Book Notes - Shortchanged: Life and Debt in the Fringe Economy

Notes on Shortchanged: Life and Debt in the Fringe Economy

Howard Karger, 2005

Read May-June, 2007

I’ve been somewhat puzzled by the massive proliferation of check-cashing/paycheck loan stores. It wasn’t long ago that you would only see these in the economically weaker parts of town. Now there are three within a mile of my house. I’m curious about what those places are, and why they are increasing in number. Actually, I’m more curious about why they exist at all, because they all seem like ripoff joints to me.

Shortchanged covers the “fringe economy”, which can be loosely defined as the part of the financial economy that mainstream banks don’t serve. Alternatively, you could define it as that set of financial institutions that serve customers without good credit ratings. Specific sectors covered in this book are: credit cards, pawn shops, payday loans, tax refund lenders, check-cashers, rent-to-own, prepaid phones, the subprime loan market, foreclosure “protection”, used car dealer financing, and the getting-out-of-debt industry.

The fringe economy is huge. The rent-to-own industry brings in six billion dollars a year. There are about as many check-cashing and payday loan stores combined as fast food restaurants.

Karger confirms what I’ve personally observed, that the fringe economy has grown rapidly in recent years. In 1985, there were 4500 pawnshops in the U.S. In 2000, there were 14,000. The tax refund loan business doubled its revenue between 1998 and 2001.

A key point is that the profitable part of the fringe economy is not so much the sale of a product, but its financing. In most sectors, customers get into situations where they have to keep paying installments, and the fringe economy makes its profits by keeping them there.

Why is the fringe economy growing? Karger lists these reasons:

1. Abandonment by the mainstream financial industry. In 2000, there were no banks in Southwest Baltimore, a region where the median income was $19,000 and 58% of the residents lived below the poverty line. South Central Los Angeles is a community of 400,000 that had 19 bank branches and 133 check-cashing outlets (date unknown; probably mid-90’s). A main role of the fringe economy is to fill this void. There are indications that mainstream banks are starting reclaim some of this territory, although it’s unclear if that will be good or bad for consumers.

2. The rise of the working poor. The minimum wage was constant between 1997 and 2007. The median wage in real dollars has been decreasing.

3. Welfare reform. Without the safety net of welfare, people need other ways of raising money in hard times.

4. Immigration – uneducated immigrants who don’t trust or understand banks; illegal immigrants who must live in the cash economy.

5. The internet, and other technical advances which decrease the barriers to entry for new financial businesses.

You might add the rise of consumer debt, which has increased the number of people with bad credit ratings. The fringe economy has been making inroads into the lower-middle class lately.

The book does a good job of covering the different sectors. Lots of good information there. It’s well-written I’m glad I read it. I give it a solid ‘B’ for doing yeoman work in covering a topic that I’m clueless about.

But … the book disappoints me, as I’m more interested in deeper questions. The book generally reads like it was compiled by a guy reading a bunch of magazine articles. Nothing wrong with that, but I was hoping for more. Some specifics:

- There is little “inside information” on the industry. In the introduction, Karger says he tried, but these companies were very tight-lipped. Employees were afraid to talk. So I give him slack because it’s a difficult problem, but it would have made for a better book. Maybe some research project can involve sociology grad students working undercover in pawnshops etc. Now that would be interesting.

- Likewise, although there are a number of personal stories, I’m not sure I really understand what’s going through people’s minds when they make what seem to me to be poor choices. I’d really like to understand that better.

- A big question, and one I’m intensely interested in, is whether indebtedness is growing due to “overconsumption”, or more structural reasons. Put crudely, are people too blame for spending too much, or have costs risen beyond their control. Karger brings up the question, and is not impressed with the overconsumption argument. But doesn’t really answer the question to my satisfaction. He does state that “America has clearly undergone a major change regarding the acceptability of high debt and high levels of consumption” – without which the fringe economy would presumably not be growing as it is.

Karger’s moralistic conclusions about the fringe economy: it certainly serves a necessary role. This is explained well. However, it does so in a needlessly exploitative fashion. Sure, loans to people without good credit are going to be riskier, and you are justified in charging higher fees in this case. But many of the loan categories aren’t that risky: tax refund loans or payday loans where the consumers have a promise of future earnings and track records of past performance, or pawn and car loans where you have collateral. Profit margins are very high, which is shameful considering the profit is at the cost of people with the least amount of money. The grand irony is that often, poor people pay more money for less in return than the rest of us do. Where’s the fairness in that?

Karger’s suggestions for fixing the industry generally involve tightening of usury laws and greater regulatory oversight. Some states do have usury laws, but the rise of the internet and communications technology in general has made it easy for companies to avoid those laws by being located in laxer states.

Specific sectors – some interesting passages:

Credit cards. “Lenders want the original loan paid back for only two reasons: if they think they can lend the money to someone else at a higher interest rate, or if they are concerned that they won’t get their money back at all. Hence, the goal of a lender is to collect the most money possible through the highest interest rates and fees that the market will bear.” I guess that’s kind of obvious when you think about it, but it’s not very nice.

Pawnshops – actually in many ways the simplest and least dangerous of all fringe loans. The terms are obvious, and you can’t get into a spiraling debt trap.

One dirty trick pawnshops play has to do with avoiding stolen merchandise being pawned by theives and subsequently being found by the rightful owners. The larger chains will display jewelry in different stores (or even states) than where the jewelry was pawned. Gold is often melted down to be unrecognizable.

Payday loans. “Only 1% of all payday loans go to one-time emergency borrowers who pay their loan within two weeks and don’t borrow again within a year.” The problem here that many people run into is: you take out the loan, can’t cover it when it comes due, so you extend it, doubling your fees … it’s not uncommon to end up paying full multiples of the original loan amount.

Banks. Some banks get the most out of insufficient funds charges by using “big-to-small” algorithm. The idea is that if you write multiple checks in one day, the bank will process the one with the largest amount first, in the hopes of depleting your account sooner so the smaller checks will bounce. Nice.

Tax refund loans – fantastically profitable, since the lending risk is low. Note that many users of these services don’t have bank accounts, so they have to use check-cashing outlets, so they get double-ripped. One final point; I naively figured that not too many poor people get tax refunds, on the grounds that they don’t pay too much in taxes. Not so, because some significant government welfare programs work by providing tax refunds (sometimes in excess of tax paid), to the tune of over $30 billion per year. Here it would be good if the IRS were allowed to provide its own tax-preparation software and free online filing – right now it’s prohibited by law from doing so. (Personal note: you would think that these are some of the easiest tax returns around to file; 1040EZ isn’t that hard. Kind of strange that it’s the biggest growth area for tax preparation services.)

A growth area for the fringe economy may be in consolidation of services; providing one-stop shopping. On a somewhat black note, Karger points out the arrival of check-cashing services in convenience stores – not only do you get slammed by the check fees but you get to spend it on the highest-price groceries around.

Wal-Mart appears to be entering the check-cashing forum. From the tone used, Karger is no fan of Wal-Mart, but it should be noted that their fees are an order of magnitude less than most of the competition. Personally, I would figure Wal-Mart’s appearance here could be a real boon to consumers given that they would crush much of the predatory competition and provide reasonable service in its place.

Rent-to-own. This one puzzles me the most. Especially if your childless, it seems that much furniture is optional. So why would you pay quadruple what a tv is worth over two years, instead of going without one for six months and then owning one free and clear?

I'm very interested in that question, and Karger’s puzzled by it too. The reasons he gives are:

- Service at rent-to-own stores is generally very good (at least on the purchasing end). Customers are treated with much more respect than they would get at a middle-class appliance store.

- It’s what people know. Many customers are simply used to paying monthly fees for everything.

On the plus side, although expensive, rent-to-own has its benefits: you can get something useful for little money down, and there’s no risk of getting trapped in a debt cycle. You miss a payment, they repo the furniture, but there’s little long-term risk. An FTC study found that 75% of RTO (rent-to-own) customers are satisfied with their transactions.

Home refinancing. A dirty trick known as “equity stripping”. Qualify someone for a home-equity loan, but structure the loan in such a way that the payments are unlikely to be affordable. A likely way out for the customer? Take out another home-equity loan. Repeat the cycle until foreclosure. Home loans should be based on the ability to repay them, not on the amount of equity in the home.

Foreclosure notices are public, and are now being used by swindlers who try to scare homeowners into making emergency loans (or unknowingly, sales) at major cost.

Lots of nasty stuff going on in the housing market. It’s not so much subprime lending that’s a problem as predatory lending. The good side of the subprime market is that home ownership has become a realistic possibility for millions more people.

Used-car financing. In-house financing by independent car dealers is a major growth area of the fringe economy. Up to a quarter of all car sales in the U.S. happen at these dealerships. These places can be attractive because they don’t require credit checks. But the cruel flip side is that if you successfully pay off your loan, you haven’t strengthened your credit history at all. Next time you need to buy a car, you are back in the same position.

The fringe auto market is brutal: sticker prices are inflated; then you pay heavy interest rates, and then finally insurance premiums on the fringe are scandalous (Karger goes into this in detail). The net effect of this is that it’s not uncommon for a poor person to pay as much for a beater car as a middle-class person does for a new, nicer car.

Credit-counseling agencies – tend to strongly discourage bankruptcy. Get a cut of the amount repaid. Some agencies are reputable and honestly want to help consumers get out of debt. Many others don’t. Lots of sleaze among those. Major conflict of interest.

Playground Musings - II

As a followup to the last post, a few weeks ago, my family took a walk around our neighborhood and to our local park. Gorgeous day, about 6 pm. We walked through four blocks of housing, and did not see a single child playing. Got to the park, and there was one family there flying kites, and one middle-aged guy shooting hoops. Walked back home; saw nobody else along the way. From the park, we could see the backyards of a number of houses, many with their own play structures. But no kids using them. I can’t help but think that you just don’t see kids playing outside as much these days, at least in unstructured (i.e. non team-sport) play.

Let me see if I can knock off my other playground thoughts quickly.

1. Thinking about how playgrounds have changed in the last thirty years. The play structures of today were pretty rare when I was growing up; I don’t remember seeing many (in the U.S. at least) until the early 80’s. That’s a good thing; I think a lot of those structures would be really cool to play if I were a kid. On the other hand, playgrounds are missing a number of items that used to be standard: see-saws, merry-go-rounds, those funky animals-on-springs that you ride on. I don’t think a single park in Westminster has any of those, although I’ve seen a merry-go-round or two in other suburban parks. About half of the parks in Westminster don’t have swings.

Those were pretty fun things to play on; I assume the reason why they’re gone is for safety or liability reasons. Without digging into the safety statistics, I can’t tell how warranted that is, but it does seem unfortunate. And there is a tradeoff here – isn’t obesity a major health crisis in this country? Don’t we want kids to exercise more, and isn’t a good way to do that to make playgrounds more fun? Although, at the same time, I wouldn’t put any play equipment in my backyard that I would consider a safety risk (in particular, a trampoline, which seems to have gotten a lot more pervasive). But it seems like progress should have enabled us to have it both ways – fun equipment that is safer than it was 30 years ago.

I haven’t really dug into the topic much, but I enjoyed this article which discusses some the same of the same concerns: http://www.utexas.edu/features/2007/playgrounds/index.html.

2. A few of the parks that we take our kids to have the same general pattern – a smaller toddler section for the younger kids, and then a much larger main structure for the older kids. The toddler structures are more than sufficient to entertain a toddler; if we had one in our backyard, our daughter would love it. It was interesting then to observe that from day one my daughter always gravitated towards the largest, riskiest, highest structure in the playground. She only turned to the toddler section when bored with the larger one. I’m not sure what that signifies, except possibly that often our kids want to challenge themselves more than we’re ready for.

3. We went swingset-shopping earlier this year. You basically have two options: the tradational metal A-frame structure with various types of swings and maybe a slide. Prices generally run from $100 to $350. There don’t appear to be too many vendors. Or you can get a wooden structure. Huge number of vendors. Huge variance in the price. It’s hard to get a handle on the median price. Walmart has one as low as $288; seems like for most vendors the low end starts around $500 or so, and the high end goes into five figures.

We settled on a fairly nice metal one, at least for now, which cost about $250. But the process made me think about the meaning of inflation. In 1972 or so, my parents bought us a nice swingset that was fairly comparable in features to the one we bought this year. According to the government’s CPI data, the value of a dollar has decreased by about a factor of five in the past 35 years. So if that rate applied to swingsets, then my parents would have dropped about $50 for our set back then. That’s probably about what they paid. Looking online, I found a quote for $59 for a comparable set here: http://www.gti.net/mocolib1/prices/1972.html.

But the interesting thing is to think of how the CPI can be misleading. For this apples-to-apples case, it looks like it tracked well – mostly. One quibble: I bet the set we bought this year is safer and made of higher quality plastic and steel so it lasts longer. So the 2007 set is better, and the comparison isn’t quite even.

More importantly, the standard of living (in this case, the standard of swingsets) has increased as well. Our playground in 1972 was one of the best in the neighborhood. There’s a good chance that the one we bought this year was the worst one bought in our neighborhood – all the ones I’ve seen around us are nicer wooden sets. I’ll pull some numbers out of the air, and say that the price of the average swingset went from maybe $40 in 1972 to $800 now, or a twenty-fold price increase.

I don’t have a coherent point to make here; it’s just interesting (for me) to think about.

Back in Business

Sorry for the extended break. Too much stuff going on, and my leisure time allotment got whacked. Let's see if I can get going again.