Economic Recovery on Edge
|Ben Hallman||May 31st 2011|
To millions of member-customers, credit unions are the financial equivalent of a trusted uncle, dispensing prudent loans for cars, homes, and education without the profit motive of traditional banks.
The National Credit Union Administration (NCUA), which supervises and insures about 4,600 federally-chartered credit unions, says they operate with a “not for profit but for service” philosophy, providing “an alternative to the oppressive loan rates charged by predatory lenders.”
But encouraged by federal regulators, an increasing number of credit unions are competing directly with traditional payday lenders, selling small loans at prices far higher than they are permitted to charge for any other product.
Last September, the National Credit Union Administration raised the annual interest rate cap to 28 percent from 18 percent for credit unions that offer payday loans that follow certain guidelines.
Under this voluntary program, credit unions must allow at least one month to repay, and cannot make more than three of these loans to a single borrower in a six-month period. Credit unions are not allowed to roll over the loans, a practice that typical payday lenders use to make big profits.
But because these firms can charge a $20 application fee for each new loan, the cost to borrow $200 for two months often translates into an annual interest rate of more than 100 percent.
What’s more, many credit unions prefer to sell loans outside the federal program, allowing them to charge significantly more in fees.
At Mountain America Federal Credit Union in Utah, a five-day $100 “MyInstaCash” loan costs $12, which works out to an 876 percent annual interest rate. That rate rivals traditional storefront payday lenders.
An investigation found 15 credit unions like Mountain America that continue to offer high-cost loans that closely resemble the payday loans they are meant to replace.
“They are promoting these loans as payday alternatives, but they are not really alternatives, they are egregious payday products,” said Linda Hilton, a community activist in Salt Lake City. “We look at it as a moral lapse of credit unions.”
All told, more than 500 credit unions are making payday loans with widely varying interest rates—from a modest 12 percent with no fees at State Employees’ Credit Union in North Carolina to the high triple-digits loans sold by Mountain America. It has become a fast-growing trend in an industry struggling to remake itself after the financial crisis.
Consumer groups typically warn against borrowing at interest rates higher than 36 percent per year. That’s the maximum allowed by many states and by the U.S. Defense Department for loans to active-duty members of the military.
The top U.S. regulator of credit unions hopes more will adopt payday-style lending with new rules that came out of her own experience working at a credit union.
Many credit unions, NCUA Chairman Debbie Matz said, were afraid to make small-dollar loans for fear of losing money. Short-term loans are risky because there isn’t a credit check, and that higher interest costs are necessary for credit unions to recoup the costs from the larger proportion of customers who will default, she said.
“We spent a long time trying to do this in a way that would work for members and for the credit unions and not be predatory,” Matz said.
New revenue stream
Credit unions date to the mid-1800s when mill and bakery workers in Germany created democratic cooperatives to loan money to each other at reasonable rates. The cooperative approach to lending money to members for home and auto purchases flourished in the United States throughout much of the mid-20th century, but some critics say the business model has outlived its usefulness.
Most U.S. credit unions have struggled in the wake of the 2008–09 financial crisis with many of the same problems as banks—a surge in loan defaults and a drop in customers looking for loans on big ticket items like homes and cars. Unlike banks, credit unions operate as not-for-profits. Their assets are primarily member deposits. They need to make loans in order to pay interest and insurance on those deposits. And, unlike banks, they can’t raise investor capital when times are lean.
At the end of 2010, the NCUA had designated 368 credit unions as either a serious supervisory concern or at high risk of failure. Forty-one credit unions have closed since 2009.
Thomas Glatt, an industry consultant in North Carolina, said that his analysis of financial reports suggests that 700 mostly small credit unions are in financial distress. While most credit unions offering payday loans do so to give members a better alternative to storefront payday lenders, Glatt said some appear to see the loans as a new revenue stream to shore up crumbling finances.
“Not every credit union is as pure as they could be,” he said. “If they are offering something similar to what is sold on the street corner, you have to wonder if that is in keeping with the credit union philosophy.”
It isn’t clear how profitable payday lending is for credit unions. But there is potential for big profits. Payday lenders extended an estimated $40 billion in credit in 2009, according to Consumers Union. Profits were about $7 billion.
Many of the credit unions that offer high-cost loans declined to discuss their profitability, but NCUA filings show that Mountain America Financial Services—which administers the Mountain America credit union payday program—reported profits of $2.4 million in 2010. That includes profits from its insurance business, which the subsidiary operates.
Still, several that offer low or moderate-priced loans said they either broke even or lost a little money on their programs.
Fast cash for car loans
On a recent Saturday morning, Sam Heredia, a 29-year-old producer for a Spanish language morning radio show, stopped in at a Nix Check Cashing branch in Highland Park, a middle-class Mexican-American neighborhood just north of downtown Los Angeles.
Heredia had come for the Nix standard payday loan offer: a $400, 14-day loan, for $42.25. He wrote a postdated check for the full amount and pocketed the cash.
Heredia, who was wearing sunglasses and a bright red and blue soccer jersey, said in an interview in the parking lot that he needed fast cash to help stay current on bills.
The biggest drain on his finances is his car, a 2007 Toyota Tundra. He said that the car was his pride and joy—“I love it,” he said—but that he took out a loan to pay for it under his father-in-law’s name because he has bad credit. He is having trouble keeping up with the payments and other accrued debt.
Every two weeks or so for the past year, Heredia has made the trip to Nix, borrowing $400 each time. That means he has paid about $1,000 in interest on his borrowing, which works out to a 362 percent annual interest rate.
“I think it’s a high percent,” he said.
With 48 branches in mostly low-income neighborhoods, Nix Check Cashing is one of the largest payday lenders in the Los Angeles area.
The Nix chain was acquired four years ago by Kinecta Federal Credit Union, a major player in the credit union industry, founded in 1940 by employees of Hughes Aircraft Co. Workers at the California company were tired of driving into town to do their banking and asked owner Howard Hughes, the aviator, engineer and Hollywood producer, for permission to start a credit union at the plant.
“Just keep my name clean. I don’t want anything funny going on,” Hughes replied, according to credit union founder Lou Merandi. In the early days, membership in the Hughes credit union cost just 25 cents and members could borrow up to $200.
Today, Kinecta has grown to $3.5 billion in assets, 227,000 members and ranks as the 27 th largest U.S. credit union. It maintains the tradition of sponsoring little league baseball teams, neighborhood street fairs, college scholarships for high school students and budgeting classes for the community.
Kinecta also directly finances the payday loans offered by Nix to customers like Heredia through a service company called Kinecta Alternative Financial Solutions. The interest rate cap for loans that don’t follow the new federal payday guidelines is still 18 percent. So how is Kinecta allowed to charge a rate that tops 350 percent?
In calculating Heredia’s $42 charge, Kinecta says that just $3, or 15 percent, is interest. The rest of the charge comes from an application fee. The application fee is charged each time, even for repeat borrowers.
Kinecta Alternative Financial Solutions president Randy Dotemoto said that the federal truth-in-lending law known as Regulation Z permits financial institutions to calculate the interest on a loan without including the application fee.
Consumer advocates say that credit unions are using inflated application fees to get around the interest rate cap. Regulation Z says that application fees are to “recover the costs associated with processing applications for credit,” such as credit reports, credit investigations and appraisals, notes Lauren Saunders, the managing attorney of the National Consumer Law Center’s Washington, D.C. office. She has been pressing the NCUA to use its regulatory authority to crack down on credit unions like Kinecta since 2009.
The whole idea of payday lending, promoted for being fast and needing no credit check, is to offer a speedy loan without any underwriting, Saunders said. “The NCUA is not being aggressive enough in defending its own statute.”
An NCUA spokesman said that Kinecta must comply with the truth-in-lending law, but declined to comment on whether Kinecta was doing so.
Payday loans are a product of the deregulation trend of the 1990s, when many states rolled back laws that limited how much a lender could charge for a loan.
In a typical loan, a customer borrows a small sum, usually less than $500, for a week or so, until their next paycheck. Lenders assess flat “fees” for these loans, rather than typical interest charges. At Advance America, the nation’s biggest payday lender, a borrower in Texas pays $40.91 to borrow $200 for two weeks—a 533 percent annual interest rate.
Lenders say they provide short-term cash to people in need. They say they have to charge high fees because they loan to borrowers with bad or no credit.
Dotemoto said that payday lenders like Nix perform a vital community service. Before payday lending was legalized in California in 1997, payday customers bounced checks, paid high bank overdraft fees, or pawned their possessions when in a financial crunch, he said.
Critics say the loans can trap customers in a cycle of debt. Many payday borrowers juggle multiple loans at any given time. “Borrowing more money at triple-digit interest rates is never the right solution for people in debt,” the Consumers Union says in its payday lending factsheet.
Credit unions are still new to the payday business. Most started making small dollar loans in the past five years. Some go out of their way to offer small loans, even if it means losing money.
Campus Federal Credit Union, which serves mostly students and employees of Louisiana State University, offers a “Money-Wise” loan. Loans from $100 to $345 are available, at an 18 percent interest rate, with six months to repay. There are no additional fees.
John Milazzo, the president of Campus Federal Credit Union, said it loses about $30 on each payday-style loan. But with just a handful of borrowers—63 as of mid-April—the credit union can afford a small loss. “We understand that this is part of the business of helping,” he said. “And hopefully we can establish a good customer.”
More typically, credit unions aim to at least break even on their loans.
In Ohio and Michigan, about 50 credit unions have banded together and collect annual fees from subprime borrowers of $35 or $70, depending on whether they want a $250 or $500 credit line. Those fees go to a central fund, with current assets of $633,000, used to backstop losses at participating credit unions. Once a customer has paid the annual fee, loans are made at 18 percent interest.
A customer who took two loans in a year under these terms would pay an effective annual interest rate of more than 100 percent. But the architect of the loan program, Douglas Fecher, the president of Wright-Patt Credit Union in Dayton, Ohio said that annualized interest rates are not the best way to gauge short-term, small-dollar loans.
Without the annual fee, he said, credit unions couldn’t afford to make the loans.
A lender earns just $3 on a $250, 30-day loan offered at 18 percent interest, he said. “If one person doesn’t pay that back we would need to make 80 more loans to make up for it,” he said.
Fecher said he opposes any type of lending that preys on vulnerable customers. His loan, “doesn’t save the world,” he said. “But it’s cheaper than what they can get somewhere else.”
“Wild West of financial services”
Consumer advocate Linda Hilton has been battling payday lenders in her home state of Utah for nearly 20 years.
“It’s the Wild West of financial services out here,” Hilton, the director of the Coalition of Religious Communities, said in a recent interview in her Salt Lake City office. A two-mile stretch of State Street, which descends from the state capitol building into a working-class neighborhood, boasts three payday lending outlets, a pawn shop that also offers payday loans, and a branch of Mountain America Credit Union. Public officials in the state have mostly sided with the payday lenders.
Utah Attorney General Mark Shurtleff, for example, has said that banning payday loans could hurt the poor more than it would help them.
In 2007, Shurtleff accepted free round-trip airfare to the Bahamas from the Community Financial Services Association of America, a payday-lending trade group, which had invited him to speak at its annual convention. Shurtlefftold told the Deseret News he did nothing wrong, saying “I accept airfare from various groups when I fly out to speak to them.”
The fight got personal last summer, when Hilton learned that her credit union, America First, was selling high-cost loans online and at a kiosk in one of its branches. A $4.7 billion credit union, America First grew from modest beginnings in 1939 when a group of civilian employees at an Army base in Salt Lake City used a tobacco can to store the nascent credit union’s funds.
“They are supposed to be stores of the people owned and operated by shareholders,” Hilton said. “I expected more of them than to sell their members on a product that can lead to a payday loan trap.”
She and religious leaders staged a protest outside an America First branch, which drew local press attention. Under public and private pressure—the NCUA was also investigating America First—the credit union dropped payday loans altogether.
America First, like most credit unions offering high cost loans, was partnering with an existing payday lender.
That company, called Capital Finance LLC, still funds loans at a handful of credit unions, including those made by Mountain America, the second-biggest credit union in Utah after America First, under the “MyInstaCash” brand.
Hilton was surprised when she learned from a reporter that Mountain America, which has $2.8 billion in assets, was still in the payday business. “That’s just terrible,” she said.
Sometimes, it is a state-chartered credit union that doesn’t have to follow federal lending rules that is financing the payday loans.
For example, Orlando Federal Credit Union offers an XtraCash loan that tops out at 266 percent interest per year. Those payday loans are financed by Mazuma Credit Union, a state-chartered credit union in Kansas City.
Saunders, the consumer lawyer, said that regulators should stop these relationships.
“They should prohibit any federal credit union from partnering with payday lenders or marketing anything that they would be prevented from offering themselves,” she said.
An NCUA spokesman said credit unions are permitted to direct customers to payday lenders from their web sites in exchange for a commission fee.
Mountain America declined to comment, referring questions to Scott Simpson, the head of the Utah Credit Union Association, a trade group. Simpson said that he didn’t know how much Mountain America or other credit unions make from their payday lending partnerships. He said he was surprised that there was opposition to the loans.
“They are creating an alternative in the marketplace,” he said of credit unions like Mountain America, which was foundedin 1934 for Salt Lake City telephone workers. “The demand doesn’t stop if these loans go away.”
Mountain America Financial Services, which administers the Mountain America credit union payday program, reported profits of $1.8 million in 2009 and $2.4 million in 2010. But that number also includes profits from the credit union insurance business, which the subsidiary operates.
America First also declined to discuss its payday programs, or to say how much it makes from referral fees paid back to the credit unions from the third-party payday vendor.
Orlando credit union president John Neusaenger said that his credit union makes “very little” in referral fees that come back to the credit union for each XtraCash loan. Gateway declined to disclose how much it earns in referral fees.
Nix Check Cashing, likely the biggest credit union payday lending operation in the country, has actually been operating at a loss. Nix lost $4 million in 2010 and $2 million in 2009.
Dotemoto attributed the losses to a down economy. Much of Nix’s business comes from people who pay a fee to cash work checks, he said, and that business is off 30 percent from a few years ago.
How much is too much?
The NCUA says that 244 credit unions as of December 31, 2010 had $14 million in outstanding loans under the new federal short-term loan guidelines.
Borrowers who take those loans typically pay less than the high-cost credit union lenders. Those borrowers, in turn, typically pay less than at a storefront payday lender. So how much is too much?
Pentagon rules prohibit loans to active-duty service members for more than 36 percent annual interest, all inclusive. That is also how much a recent Federal Deposit Insurance Corp. pilot program for banks allows.
Some credit union executives have decided they shouldn’t be in the payday business at all.
American Southwest Credit Union in Arizona for years offered a short-term loan with an 18 percent annual percentage rate and a $25 quarterly fee. As a goodwill gesture to struggling customers, America Southwest offered to waive the fee if payday borrowers came in for a financial counseling session, even though the credit union was losing money on the overall program.
“Not a single person took us up on it,” said Brian Barkdull, the chief executive.
Meanwhile, customers with short-term loans from the credit union were also usually juggling several payday loans from more traditional lenders. They wouldn’t take the counseling, and they didn’t stop borrowing.
Barkdull eventually pulled the plug on American Southwest Credit Union’s short-term loan program. “The payday loan is a highly addictive product conditioning borrowers to live beyond their means,” he said. “This is a product that should never have been created.”