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Federal Reserve Bank of New York Staff Reports Payday Holiday: How Households Fare after Payday Credit Bans Donald P. Morgan Michael R. Strain Staff Report no. 309 November 2007 Revised February 2008 This paper presents preliminary findings and is being distributed to economists and other interested readers solely to stimulate discussion and elicit comments. The views expressed in the paper are those of the authors and are not necessarily reflective of views at the Federal Reserve Bank of New York or the Federal Reserve System. Any errors or omissions are the responsibility of the authors. Payday Holiday: How Households Fare after Payday Credit Bans Donald P. Morgan and Michael R. Strain Federal Reserve Bank of New York Staff Reports, no. 309 November 2007; revised February 2008 JEL classification: G21, G28, I38 Abstract Payday loans are widely condemned as a “predatory debt trap.” We test that claim by researching how households in Georgia and North Carolina have fared since those states banned payday loans in May 2004 and December 2005. Compared with households in states where payday lending is permitted, households in Georgia have bounced more checks, complained more to the Federal Trade Commission about lenders and debt collectors, and filed for Chapter 7 bankruptcy protection at a higher rate. North Carolina households have fared about the same. This negative correlation—reduced payday credit supply, increased credit problems—contradicts the debt trap critique of payday lending, but is consistent with the hypothesis that payday credit is preferable to substitutes such as the bounced-check “protection” sold by credit unions and banks or loans from pawnshops. Key words: payday credit, consumer welfare, bounced check protection, informal bankruptcy Morgan: Federal Reserve Bank of New York. Strain: graduate student, Cornell University. Address correspondence to Donald P. Morgan (don.morgan@ny.frb.org). The authors thank the following: Anna Peterson and Mathew Botsch for research assistance; Richard Stevens from the Federal Trade Commission for compiling complaints data; and Angel Annussek, John Caskey, Richard Hynes, Ronald Mann, Mike Morgan, James Vickery, Til Schuermann, and Charles Steindel for helpful comments. The views expressed in this paper are those of the authors and do not necessarily reflect the position of Cornell University, the Federal Reserve Bank of New York, or the Federal Reserve System. 1 The payday loan industry depicts itself as a financial crutch propping up struggling borrowers until their next paycheck. In truth, the loans are financial straitjackets that squeeze the working poor into a spiral of mounting debt (Atlanta (GA) Journal-Constitutional Editorial, 12/8/2003) I. Introduction In 1933 President Roosevelt closed all banks in the U.S. The “bank holiday” was a desperate effort to calm bank depositors and halt the runs that were draining money and credit from circulation. In 2004 and 2005 the governments of Georgia and North Carolina permanently closed all the payday lenders operating in their state. Payday lenders are “fringe banks” (Caskey 1994): small, street-level stores selling $300 loans for two weeks at a time to millions of mostly lower middle income urban households and members of the military. The credit is popular with customers, but despised by critics, hence the bans in Georgia and North Carolina. This paper investigates whether those “payday holidays” helped households in those states. Why might less credit help? Because payday loans, unlike loans from mainstream lenders, are considered “debt traps” (Center for Responsible Lending 2003). 1 The debt trap critique against payday lenders seems based on three facts: How Households Supply Financial Capital How Households Supply Financial Capital By: OpenStaxCollege The ways in which firms would prefer to raise funds are only half the story of financial markets The other half is what those households and individuals who supply funds desire, and how they perceive the available choices The focus of our discussion now shifts from firms on the demand side of financial capital markets to households on the supply side of those markets The mechanisms for saving available to households can be divided into several categories: deposits in bank accounts; bonds; stocks; money market mutual funds; stock and bond mutual funds; and housing and other tangible assets like owning gold Each of these investments needs to be analyzed in terms of three factors: (1) the expected rate of return it will pay; (2) the risk that the return will be much lower or higher than expected; and (3) the liquidity of the investment, which refers to how easily money or financial assets can be exchanged for a good or service We will this analysis as we discuss each of these investments in the sections below First, however, we need to understand the difference between expected rate of return, risk, and actual rate of return Expected Rate of Return, Risk, and Actual Rate of Return The expected rate of return refers to how much a project or an investment is expected to return to the investor, either in future interest payments, capital gains, or increased profitability It is usually the average return over a period of time, usually in years or even decades Risk measures the uncertainty of that project’s profitability There are several types of risk, including default risk and interest rate risk Default risk, as its name suggests, is the risk that the borrower fails to pay back the bond Interest rate risk is the danger that you might buy a long term bond at a 6% interest rate right before market rates suddenly raise, so had you waited, you could have gotten a similar bond that paid 9% A high-risk investment is one for which a wide range of potential payoffs is reasonably probable A low-risk investment will have actual returns that are fairly close to its expected rate of return year after year A high-risk investment will have actual returns that are much higher than the expected rate of return in some months or years and much lower in other months or years The actual rate of return refers to the 1/19 How Households Supply Financial Capital total rate of return, including capital gains and interest paid on an investment at the end of a period of time Bank Accounts An intermediary is one who stands between two other parties; for example, a person who arranges a blind date between two other people is one kind of intermediary In financial capital markets, banks are an example of a financial intermediary—that is, an institution that operates between a saver who deposits funds in a bank and a borrower who receives a loan from that bank When a bank serves as a financial intermediary, unlike the situation with a couple on a blind date, the saver and the borrower never meet In fact, it is not even possible to make direct connections between those who deposit funds in banks and those who borrow from banks, because all funds deposited end up in one big pool, which is then loaned out [link] illustrates the position of banks as a financial intermediary, with a pattern of deposits flowing into a bank and loans flowing out, and then repayment of the loans flowing back to the bank, with interest payments for the original savers Banks as Financial Intermediaries Banks are a financial intermediary because they stand between savers and borrowers Savers place deposits with banks, and then receive interest payments and withdraw money Borrowers receive loans from banks, and repay the loans with interest Banks offer a range of accounts to serve different needs A checking account typically pays little or no interest, but it facilitates transactions by giving you easy access to your money, either by writing a check or by using a debit card (that is, a card which works like a credit card, except that purchases are immediately deducted from your checking account rather than being billed separately through a credit card company) A savings account typically pays some interest rate, but getting the money typically requires you 2/19 How Households Supply Financial Capital to make a trip to the bank or an automatic teller machine (or you can access the funds electronically) The lines between checking and savings accounts have blurred in the last couple of decades, as many banks offer checking accounts that will pay an interest rate similar to a savings account if you keep a certain minimum amount in the account, or conversely, offer savings accounts that allow you to write at least a few checks per month Another way to deposit savings at a bank is to use a certificate of deposit (CD) With a CD, as it is commonly called, you agree to deposit a ...[...]... learned the lessons of the 1930s • 1 • 2 • THE COST OF CAPITALISM When faced with a collapse of the financial system, any and all steps are taken to stabilize the situation But policies leading up to the crisis of 2008, enacted over the past 25 years, make it abundantly clear that economists, elected of cials, and central bankers did not learn the lessons of the 1920s The record of the U.S economy over the. .. on Main Street and the Boom and Bust Cycle of the Past 25 Years In years to come a casual reader of economic history may find it hard to piece together how things so quickly went from serenity to panic as the first decade of the new millennium came to a close Paradoxically, the seeds of the 2008 crisis can be found in the widespread acceptance of the notion that the U.S economy, over the previous decades,... legal access to the safety nets put in place for commercial banks in the aftermath of the Great Depression It is not hyperbole, therefore, to lay the multi-trillion-dollar bill for the 2008 financial system bailout, and the deep recession of 2008-2009, at the doorstep of misguided confidence in the infallibility of free markets Is this book, therefore, simply an indictment of Alan Greenspan and Ben Bernanke?... winter of 1990, on the eve of the first U.S war with Iraq, I lunched with a close friend and colleague, Paul DeRosa, a fellow economist Over the course of the meal I explained that I intended to publish a radical forecast for the U.S economy The centerpiece of my outlook was the S&L crisis and the high debt levels of U.S households Oil prices and the Mideast, I was convinced, were sideshows The headline for... in the pages that follow, mainstream policy makers, economists, and central bankers spent the past 25 years willfully denying these two self-evident truths The global financial crisis of 2008 and the 2008-2009 worldwide recession, this book will make clear, can be laid at the doorstep of these painful omissions of economic fact Amidst the wreckage of the recent crisis, calls for expansive retooling of. .. recession was baked in the cake, and that the snowballing problems in the financial system would require both dramatic additional Fed ease and some form of direct federal intervention Just as in 1990, it turned out, my understanding of Hy Minsky’s work put me lightyears ahead of the consensus thinkers in the months leading up to the 2008 crisis But by the summer of 2008, as the world flirted with an economic... Crisis, and End 6 • T HE C OST OF C APITALISM Figure 1.2 010099989796959493929190898887868584 40000 30000 20000 10000 9000 100 90 80 70 Index, 6-Month Moving Average, Log ScaleIndex, 1-Month Moving Average, Log Scale Japan’s Stock Market Collapse and the Lost Decade for Its Economy Japan: Nikkei Stock Market Index vs. Industrial Production Nikkei Stock Price Index (L) Industrial Production (R) economy did not reduce wild Wall Street swings. In succession, we wit- nessed the 1987 stock market crash, the S&L crisis of the early 1990s, the Long-Term Capital Management meltdown, and the spectacular technology boom and bust dynamic of the late nineties. In Asia we had two bouts of financial market mayhem: Japan’s early 1990 collapse (see Figure 1.2) which was followed a few years later by the panic that swept through much of the newly emerging Asian economies. As it turned out, this daunting list of financial market upheavals were simply dress rehearsals for what was to later occur. The unprece- dented rise and then swoon in U.S. residential real estate catalyzed a global financial market meltdown of unprecedented proportions. And the cost around the world includes a deep global recession. Any notion that the Great Moderation was a permanent fixture died in 2008. How did things go from so good to so bad in such short order? May- hem on Wall Street following serenity on Main Street, I contend, is no coincidence. Instead, quiescence on Main Street invites big risk taking on Wall Street. And big wagers create the potential for big prob- lems from small disappointments—despite the reality of a moderate economic backdrop. And therein lies the paradox. Goldilocks growth on Main Street spawned risky finance on Wall Street and, ultimately, the crisis of 2008. Mainstream economists missed this dynamic because they were so excited about low wage and price inflation. Thus, a legion of con- ventional analysts simply failed to recognize that the inflationary boom and bust cycle of the 1970s had been replaced by an equally violent Wall Street driven cycle. Hyman Minsky, a renegade financial economist of the postwar period, would be amused if he were alive today. Minsky, throughout his professional life, insisted that finance was always the key force for mayhem in capitalist economies. He put it this way: Whenever full employment is achieved and sustained, busi- nessmen and bankers, heartened by success, tend to accept larger doses of debt financing. During periods of tranquil expansion, profit-seeking financial institutions invent and reinvent “new” forms of money, substitutes for money in portfolios, and financ- ing techniques for various types of activity: financial innovation is a characteristic of our economy in good times. 1 Minsky argued that this phenomenon guaranteed financial insta- bility. He developed a thesis that linked the boom and bust cycle to the way in which investment is bankrolled. He made two simple The Postcrisis Case for a New Paradigm • 7 observations. First, the persistence of benign real economy circum- stance invites belief in its permanence. Second, growing confidence invites riskier finance. Minsky combined these two insights and asserted that boom and bust business cycles were inescapable in a free market economy—even if central bankers were able to tame big swings for inflation. Much of this book critically reexamines the last several decades with an eye toward the interplay of Goldilocks growth expectations versus increasingly risky finance. I make the case that U.S. recessions in Recall that when Hanna boarded the bus for Phoenix, she had handed her house to her bank. The bank, at that moment, had a house that it could sell for $538,000. But it loaned Hanna $588,000. Thus, the bank lost $50,000 on the deal. Banks are in the business of borrowing money from some and lending to others. The value of what they owe—their liabilities—is always supposed to be lower than the value of what is owed to them—their assets. When they subtract their liabilities from their assets, the remainder is their equity. The problem for banks arises if the banks have lots of Hannalike loans in their portfolio. As the pie charts in Figure 3.2 make clear, that is exactly what happened. In 2001 nearly 60 percent of mort- gage borrowers looked like Hal, and less than 10 percent were involved in risky finance. By 2006 fully one-third of home buyers opted for risky mortgage products. Moreover, a large number of homeowners with no moving plans decided that Hanna had the right strategy. If we combine refinancing with risky home buying finance, we discover that by 2006, nearly half of the housing-related financ- ing was done with risky loans. When the bank forecloses, it replaces one asset with another. The loan to Hanna is replaced by the house, since the loan has gone bust and the bank now owns the home. But the loan was for $588,000, and the house is worth $538,000. If lots of home loans go the way of Hanna’s loan, then the total value of the bank’s assets falls below the total value of its loans to other people—its liabilities. When a bank’s liabilities are larger than its assets, it is bankrupt. When banks, and investors in those banks, simultaneously discover that bank assets are worth much less than previously thought, we have hit the Minsky moment. At that juncture, if we force banks to 34 • T HE C OST OF C APITALISM The ABCs of Risky Finance • 35 Figure 3.2 Risky Finance in Mortgages 2001 Jumbo Prime 20% Subprime 5% Alt-A 3% FHA & VA 8% Home Equity Loans 6% Conventional, Conforming Prime 58% 2006 Conventional, Conforming Prime 33% Home Equity Loans 14% FHA & VA 3% Alt-A 13% Subprime 20% Jumbo Prime 16% 2007 Jumbo Prime 10% Subprime 3% Alt-A 6% FHA & VA 7% Home Equity Loans 13% Conventional, Conforming Prime 61% revalue their assets to current market prices, it becomes apparent that they are insolvent. At such moments, Minsky liked to talk about the “parade of walking bankrupts” that dotted the banking commu- nity landscape. But we don’t drive all banks into bankruptcy. We collapse inter- est rates. We engineer forced mergers. We come to the banks’ res- cue with expensive bailouts. Policy makers, thankfully, learned their Source: Inside Mortgage Finance (by dollar amount); 2007 data is as of December 31, 2007 lessons from the 1930s. There is a paper trail of furious governmen- tal efforts, cycle to cycle, each aimed at protecting the banking system. The most important two lessons to take away from the saga of Hanna and Hal? When good times persist, risky finance is the logi- cal outcome. Risky finance, in turn, sets both the borrower and the lender up for mayhem somewhere down the road. 36 • T HE C OST OF C APITALISM • 37 • Chapter 4 FINANCIAL MARKETS AS A SOURCE OF INSTABILITY Those of us who looked to the self-interest of lending institutions to protect shareholder’s equity (myself especially) are in a state of shocked disbelief. —Alan Greenspan testimony, October 23, 2008 I’m shocked, shocked to find that gambling is essentially do the same thing. As they contemplate their Bloomberg screens, they see how opinions about the world ahead are evolving. Emerging company, industry, and sector developments inform opinion about the economic entities in question and also influence attitudes about overall economic prospects. Likewise, changing senti- ments about aggregate trajectories at times weigh on opinion about company, industry, and sector prospects. In Wall Street jargon, bot- tom-up and top-down opinion influence one another. Obviously, company projections, macroeconomic forecasts, and TV talking head commentary are different animals. Companies care about sales rates and bottom lines. Economywide forecasts attempt to pres- ent a consistent vision of the future for major economic barometers. News coverage must be instantaneous and entertaining. Nonetheless, most conjecture about the future shares a common language and arithmetic. Talk almost always compares emerging news to previous expectations. Growth rates, not levels, are in focus. Moreover, we are most captivated by evidence of changes in growth rates, not in the ascent to new levels nor in the extension of ongoing trends. As my dad, a physicist, liked to put it, “It’s a second derivative world.” Capitalist Finance Drives Schumpeter’s Innovation Machine This immediate processing of news, to constantly reshape our vision of the future, provides spectacular benefits to capitalist economies. As the news shapes opinion, it rewards success and punishes failure. In particular, money pours into areas where innovative approaches rev- olutionize effort. Wall Street, on a real-time basis, shines a spotlight on such successes. And success, for a long while, breeds imitation and more success. In that fashion, capital markets channel funds toward 62 • T HE C OST OF C APITALISM innovative and therefore lucrative endeavors, and deny funds to anti- quated enterprises. Real-time, 24/7, Wall Street feeds the innovation machine. For Schumpeter, this is God’s work: [In] capitalist reality as distinguished from its textbook picture, it is not [price] competition which counts but the competition from the new commodity, the new technology, the new source of supply . . . which commands a decisive cost or quality advan- tage and which strikes not at the margins of the profits and the outputs of the existing firms but at their foundations and their very lives. [An analysis that] . . . neglects this essential element of the case . . . even if correct in logic as well as in fact, is like Hamlet without the Danish prince. 2 Thus, capitalist finance, most of the time, provides the monetary reward system that propels Schumpeterian magic. Schumpeter’s great insight was his rejection of models that looked at the world as static. His notion of creative destruction—innovations that bankrupt cham- pions of an earlier order—transcended theories concluding that mar- kets came to stable resting places—equilibriums. Thus, Schumpeter and his student, Hyman Minsky, were in complete accord when it came to the issue of the unstable nature of capitalism. For Minsky, however, upward instability over time morphs into destabilizing down- turns. And that morphology takes place in the world of finance. Conventional Thinkers Forecast the Recent Past Capital flows engineered the great global boom of the 1985-2007 years. And the gains that arrived cannot be minimized. Nonetheless, seasoned students of financial markets know that there is a pitfall in Free Market Capitalism: ... these companies and also capital gains arising from increases in the 9/19 How Households Supply Financial Capital value of the stock (For technical reasons related to how the numbers are calculated,... by unfavorable supply and demand conditions or hurt by unlucky or unwise managerial decisions Thus, a standard recommendation from 10/19 How Households Supply Financial Capital financial investors... fund 16/19 How Households Supply Financial Capital Housing and other tangible assets can also be regarded as forms of financial investment, which pay a rate of return in the form of capital gains