and additional interest.  Since people who need these advances are invariably low income and struggling to pay their bills in the first place, these fees and interest charges quickly build up and can create a growing and never-ending cycle of debt.

But the practice is problematic for the banks, too. They do not typically do a credit check for deposit advance loans, which means they cannot assess the real risk of lending to such borrowers. Plus, high interest loans can easily push borrowers with bad credit further into the red and render them unable to pay back the bank. Free enterprise is not a license for irresponsibility and there are few business practices worse than lending to unqualified borrowers at high rates.  The outcome is predictable and ultimately runs to the detriment of both the borrower and the lender.

To see evidence of this, look no further than the subprime mortgage crisis of 2008, which began with mortgage loans to unqualified borrowers and ended in mass foreclosures and the widespread destruction of wealth.  While in that case banks and mortgage originators were able to offload most of their risk onto quasi-governmental agencies like Fannie Mae and Freddie Mac, there is no such safety net for deposit advance loans. 

It is also worth noting that the investment banks that bought the bad mortgages in order to securitize them and sell them to outside investors profited at first but eventually took massive losses when the loans went bad and the insurers who had backstopped them could not pay up. The moral of the story is that whenever lenders fail to assess true risk or actually compound that risk through onerous terms, the results are bound to be bad.

That’s why the new federal guidelines should help banks. They require banks to moderate the fees and interest on their loans to avoid increasing the chances of default and, equally importantly, refrain from lending when consumers show patterns of delinquency. It’s sad that in a free enterprise system the federal government has to step in to save the banks from themselves, but when lending bubbles can cause the type of havoc we witnessed in 2008, and when respected banks like Wells Fargo (Ticker: WFC) and U.S. Bancorp (Ticker: USB) choose to ignore the risk of offering dubious products like deposit advance loans, what choice is there?

For a list of the banks who do this and their respective terms, click here.

– Political and business commentator Sanjay Sanghoee has worked at leading investment banks Lazard Freres and Dresdner, as well as at multibillion-dollar hedge fund Ramius. His opinion pieces have appeared in Time, Bloomberg Businessweek, Fortune, and Huffington Post, and he has appeared on CNBC’s ‘Closing Bell’, TheStreet.com, and HuffPost Live.