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Follow the Money: Payday Laundry Edition

posted by Adam Levitin

Gretchen Morgenson is asking some interesting questions about where the money comes to fund predatory loans. The issue boils down to this:  the most questionable consumer is not done by depositories.  It's done by finance companies or (prior to 2008) by mortgage banks.  That means that these lenders need another source of funding for their loans. That could be their investors' equity, but more typically it is via lines of credit from other financial institutions. Absent lines of credit from large financial institutions, the amount of high-risk lending done in the US would likely be substantially less.

I hope that bank regulators (and Congress) start asking why banks are willing to fund loans that they aren't willing to make directly themselves because of reputational concerns. The current situation looks a lot like a rent-a-BIN variation:  instead of the bank providing the front to avoid usury laws or to enable MC/Visa card issuance, here we have the rent-a-finance-company situation, with the banks basically undertaking predatory lending behind the mask of the finance companies. Specifically, it sure looks as if NY banks were financing on-line payday lenders that made loans to NY residents at rates that violated the NY usury laws. (Let me emphasize that the issue here is not whether payday loans are good or bad--that's a separate discussion--but simply whether the NY usury laws were violated.)

It's hard to believe that the banks didn't know that the on-line loans were being made into NY. While there is a legal question about whether the on-line lenders are subject to the NY usury law, this was a risk the banks seem to have been willing to accept.  I don't know if that's enough to rise to the level to justify charges like aiding-and-abetting or conspiracy or the like (does Destro bear guilt for COBRA's actions?), but it's hard to call it anything other than payday loan laundering. 

Comments

At the end of the FIRE economy in 2006-2007, a significant number of borrowers were having trouble servicing their mortgages until they could get the properties flipped. They turned to hard money lenders for what they thought would be a short-term arrangement. Much of the hard money coming to the table was being raised from third parties in ways that did not comply with securities laws, but the regulators looked the other way. At least until it all fell apart, at which point they swooped in like self-righteous vultures.

Now financial institutions are raising bushels of funds, and since they supposedly have no other place to put them, they are shoveling them into payday lenders. Was this disclosed to the folks they raised the money from? If not, why aren't the regulators jumping all over this? If it was disclosed, why can't we find it in SEC filings?

Concerning Katya Jestin's quote in the article, does she really think a borrower and lender can contract away regulatory authority? Novel argument.

What an inept article that was. The author of the article did not do the most basic research on the company that is the focus of the article. If she had bothered to read the Rule 7.1 Corporate Disclosure Statement filed in the lawsuit mentioned in the article, she would have seen that Cash Call is "owned entirely" by J. Paul Reddam, who can be easily looked up on Wikipedia, Google, etc. and is a very rich man who owns a horse that won 2/3 of the Triple Crown. Reddam's name appears on the face of the complaint as a plaintiff for Pete's sake. This is such lazy lazy, lazy journalism. As neither CIGPF nor DBSI had any interest in its equity, they likewise had no interest in its profits from the alleged usurious lending. Thus, your surmise that they were somehow using Cash Call to avoid usury laws that would apply to them if they made the loans directly is unsupported. As a senior loan facility is the cheapest form of financing out there, it is not going to be carrying interest rates anywhere close to usury or getting a profit participation. There is no reference in the complaint to any equity or profit participation being held by CIGPF. Reddam's wealth implies that he was getting the profits, obviously.

Further, had the article fully described the lawsuit, the reader would have learned that it was filed against CIGPF because they had STOPPED financing Cash Call in 2007 and Cash Call was saying that was a breach of contract and tortious interference. But that would have spoiled the narrative about big banks that some people tell to sell newspapers.

The thesis that something which isn't being regulated directly should be regulated indirectly by regulating its lenders amounts to saying lenders should be made into regulators to fill regulatory gaps. That is a strange idea to emanate from people who think banks are nothing but fonts of evil and greed! What a resume to become a regulator! As a policy matter, organizations should do what they are best at and not the opposite. Governments have many mechanisms to regulate conduct directly. Capital is allocated best if it is allocated based on economics.

@ NP:

(1) Yes, the CIGPF suit is from 2007 and was about a dispute over the line of credit, but it was also resolved very quickly. We don't know what the resolution was, but CashCall clearly continued to have funding from someone. It's a reasonable surmise that it is not being financed entirely by equity now if it wasn't then.

(2) "As neither CIGPF nor DBSI had any interest in its equity, they likewise had no interest in its profits from the alleged usurious lending." WRONG. , "Profits" go to equity, but "profits" are determined by the cost of the financing. If the financing is more expensive, that means more of the revenue is going to the financiers and less to the equity.

(3) "As a senior loan facility is the cheapest form of financing out there, it is not going to be carrying interest rates anywhere close to usury or getting a profit participation." NOT QUITE. A senior loan isn't "cheaper" than equity per se: the price of financing has to be measured relative to risk. Comparing the cost of a senior loan and equity is comparing apples to oranges. We'd need to know whether the senior lenders are getting a relatively high return. I'm guessing reputational risk translates into a premium here. True, the banks are only taking the senior piece, but to make the loans work, you've got to be able to fund both the senior and junior pieces, the same as with a securitization.

(4) "The thesis that something which isn't being regulated directly should be regulated indirectly by regulating its lenders amounts to saying lenders should be made into regulators to fill regulatory gaps." This is just WRONG. The argument here is that something that IS that banks should not be able to do indirectly (fund usurious loans) if they cannot do it directly. If NY didn't have a usury law, then there'd be a place for your argument, but whatever one thinks of it, NY does have such a law.

(5) The banks named in the CIGPF suit (Citi and Deutsche) don't make signature loans directly. One might also note that they don't make and sell cars. But they are in the business of lending money, and when they are financing loans that they themselves won't make, it certainly starts to look like a laundromat. There's no regulatory capital arbitrage between these types of loans; the only arbitrage is on the legal/reputational risk.

(6) "Capital is allocated best if it is allocated based on economics." What does that even mean? Are you saying that absent regulation we will end up with Pareto efficient capital allocations? I'd like to see the evidence for that. Maybe we get a Kaldor-Hicks efficient world, but that doesn't mean a lot unless the parties are actually able seamlessly reallocate among themselves, which seems unlike given the reality of transaction costs. Economics just doesn't exist in a theoretical vacuum world without regulation.

Adam,

I think you try to prove a bit too much here.

Gretchen Morgenson's argument seems to be that we should "name and shame" banks that provide debt financing to payday lenders. I suppose I do not have a substantial problem with such information being publicized in the hopes of pushing banks toward a little more corporate social responsibility. (Though I wonder how much impact this will truly have; can banks’ really get more unpopular with the sort of people that are opposed to payday lending?)

But your argument seems to be that "banks [are] basically undertaking predatory lending behind the mask of the finance companies." In other words, by loaning money to payday lenders, they are doing payday lending, and, as you noted to NP, because "'profits' are determined by the cost of the financing," banks are reaping profits off this and are doing indirectly what they cannot do directly.

But there are a whole host of things that banks are not permitted to do, starting with 12 U.S.C. 24 Seventh through Dodd Frank. If it were true that banks are not permitted to lend money to businesses that perform a function that a bank cannot itself engage in, than banks can do nothing more than lend money to each other. (And travel agencies; See Arnold Tours, Inc. v. Camp). In short, the standard you propose, if a bank is forbidden from doing it, it cannot provide financing to someone doing it, is plainly unworkable.

Now, the allegation in this article is that the payday lenders were engaged in unlawful conduct. If one can prove that banks knew or should have known that the proceeds of their loans were going to be used to fund illegal activity, I can understand regulation. But my understanding is that regulation already exists to ensure that banks do not fund criminal activity. Further, my understanding from your post (e.g. "banks [are] basically undertaking predatory lending behind the mask of the finance companies.") is that it need not matter whether the payday loans are legal are not; what matters is that banks are deriving money from something they are not permitted to do.

Now, I could understand an argument where banks are alleged to have an equity interest in a payday lender disguised as a debt interest. For example, to simplify the analysis of loan origination, if banks just always lent money at 3% to companies with under $100MM in revenue, and a payday lender that fit that bill got a loan at 10% because the bank knew that the payday lender could pay the additional 700 bps due to the latter’s profit margins, that would might something different. Now the bank is essentially earning 300 bps on the loan and 700 bps on an equity stake.

Of course, the problem with the above analysis is that the bank might argue that the extra 700 bps are to cover the risk of reputational harm that it might suffer when journalists and law professors name and shame them. The bank might also argue that payday lenders are subject to higher regulatory and legislative risks. In short, it is hard to prove that the bank is earning more off loans to payday lending than off comparable loans.

I think the thought here, which is tantalizing is that:

(1) Payday lending is bad but efforts to outlaw or regulate it away have failed
(2) Payday lending requires debt financing from banks
(3) Efforts to regulate banks have been far more successful recently
(4) It may be possible to regulate away or outlaw bank lending to payday lending on the argument that banks should not lend to unsavory businesses, thus effectively outlawing or regulating away payday lending.

While this appears clever, setting a precedent that the government can go after businesses it dislikes by regulating away the availability of financing for such businesses creates serious risk for abuse. For example, a Republican congressman could argue that a bank that provides a working capital line to a doctor who provides abortions is a bank that is now indirectly aborting fetuses, which banks are not permitted to do. And a bank that provides financing to a plaintiff’s attorney is now indirectly practicing law, which banks are not permitted to do. And so on.

While few like payday lending, I think we may want to go back to the drawing board on this one.

@ Doug

(1) You're right that (national) banks are permitted to lend money to entities that are allowed to engage in activities that banks are not permitted to engage in directly. It's a false analogy, however, that misconstrues the point. National banks _are_ permitted to make payday and signature loans, but _everyone_ is prohibited from violating the usury laws. (Which usury laws apply might vary under Marquette, however.) The problem here is national banks financing a practice that is either (1) illegal for everyone or (2) legal for them, but unseemly. That's different than financing a practice that is legal for others (even if unseemly). The fact that national banks can lend to but not operate travel agencies or law firms or abortion providers doesn't have much bearing. This is about reputational risk, rather than whether banks are engaged indirectly in lines of businesses that they are prohibited to them directly.

(2) The better analog might be real estate investment: national banks can invest in real estate, but can't violate health and safety codes. If the are in the business of financing slumlords, would this be a problem? As a formal legal matter, perhaps not (see LA v. Deutsche Bank on this), but bank regulators are sensitive to reputational risks, and to the extent that financing abortions or a brutal overseas regime or environmental degradation, etc. creates reputational risk, I think its fair for prudential regulators to consider it as affecting safety-and-soundness.

(3) Obviously there's a problem if national banks are engaged in illegal activity themselves or are financing activity they know to be illegal. It's a different issue if national banks are financing an activity that they aren't sure is legal--e.g., does NY's usury statute apply to out-of-state lenders or to tribal lender?

(4) "Grey" area lending is a trickier legal issue (what is formally allowed), but should not be so difficult to parse through as a regulatory issue (what regulators will permit). My concern about national banks lending to or engaging in "grey" operations is that these aren't simply private entities. The capital structure of our banking system has an implicit government-owned tranche standing behind equity, but before debt. This implicit tranche is in the form of FDIC insurance, but also in the form of too-big-to-fail. Add to this that the national banking charter is a privilege of limited availability, and I think there is a duty for national banks to hold themselves to a higher standard of conduct and eschew "grey" areas.

(5) One might reasonably ask how far my argument goes--does it apply to all corporations because of their limited liability? Or how about any entity that requires a license to engage in business? I'm not sure, but banks are the easy case, and we do subject those other entities to various forms of regulation (e.g., common carrier duties).

(6) As far as the larger point about regulating the downstream lending (payday loans) by regulating the upstream (bank financing of payday lenders), this is something I've previously explored in my _Hydraulic Regulation_ article. It's something we already do all the time. For example, Fannie and Freddie functionally regulate the home mortgage market. Thus, when F/F indicated that they wouldn't buy mortgages with binding mandatory arbitration clauses, those clauses ceased appearing in mortgages. The same story goes for FHA and FDIC insurance--if you want to be insured, there are terms with which you must comply. Is this better than direct regulation? On an abstract level, I'd think not, but in the real world of trying to create good regulatory policy outcomes in the face of a system subject to asymmetric political influence between regulated parties and the public interest at large, this might be the most feasible option.

Adam,

(1) If you are saying that banks should not fund things they know are illegal, I agree.

(2) If you are saying that banks should not fund things they should know are illegal, I agree.

(3) If you are saying that regulators should take a hard look at banks funding things that are legal but only based on either an aggressive interpretation of the law or an interpretation that regulators or legislators could soon reverse themselves on, I also agree. (Perhaps your references to “grey areas” falls into this area and all of the below is moot?)

(4) But your and Morgenson's argument seems to extend beyond these unremarkable propositions to the notion that regulators should if not prohibit than at least hinder a bank's funding of entirely legal yet unsavory businesses, such as payday lenders. I would seriously hesitate to endorse the practice of instructing unelected regulators to use the power of the federal government to outlaw something through the back door by choking off financing for that activity. I dislike payday lending too, but the potential for this abuse is rather obvious here. (That, by the way, was the purpose of my comment on abortion and plaintiff’s lawyers, not an interpretation of the National Bank Act. )

(5) I don’t think your argument about regulators regulating safety and soundness and reputational risk from financing payday lending is terribly persuasive. First, it at best holds that regulators have the base authority to prohibit banks from making sound loans to legal businesses simply because those businesses offend the sensibilities of the regulators If says nothing about the wisdom of such a practice. Second, as said above, banks have such bad reputations that I don’t see how the discovery that banks loan to payday lenders will have a material impact on a bank’s safety and soundness. In other words, it is a highly aggressive interpretation of the regulators’ powers.

(6) The argument on FNMA and FMCC are not really on point because banks could still originate nonconforming mortgages and sell them into the private market if they so chose. That arb clauses were extirpated from mortgages after the GSE pronouncement was perhaps a recognition of the limited value of these provisions. But in any event, striking one provision from a contract is certainly distinguishable from trying to use federal bank regulation powers to bury a particular line of business.

(7) Finally, on your Hydraulic Regulation article, doesn’t the passage of Section 1044 of the Dodd Frank Act and the creation of the CFPB show that legislatures are better suited to address these issues than regulators trying to indirectly influence the market by pulling regulatory levers on the bank?

In short, I think it is a very interesting idea to ponder and discuss, but I hesitate to endorse its implementation. Your thoughts?

"The argument here is that something that IS that banks should not be able to do indirectly (fund usurious loans) if they cannot do it directly."

I think this is very fast and loose. The banks (which actually are not banks, but I will use your term for consistency)are funding at a nonusurious rate, a lender who happens to be exempt from usury laws, by hypothesis. So THEY are not doing anything usurious, directly or indirectly.

You seem to be sort of collapsing the two transactions to suggest that the "banks" should be evaluated as if they were themselves making the loans that are alleged to be usurious, but that has no economics to back it up because the banks are just getting the interest on their senior secured facility which is highly likely to have been in the single digits. And since economic substance is the only basis to collapse transactions, I don't know what you're left with. If you look at the complaint, CashCall claimed it had been contemporaneously valued at 700-750MM so I really don't think there is any foundation for speculating that the senior lenders were also getting any kind of an equity rate of return or even a subprime lending rate of return. Morgenson ends her article with the glowering admonition "Follow the money" which I am all in favor of, but if you do that, all available evidence is that the usurious portion of the money flow is going to the owner.

A final note: if the underlying transaction is privileged from state usury law by virtue of federal pre-emption, I think any state law that seeks to regulate the transaction indirectly, as you explicitly advocate, is going to have trouble escaping pre-emption itself. On its face it would be an attempt to defeat federal pre-emption.

Meant to add that a simple google search shows that at least one state regulator has had no trouble exercising jurisdiction over Cashcall this year, by determining that the economic substance of its relation with the Native American tribe mentioned in the article is a sham:

http://www.nh.gov/banking/orders/enforcement/documents/12-308-cd-20130604.pdf

Here in NY - the "pay day" lenders are all online since they are illegal. The result is that those online lenders can not use NY courts to attempt to get a judgment if the debtor fails to pay. They also routinely ignore BK stays and continue to harass debtors to pay up. (At least the ones located off shore or on Native American Reservations)

I tell my clients here in NY to quit paying them, change their bank account numbers, and ignore the threats.

Disclosure, or lack thereof is sometimes at the root of debates such as this. Companies, be they private equity lenders, beneficiaries of underhanded loan underwriters or otherwise, are able to hide their unwholesome financing practices by burying, redirecting or obfuscating policies and practices via subsidiaries and areas of the law that are too easily open to interpretation in the first place.

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