Monday, October 15, 2007

How Wrong Is Usury?

Last week, the Standard Examiner published its own report on the payday loan business in Utah (here). The article attempts to present a balanced view, but it left me somewhat incredulous.

The SE article cites high customer satisfaction rates, saying, “According to a customer-satisfaction survey conducted by researchers from Syracuse University, 63 percent of payday borrowers are satisfied, compared to 28 percent with credit cards.”

One satisfied regular payday loan customer makes relatively good money in computer engineering. He travels frequently for business and his employer doesn’t reimburse him until a couple of weeks after each trip. He gets payday loans to fill the gap, paying around $80 for a two-week $500 loan.

This guy explains that he doesn’t have a credit card because he got in lots of trouble with credit cards when he was younger. So he actually “appreciates … the stiff fees” that help “keep him in line.” Although this guy makes good money, he is obviously bad at math. He says that he prefers a payday loan to a credit card because he doesn’t “want to pay that 18 percent interest.” This is a totally bizarre statement, because he avoids that high 18% rate only by paying a 416% rate on his payday loans.

Tellingly, the reporter writes that this man is now considering getting a credit card with a $500 limit because he realized, he says, “If I pay it back within a month, I won't pay any interest at all.” Ah, the light has turned on. Maybe this guy can work on your computer system, but don’t hire him to handle your finances.

This is the kind of fiscal ignorance upon which payday lenders prey. They rely on a steady stream of dupes that are mystified by simple finances. They need people that don’t understand the availability of more viable financing options or that have made enough bad decisions in the past that some of these options are now closed to them.

Other articles have cited the fact that part of the reason payday lending flourishes is that more respectable financial institutions do a poor job of servicing the people mentioned above. Actually, the real problem is that people don’t learn how to manage their finances early in life and they develop patterns early in life for expecting to get things they can’t afford. We have a huge credit industry that encourages this type of behavior and many people fall into their traps.

The article notes that payday lenders service people with “a high discount rate.” A university professor defines this, saying, “People with a high discount rate value present consumption more than future consumption. The pleasure they are getting today outweighs the costs they are going to have in the future.” In other words, payday lenders need a stream of customers that live for the moment and demand immediate gratification regardless of the consequences.

Reporter Marshall Thompson also notes that payday lending has exploded in Utah because it is one of the eight states in the nation that hardly regulate the business. Most states have usury laws that prohibit “lending money at exorbitant interest rates,” but Utah does not.

But don’t worry. An industry rep says that “the term usury doesn't apply to the payday industry since it only charges what the market will support.” Whew, that’s a relief. He also says that with “a high customer satisfaction rating and booming demand for services, the payday loan industry must be doing something right.”

When I read this, I turned to my wife and said, “I’m sure that the prostitution industry also charges only market rates, has plenty of demand, and has a high rate of customer satisfaction. But most people don’t think it should be legal.” I also noted that we have plenty of demand for gambling in Utah and plenty of satisfied gamblers that cross the border, but that most Utahns don’t think gambling should be legal in the state either.

Libertarian critics of regulating payday lending will correctly note that doing so will limit supply; thereby, driving costs even higher and creating a black market. But there are other matters to consider. Right now the state is complicit in the payday lending industry’s scheme to dupe people. The basic business plan is to get people to default on their loans, and then take them to court where the state rules against them so that the lender can get a revenue stream from garnishing wages, getting a much higher return on the lender’s investment. The state even helps collect revenue at this point. Since the people of this state are de facto partners to this business plan, state government has a right to have a say in how it is played out.

Critics of regulating payday lenders will also say that government has no right trying to keep people safe from their own bad choices and that the state has no business legislating morality. I both agree and disagree. This is like saying that we should never put up guard rails and concrete barriers along mountainous roads with steep drop offs because it would keep people that want to drive over the edge from doing so, or because it would keep people that veer off to the side from suffering the natural consequences of their actions. Of course we should take care of public safety, including public financial safety. This is a large part of what government does. It constantly attempts to achieve an optimal balance between public safety and individual liberty. The problem happens when we put up guard rails where none are needed.

This issue also involves considerations of natural law. Some hold that our laws should pretty much follow only natural law. There are two types of law: malum in se, which means that something is naturally wrong of itself, and malum prohibitum, which means something is wrong only because it is prohibited by authority. Murder, stealing, and lying, are wrong in and of themselves, for example. It doesn’t matter whether we have laws to prohibit them or not; they are still wrong. But driving 35 mph in a zone marked 30 mph is only wrong because it is prohibited by authority.

To be sure, there are disagreements as to what fits into the definition of malum in se. The classic modern example is abortion. One side sees abortion as malum in se, while the other side does not. Some would argue that usury falls into malum in se under the pretext that it is wrong to take advantage of someone even if that person agrees to the action. Usury is prohibited in both the Bible and the Koran. People in the payday lending industry would either argue that their 500%+ rates are not usury or that usury does not fall into malum in se.

Prostitution is prohibited in most places under the pretext that it falls into malum in se. It does not matter that consenting adults enter into an agreement to sell/purchase sexual favors for money. Society mostly believes that there are still victims in this type of transaction. Whenever anyone is harmed in a democratic society, all of society is harmed; thus, prostitution is illegal in most of the U.S.

Strict libertarians will argue that questions of this nature should not be regulated by government, and that the natural operation of the free market will sort out all such moral dilemmas. They will argue that the majority has no business imposing its moral will upon the minority, as this is simply tyranny of the majority, which our Founders sought to prevent by forming a republic.

When this point is made, someone frequently throws in an argument along these lines: “You want to enforce your view of morality at the point of a gun.” This takes the valid point that government has coercive powers and demagogues it by taking it to an extreme. Certainly there are times when a law might need to be enforced with violence, but for the most part, we’re talking about putting up guard rails rather than posting a guy on the side of the road with a bazooka ready to blast you if you veer too close to the edge.

Our democratic republic was created in a way that government should only play a role in certain enumerated areas. And for the most part, it should only play a role when there is fairly broad consensus on points. When this pattern is followed, government necessarily has a narrow focus, because such consensus can only be achieved on a few points. Other than that, government should stay out of the way.

Does payday lending fall into the categories specified above? The Standard Examiner published an editorial on Saturday arguing that does. I tend to agree. We ought to put limits on businesses whose main practice is to create victims, even if they’re willing victims. We especially ought to implement limits when a significant portion of the business’ operating plan involves the unwilling complicity of state government.


JM Bell said...

all of that aside (and a well written missive, btw) it seems to me that the only time Jesus had a temper tantrum, it was because of usury.

That's a little telling.

Jesse Harris said...

I think you're dead on. Despite the libertarian ethic that we should let the market work its forces and the PT Barnum ethic that the uninformed/unwise/etc. deserve it, supporting exploitative practices with the power of the state is simply unconscionable. What struck me hardest is that many of these places charge rates above and beyond what shady mafia loan sharks would; just trade breaking kneecaps for taking a chunk of every paycheck for the rest of your life.

The payday loan industry is organized crime gone smart. We should treat it accordingly.

Democracy Lover said...

You have one statement here with which I disagree:

"Our democratic republic was created in a way that government should only play a role in certain enumerated areas."

The Constitution does not prevent government from playing a role except when it interferes with the rights of citizens. It does distribute the role of government between the 3 federal branches and the states, but I don't see that any role that could be described as aiding to "form a more perfect union, establish justice, insure domestic tranquility, provide for the common defense, promote the general welfare, and secure the blessings of liberty to ourselves and our posterity" is prohibited.

If we can have government prohibit certain businesses such as prostitution or usury, then we should first insure that we are not violating the individual rights of any human citizen and that we are doing so because it insures domestic tranquility or promotes the general welfare.

I don't see that prostitution falls into either category. In fact, by prohibiting prostitution, we endanger the general welfare by failing to insure that workers are not spreading dangerous diseases. By criminalizing a portion of the market with high demand, we drive the market underground and promote its association with real and violent criminals, thus endangering domestic tranquility.

Usury, by comparison, is not an entrepreneurial activity engaged in by individuals or free associations of individuals, but is an activity of corporate entities. As such, there are no Constitutional restrictions on its regulation. Restricting usury is obviously a way to promote the general welfare, since high-interest payday loans are dangerous to the welfare of the borrowers.

y-intercept said...

Our public schools do an absolutely abysmal job teaching financial skills.

The public schools fail to teach math and logic. The result is a populace that marches out of high school into the hands of predatory lenders. The sad thing is all of the high school graduates who lack sufficient financial education to know that 200% a year interest is a tad usurious.

Of course, if the schools did a good job educating students, there wouldn't be anyone to vote for the Democrats.

As for calling payday loans usury ... I reject that idea. "Usury" is an intent. You can't define intent with a mathematical equation.

It is expensive to administer a small volume short term loan. The risks of such loans are quite high. Assuming that the payday lender pays market wages, you would find that it takes about $20 of labor per loan. The high default rate adds at least another $10 to the cost of the loan.

if a person is in a situation where a payday loan saves them $50, then paying $40 for the loan is not a bad deal.

The usury is not in the interest rate, but intent of the lender. If the lender is trying to trap the borrower in a cycle of lending, then they are engaged in usury.

I am not willing to label any one type of loan as usury. I am of the opinion now that usury occurs when financial advisers push their clients into the wrong financial solution for their needs.

Usury can occur in any lending industry including credit cards, mortgages, venture capital, business loans. If you really want to expand the definition, you could say usury occurs when a financial advisers knowingly push people toward unwise investments.

The large number of payday lending and check cashing stores tells me that there is a large population that is under-served the current banking system.

If you look at the politics of the lending industry, you will find that all of the attempts to provide banking services to this group get beat down by progressive regulations. A case in point was the political fire storm that occurred when Walmart wanted to provide basic banking services to its low wage customers.

Reach Upward said...

The law in a number of states does apply a mathematical equation to usury. The implication is that ill intent is implicit in the application of exorbitant rates.

Legal and dictionary definitions I have researched for usury do not include the purposeful purveying of the wrong type of product for a borrower's situation. That would probably fall into the definition of fraud, or at least deceit. So, your definition of usury does not seem to match the broadly accepted meaning of the term.

Having worked in the finance industry, I know all about loan processing costs and lending risk. Yes, the processing costs on small loans is disproportionately large in comparison to the principal. While a lender must cover its costs and be compensated for its risks, the question remains as to whether extremely high-cost transactions are ever appropriate.

I think the larger problem of all lending ills lies in two age-old human tendencies: 1) the desire to have something one cannot afford, and 2) the desire to get gain regardless of the impact of the transaction on others involved. Society today facilitates and even promotes both of these types of behaviors.

Reach Upward said...

I must respectfully disagree with Democracy Lover's broad interpretation of the general welfare clause of the Constitution. Certainly there are those that embrace such a broad interpretation, and some of those have been represented in high positions in government. So he is not necessarily in small company.

However, Madison specifically rejected a broad interpretation of the general welfare clause, saying that it would render the intended limitations on governmental interference in the lives of citizens of no effect. He said that this type of interpretation would effectively undo all of the work that the Founders did.

A careful reading of the Federalist Papers and other available contemporary documents shows that the federal government was intended to be permitted only those powers specifically enumerated in the Constitution, while state governments were only limited by the specific limitations enumerated in the Constitution. The Supreme Court has since required state governments to be additionally subject to most of the rules that were intended to apply to the federal government.

Suffice it to say that I agree with Madison that the federal government should be permitted only those powers specifically outlined in the Constitution, and that we cannot read anything we wish into the general welfare clause.

So, Democracy Lover and I will simply have to agree to disagree on this point.

y-intercept said...

People have been hashing away at the definition of usury since antiquity.

I realize that to have laws about usury, the laws must be objective and mathematical and precise. Most of the definitions seem to disenfranchise people on the fringes of society.

Often the payday loans have been the best credit available for the market they serve.

The things, however, are horrible when used for the wrong purpose. A person who uses a payday loan to pay rent in June won't have rent for July for the loan and is now in a cycle of expensive debt.

The point of my post was that if we looked beyond our desire to have an objective, legal definition of predatory lending and usury, the thing that really yanks our chain is situations where the loan hurts the borrower.

A mathematical definition might be able to help us find patterns of abuse; however, to create a system that will help elevate the poor from their situation, we need better financial education and there needs to be more financial options available for the poor of the world.

BTW, your response to DL was well written. I admit, I completely gave up on "economic-hit-man" style progressives a long time ago. He clearly has not read the Constitution or the Federalist papers, or he had professors who intentionally misled him about US history.

During school, I fell into trap of thinking that the only way to really communicate is to provoke. It is habit I really am not that eager to unlearn.

Democracy Lover said...

In Federalist #45, James Madison said " It is too early for politicians to presume on our forgetting that the public good, the real welfare of the great body of the people, is the supreme object to be pursued; and that no form of government whatever has any other value than as it may be fitted for the attainment of this object. Were the plan of the convention adverse to the public happiness, my voice would be, Reject the plan. Were the Union itself inconsistent with the public happiness, it would be, Abolish the Union. In like manner, as far as the sovereignty of the States cannot be reconciled to the happiness of the people, the voice of every good citizen must be, Let the former be sacrificed to the latter."

In a democratic society, we can have some discussions and evolution as to the exact nature of the general welfare, assuming that it is in fact general as opposed to being limited to a specific group. If the US government derives its just powers from the consent of the governed, how can that government refuse to provide services that contribute to the general welfare and have the approval of a vast majority of citizens?

I am happy to hear that Y has at least heard of the "Economic Hit Man", but he probably hasn't read it. He also finds a scapegoat for predatory lending in the public school system (which he doesn't like anyway). While I would agree that our schools do not teach our children to think for themselves, it is generally conservatives who are most eager to insure that they continue to refrain from doing so.
However, instead of blaming the victim, it is much more prudent to act to stop a government-chartered entity which has no Constitutionally protected rights from perpetrating a fraud.

Reach Upward said...

Madison's words in Federalist #45 do not mean that he felt that the general welfare clause was all encompassing. In fact, his 1817 veto of the federal public works bill makes very clear that he was opposed to using the general welfare clause to allow Congress to do anything it wished as long as it could be construed to be for the general welfare of the republic.

Madison wrote that he was fully aware "of the great importance of roads and canals and the improved navigation of water courses, and that a power in the National Legislature to provide for them might be exercised with signal advantage to the general prosperity." However, he said that allowing Congress to do this under the guise of the general welfare clause "would be contrary to the established and consistent rules of interpretation, as rendering the special and careful enumeration of powers which follow the clause nugatory and improper."

Madison continued, writing, "Such a view of the Constitution would have the effect of giving to Congress a general power of legislation instead of the defined and limited one hitherto understood to belong to them, the terms "common defense and general welfare" embracing every object and act within the purview of a legislative trust." He goes on to state that he fully rejects this broad usage of the general welfare clause, even if much good would have come by its misuse.

You can twist Madison's writings in the Federalist Papers, but when he acted as Chief Executive, his intent on this matter is undeniable.

Other Chief Excecutives have not been as circumspect as Madison on this point. And three Supreme Court rulings (US v Butler in 1936, Helvering v Davis in 1937, and Flemming v Nestor in 1954) effectively nullified Madison's original intent.