Payday Loans vs. Loan Sharking

Todd Zywicki is once again crying in his coffee for high interest rate lenders:

Look, I am no fan of payday lending and auto title lending, and I also wished I lived in a world where people could get copious access to low-cost credit which they always repaid diligently and responsibly, and that no one ever had to use payday lending and the like. But taking away other people’s choices based on wishful thinking that somehow we will conjure up something better for them out of thin air, especially those with limited choices already, strikes me as an irresponsible way to think about regulation and unintended consequences. Especially when at the same time regulations supported by so-called consumer activists are making better credit products, such as credit cards, more expensive and less available for responsible low-income consumers and driving them out of the mainstream financial system.

The article to which Zywicki links is entitled "Dodd-Frank and the Return of the Loan Shark", also by Zywicki, complains that new rules could cause holders of credit cards to pay higher rates and have lower credit limits. Despite conflating high risk credit card borrowers with those dependent upon payday loans, Zywicki offers no evidence that we're speaking of the same population. I expect that there is overlap, but my experience with those who go to payday lenders is that they have no credit to begin with - when it comes to cost to the borrower, even before the 2009 Credit CARD Act you were much better off using your credit card and might consider a payday loan only after you had maxed out every other source of credit. All you need to get a payday loan is a checking account, and it doesn't matter if it's empty - in fact, that's the lender's expectation.

Zywicki complains,

Nontraditional financial products serve an important role in the marketplace for the millions of consumers who count on them. Even pawn shops and loan sharks are more palatable and less expensive than the bounced checks and utility shut-offs that would result in their absence.

Zywicki doesn't appear to know much about payday loans, pawn shops or loan sharks. Let's say I have an item of value and I want money. I can take my item of value to a pawn shop and secure a loan against the item, which the pawn shop holds as security. (Some pawn shops might also offer to buy the item outright, for resale.) If I repay the loan with interest I get my item back. The material differences between a pawn shop and a payday loan are that I don't have to own anything of value to obtain a payday loan - I simply hand over a postdated check that everybody knows to be presently worthless - and I have less time to repay the loan at a significantly higher cost than the pawn.

Granted it may still be a better deal as compared to defaulting on the pawn and losing my item of value, but there's no reason to believe I would be cavalier about defaulting on a pawn and scrupulous about repaying my payday loan. Also, I can't deepen my hole by re-pawning my item, but in many states I can make my situation much worse by obtaining payday loans from multiple sources. Many states attempt to limit borrowers in the number of payday loans they can take out at the same time or over a specified period of time, but it's difficult to police if the borrower is going to multiple lenders including out-of-state entities offering payday loans online.

Also, pawnbrokers operate under state law limits for their interest rates. Those rates may still be high, but they don't approach the rates charged by payday lenders. Why not?

A 1978 Supreme Court decision affirmed the concept of rate exportation, by which federally chartered banks can offer financial "products"—read: small (generally under $1,000) loans, via credit cards or check-cashing partners—nationwide, but in accordance with the usury ceilings in their home states. Quick to recognize an opportunity, Delaware, South Dakota, and six other states scrapped their small-loan laws (which is why your MasterCard bill always seems to originate in Sioux Falls). So, a check casher in a tough state can team up with a bank in a loose state to offer a gargantuan APR—500 percent, 1,000 percent, even 5,000 percent—regardless of local usury statutes. Virginia, for example, caps small-loan APRs at 36 percent. But a savvy Virginian lender can partner with a bank based in Delaware and then "import" that state's unregulated banking laws. The store may be in Richmond, but the rates are pure Wilmington.

Loan sharks, of course, remain subject to state and federal laws, including usury laws and RICO.

Federal authorities [in 2001 were] prosecuting Nicodemo Scarfo Jr.—the 36-year-old son of jailed-for-life Philadelphia godfather Nicodemo "Little Nicky" Scarfo—for running a loan-sharking and gambling operation in New Jersey. According to a New York Times article, an FBI sweep of Junior's computer hard drive revealed that he was breaking federal usury laws by charging annual interest of 152 percent a year for his very illegal loans.

Yes, it would appear that the most notorious loan sharks in the nation aren't able to demand the interest rates of a payday loan store. What's more,

An April [2001] New York Times survey of the practice in immigrant enclaves—the sharks' current core constituency—included the tale of one bodega owner who receives a 20 percent APR from his shark, a reward for years of dependability. For a cash-only businessman whose murky immigration status or poor credit rating might get him laughed out of Chase Manhattan, that's a solid deal.

But surely they'll break your knees if you don't pay?

Sharks prefer to seize personal property from defaulters, or hold immigration documents hostage, since brutality is likely to attract police attention. "I've always understood that it worked pretty well," Daniel J. Castleman, chief of the Manhattan district attorney's investigations division, told the Times. "We don't get a lot of reports about intimidation."

In other words, loan sharks operate by assessing credit risk and, when they guess wrong, typically by bypassing judicial process (self-help execution against a debtor's assets) or similar non-violent means. Which makes sense not only because of the possibility of law enforcement attention, but because you can't repay a loan if you're injured or dead.

But let's say the loan shark wants to go legit. He has a pool of responsible borrowers, sees the rates charged to similarly situated borrowers by credit card companies and payday lenders, and figures "I can turn a profit while charging a lot less than that." So he sets up a corporation, starts offering loans at 30%, and... Oops. Not in Michigan:

The interest of money shall be at the rate of $5.00 upon $100.00 for a year, and at the same rate for a greater or less sum, and for a longer or shorter time, except that in all cases it shall be lawful for the parties to stipulate in writing for the payment of any rate of interest, not exceeding 7% per annum.

Our ex-loan shark hasn't successfully obtained an exemption from that law, as have banks and credit unions, so he's limited to an interest rate well below what Zywicki argues is fair. In fact, so are you. So am I. And the consequence of violating that law is serious - all payments of interest (as well as penalties, late fees, etc.) are credited to the principal balance, meaning the law transforms the loan into a 0% interest loan. Every year or two I encounter a case where a borrower, fully aware of this law, convinces a friend to loan them money on a promissory note with a higher-than-lawful interest rate, knowing that "They tricked me" won't get the lender anywhere in court if they try to collect. Moreover, if you charge more than a 25% simple interest rate, still a mere fraction of what Zywicki suggests is a fair compound interest rate for those most in need of the money, you're a felon.

Zywicki has previously lectured us,

So social engineers may want to be careful about "saving" the poor from the scourge of subprime lending, because by restricting those choices they are likely just pushing them into even less-favorable credit options.¹

Except the fact that people use pawn shops and loan sharks suggests that, for many, those options are more favorable than payday loans. Certainly being able to enter into a binding promissory note with a friend or family member at 15% APR (or that loan shark who was lending to good borrowers at a 20% APR) is superior to forcing people to go to payday loan shops. So why does Zywicki seem to care only when regulation affects high interest rate lenders who are in business primarily because they've lobbied their way around laws that restrict or criminalize their competition - competition that in many cases would be a better source of money? Isn't he supposed to be a libertarian?
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1. That lecture came in a defense of subprime lending to people with marginal credit, dated March 14, 2005. I'll grant that he's not the only smart person whose insight into the housing market bubble seems retrograde, but why does his pattern seem to be "If regulation hurts major financial institutions, any other facts are irrelevant."