Sub-Prime Lending in Canada: Implications & Opportunities for Investors Issue Brief For low- and middle-income families, borrowing money from institutions that specialize in lending to those with poor credit ratings presents both a danger and an opportunity. Properly extended credit can assist with home purchases, business development or family emergencies. But lending practices that attach excessive fees and charge high interest rates, sometimes without appropriate transparency, can create a cycle of debt, financial vulnerability and increasing poverty. Among the diverse financial institutions linked to “sub-prime” lending, Canada’s major chartered banks play a role both as primary providers of banking services to Canadian consumers, as financial intermediaries for sub-prime lenders or as brokers for subprime products. This situation presents both risks and opportunities for bank shareholders.
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Introduction
The following will provide an overview of the sub-prime lending industry and consider the risks and opportunities that sub-prime lending practices present to investors. The first section gives a brief overview of the industry in Canada including who the key players are, what their business models look like and what the size and growth rate of the industry is. The next section will outline the key issues that emerge in subprime lending, the impacts of these activities on individuals and communities as well as the key investment risks and opportunities. The last section includes possible courses of action for investors. 2
Industry Overview
Sub-prime lending targets borrowers who cannot obtain credit in the prime market, often carrying higher costs in order for lenders to incur higher risk. Borrowers who tend to fall into the „sub-prime‟ category include new immigrants with no Canadian credit history, self-employed entrepreneurs or „contingent‟ workers with irregular or seasonal incomes, single parents who have missed mortgage payments or lower income Canadians who need extra cash for unexpected expenses. The sub-prime lending industry in Canada has grown over the last ten years and has manifested in a number of different lending practices including payday loans, rent-toown financing, tax rebate loans, sub-prime mortgages, vehicle financing, internet lending, cheque cashing1, and pawnbrokers. Payday lending – the practice of offering a short-term loan against an individual‟s regular income – is the fastest 1
Cheque cashing becomes a form of lending when a person doesn‟t have a bank account or his/her account balance is less than the value of the cheque and the 5-day hold is onerous. When the cheque is cashed at a fringe outlet the fee for this service can be understood as the interest on a 5-day loan.
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growing area of the sub-prime lending industry. It is now estimated to be worth $2 billion a year in Canada in terms of loan volume with more than 1,300 storefront operations across the country.2 2.1 Payday Lending The key players in Canada‟s fast-growing payday lending industry include Money Mart, the Cash Store and Cash Money, with many smaller companies concentrated in particular provinces or operating only a single store. Money Mart, a subsidiary of the U.S.-based Dollar Financial Group (NASDAQ: DLLR), estimates its market share in Canada to be 30% by number of stores and close to 50% by volume of business.3 In the fiscal year 2004-2005, revenues from Dollar Financial Groups‟ Canadian operations were US$108.2 million or 37.15% of the company‟s total revenues. Money Mart‟s largest competitor in Canada is Rentcash Inc. (TSX: RCS), which is the only publicly traded payday advance company in Canada that trades on the Toronto Stock Exchange. Rentcash operates under three separate entities: The Cash Store, Instaloans and Insta-rent. According to its 2005 Annual Report, Rentcash Inc. owned and operated 361 stores in Canada and employed 1,300 associates. It reported earnings of $7.3 million in fiscal 2005 and a growth in revenue of 247% from the previous year. The payday loan industry in Canada created an industry association in 2004. The Canadian Payday Loan Association (CPLA), previously known as the Community Finance Service Association, represents 22 companies with 850 retail service outlets across Canada.4 According to their website, the CPLA‟s mandate is to work with governments on a regulatory framework that protects consumers and allows for a viable industry and to enforce its code of best practices among its member companies.5 While Money Mart is listed as a member of the CPLA on its website, neither Rentcash nor any of its subsidiary companies are currently listed as CPLA members. 2.2 Sub-Prime Consumer Financing Consumer financing covers diverse lending activities including personal loans, auto loans and financing for furniture, appliances and electronics. Getting a sense of the size and breadth of this segment of the sub-prime lending industry is challenging, as there are so many players and very few statistics. Even more challenging is charting the relationships between these consumer finance companies and the major Canadian- and foreign-owned banks. The likes of Wells Fargo, Citigroup and HSBC have an increasing presence in Canada through their financing activities at car
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StratCom, 2005, Survey of Payday Loan Users in Toronto and Vancouver, report for the Association of Community Organizations for Reform Now (ACORN). 3 A. Kitching, 2006, Payday Loan Companies in Canada: Determining the Public Interest, Library of Parliament, Parliamentary Information and Research Service. 4 For a list of their members, see http://www.cpla-acps.ca/english/aboutmembers.php. 5 To view the CPLA Code of Best Business Practices, see http://www.cpla-acps.ca/english/consumercode.php.
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dealerships and through retailers like The Brick, Future Shop and United Furniture Warehouse. Canadian banks are also being drawn to the sub-prime sector through acquisitions of consumer financing companies. Toronto Dominion Bank (TSX: TD), for example, acquired VFC Inc. in April 2006. VFC is one of the largest Canadian-owned indirect consumer finance companies specializing in sub-prime automotive purchase financing. 2.3 Sub-Prime Mortgage Lending While the sub-prime mortgage market has only recently developed in Canada, it is currently the fastest growing segment of the Canadian mortgage market. During the first half of 2006, the number of sub-prime loans rose by 50% compared to the first half of 2005.6 CIBC World Markets forecasts that the number of sub-prime loans will increase at an annual average rate of 20% over the next five years – more than double the predicted pace for prime loans.7 The Bank of Nova Scotia launched the Mortgage Authority in April 2006, after purchasing Maple Financial Group, which will accept broker referrals of borrowers with slightly lower credit scores than the bank has required previously. 8 Mortgage specialists such as Xceed Mortgage Corp. (TSX: XMC) and Home Capital Group Inc. (TSX: HCG) also focus on the sub-prime market. Their customers are largely renters, self-employed entrepreneurs and recent immigrants to Canada who do not conform to the major banks‟ credit-scoring criteria for prime mortgages. These companies generate their business from both mortgage brokers and from Canadian financial institutions. 2.4 Other forms of Sub-Prime Lending Other forms of sub-prime lending activities include refund anticipation loans, which advance customers the amount of their tax return for a substantial fee equivalent to an annualized interest rate of 150 to 400%. Tax services firms like H&R Block (NYSE: HRB) are at the forefront of these types of loans. In November 2005, Rentcash and H&R Block entered into an agreement to offer H&R Block‟s tax preparation services in the Cash Store and Instaloan locations. 3
Key Issues
3.1 High Interest Rates and Fees for Services Many Canadians with bad or no credit history or those with insufficient or irregular income cannot access „prime‟ credit from mainstream financial institutions. In order for these “sub-prime borrowers” to get access to credit, they have to pay exorbitant 6
ACORN Canada, 2007, A conflict of interest: How Canada‟s largest banks support predatory lending. Available on-line at www.acorn.org. 7 CIBC World Markets, Consumer Watch Canada, October 10, 2006, Sub-Prime as Prime Target: The Surging Non-Conforming Mortgage Market in Canada. Available on-line at: http://research.cibcwm.com/economic_public/download/cwcda-102006.pdf. 8 J. Daly, May 31, 2005, “The Loan Rangers,” Globe and Mail: Report on Business.
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interest rates and additional fees. According to industry representatives, high interest rates and extra fees reflect the higher risks associated with sub-prime lending as well as the increased costs of making small, short-term loans. For borrowers, however, the cost of borrowing can be financially crippling. Payday lenders in Canada charge, by far, the highest fees on their loan products. Although Canada‟s criminal code clearly states that annual effective interest rates must not exceed 60%, the total cost of borrowing from payday lenders can be between 300 to 1000%. How do they get away with it? They hide the costs of borrowing in various fees including collection fees, processing fees, convenience charges and brokerage fees. The interest rates for sub-prime mortgages, although not as high as payday loans, can be as high as 30% annually. Interest rates on sub-prime vehicle financing can be as much as double the interest rate of a prime bank loan or line of credit.9 The costs of refund anticipation loans from tax preparation companies such as H&R Block can run between 150 to 400%. 3.2 Impact on Borrowers and Communities The growth in the sub-prime lending industry in Canada has impacts at both the individual and community level. For individuals, sub-prime loans can initiate an unsustainable cycle of debt whereby borrowers are unable to make monthly loan payments and may have to continue to borrow at high interest rates, or default on their loans. Such debt cycles contribute to the increasing financial vulnerability of Canadians to economic shocks, emergencies or job loss. This vulnerability is compounded by other socio-economic factors including a lack of access to mainstream financial services, increased debt-to-income ratios, a declining ratio of savings-to-disposable income, as well as increased costs of living amidst stagnant incomes. Combined, these factors lead to growing financial insecurity among Canadians and vulnerability to the predatory practices of the sub-prime lending industry. Research conducted by ACORN Canada in 2004, analyzed the geography of bank closures in relation to payday lending stores in Toronto and Vancouver. The findings of this analysis show that: • Bank branch closures are concentrated in lower-income neighbourhoods; • Payday lenders are moving aggressively into this vacuum; • The distribution of payday lending operations is closely related to concentrations of low-income families and those without knowledge of one or both official languages.10 ACORN‟s mapping exercise supports the argument that there is a growing „missing middle‟ in financial service provision in Canada between a highly sophisticated financial system characterized by investment banking and incentive-based products 9
J. Daly, “The Loan Rangers,” Globe and Mail Report on Business Magazine, May 31, 2006. ACORN Canada, 2004, Reining in the Payday Lending Industry.
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and a highly unregulated and decentralized system characterized by predatory lenders whose market consists of those who cannot cover expenses from one paycheque to the next. This trend is significant beyond the impact on the individual in that it works to deepen income inequality with middle- and higher-income households accessing a greater range of products and services to increase their assets and wealth while poorer households, left with very few options, get trapped in financially crippling and unsustainable debt cycles. 3.3 The ‘Arms-Length’ Role of Canada’s Major Banks Canada‟s mainstream banks play multiple and substantial roles in supporting the sub-prime lending industry. By closing down branches in low-income or „redlined‟ neighbourhoods and shifting their business increasingly towards corporate and highnet-worth individual banking, the banks are contributing to an increasingly polarized financial system. As a result, mainstream financial services are less accessible to lower-income Canadians, creating a huge void for sub-prime lenders to flourish. The banks are not, however, missing out on the opportunities to profit from the subprime lending industry. Although they may not be providing sub-prime loans through traditional retail banking services, they are still active players in the industry. Their involvement includes purchasing sub-prime lending companies who specialize in vehicle financing or mortgages, offering products from sub-prime companies to customers who do not qualify for the banks‟ „prime‟ products, acting as third-party lenders through broker arrangements and providing financial services to payday lending companies including credit facilities and insurance. The possibility that banks are acting as „financial partners‟ to payday lending companies is particularly alarming. Through the employment of its‟ broker business model Rentcash, for example does not actually advance loans directly, but rather acts as an intermediary with undisclosed financial partners to provide the payday loan.11 The cost for this service is the brokering fee that it adds to the total cost of borrowing. As described in the latest Rentcash Annual Report: Since third party lenders provide the funds and the Company does not advance its own capital, we significantly lower our capital risk. The Cash Store manages the application and approval process and collects the funds for repayment to the third-party lender.12
This broker business model appears to provide an anonymous entry point for third party lenders into the sub-prime lending market. More research is required in Canada to ascertain whether Canada‟s major banks are taking advantage of this anonymous entry point and providing the on-lending capital. In the United States, payday lenders have used a similar broker-type model in order to evade state usury laws, small loan caps and state payday lending laws. A report conducted by the Centre for Responsible Lending has coined the term “rent-a-bank” 11
J. Lawford, 2003, Pragmatic Solutions to Payday Lending: Regulating Fringe Lending and “Alternative” Banking, Public Interest Advocacy Centre. 12 See: http://www.rentcash.ca/Uploads/Objects/annual-lores.pdf.
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to describe this phenomenon. The 2001 report states that the payday loan companybank relationship: involves loans made over the counter at the non-bank company‟s location, such as check cashers, pawnshops, and convenience stores. The bank nominally involved in the loan, sells back most of the loan obligation immediately. The payday lender advances the money, takes the risk, and collects the debt. Because a bank is involved, the lender claims that state consumer protection laws are pre-empted and that the bank can export deregulated interest rates from the state where the bank is located. Critics charge that banks merely rent their charters to assist nonbank companies evade state usury and consumer protection laws.13
This “rent-a-bank” phenomenon could develop in Canada considering federal jurisdiction over interest rates and banking and the proposed Bill C-26 (see below), which would move regulatory authority of payday lending operations to the provinces. Payday lenders seeking to avoid restrictive provincial legislation, such as in Quebec and that proposed in Manitoba, may look to develop broker-type relationships with the federal financial institutions in order to continue their operations.14 The above broker model is similar to the relationship between some banks and subprime mortgage companies. While Canada‟s banks are restricted by regulation from providing high ratio mortgages15, they can work through entities like Xceed or Home Capital and offer customers these alternative mortgage products. As stated in Xceed‟s 2005 Annual Information Circular, by working with Xceed, banks “can offer customers an alternative mortgage product either up-front or to declined customers, thereby protecting the banks‟ relationship with their customers and allowing Xceed to fund the mortgage.”16 For this service, the banks receive a commission based on the volume of mortgages funded as well as the efficiency ratios of such institutions. 3.4 Legislative Change in Canada On 6 October 2006, the federal government introduced legislation in the House of Commons aimed at regulating the payday loan industry. Bill C-26 proposes to amend Sec. 347 of the Criminal Code, which deals with criminal interest rates, allowing the provinces to set short-term rates for the payday loan industry.17 While the fees and service charges currently charged by payday lenders clearly exceed the allowable 60% effective annual rate, the industry continues to operate more or less unabated.18
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Centre for Responsible Lending, 2001, Rent-A-Bank: How Banks Help Payday Lenders Evade State Consumer Protections. Available on-line at: http://www.pirg.org/consumer. 14 Lawford, op. cit., 2003. 15 High-ratio mortgages are those that exceeds the normal limit of 75% LTV (loan to value) of a
conventional mortgage. Typically made possible by a mortgage insurance plan, eg CMHC or GE Capital. See http://www.bc-realty.com/mortgage/glossary.html. 16
See http://media.integratir.com/T.XMC/Listings/AIF%202005%20FINAL%20_2_.pdf. Text of Bill C-26 available at http://www2.parl.gc.ca/HousePublications/Publication.aspx?DocId=2390859&Language=e&Mode=1. 18 The Province of Quebec has passed a bill to limit the interest rate to 35 per cent. 17
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The failure of the federal government to enforce this law has been attributed to several factors. One factor is the apparent jurisdictional void whereby consumer protection resides with the provinces while enforcement of interest rates resides with the federal government. Another opinion expressed is that the law has not been enforced to date because policy makers recognize a genuine need for short-term, unsecured lending and see that payday lenders and other fringe financial services fill credit voids, particularly in poor communities, that would otherwise pose unacceptable risk to mainstream financial institutions. Within this context, the introduction of Bill C-26, which would move regulatory authority to the provinces, has been met with both optimism and scepticism from all sides. The Canadian Payday Lending Association welcomes the legislation but also expresses its concern over proposals to introduce caps on interest rates. If provinces decide to maintain and enforce the current 60% effective annual rate cap, many have argued that this would effectively close down the entire industry. In a report written for ACORN, Chris Robinson from York University notes, “no self-standing payday lender‟s cost structure can possibly sustain the business if the total of all fees is limited to 60% per annum.” If Bill C-26 goes through, therefore, the provinces will be faced with the difficult task of determining whether or not to allow short-term lenders to charge fees higher than the current criminal rate in order to maintain the industry. 3.5 Class Action Lawsuits Several class action lawsuits have emerged against sub-prime lenders in both Canada and in the United States. In May 2006, the Superior Court of Justice certified a class action lawsuit against the Cash Store Inc., alleging that broker fees are illegal pursuant to the interest rates set in Canada‟s criminal code. Separate lawsuits against the Cash Store are ongoing in British Columbia and Alberta. In July 2004, consumers in the U.S. filed a series of lawsuits against three large payday lenders including Advance America, Check into Cash and Check „N Go. In addition, two major settlements were reached in class actions against H&R Block in 2005, over its refund anticipation loan (RAL) practices. One of these settlements was a multi-state settlement, which provided at total of $62.5 million (including attorneys fees and administration costs) to the class. 4
Investor Risks
The practice of sub-prime lending presents important risks, not only for borrowers, but also for investors. As illustrated in the U.S. housing market recently, sub-prime lenders face higher loan delinquency and default risks, particularly in the context of rising interest rates and flat or falling home prices. In Canada, these risks do not appear to be as high due to a number of factors including a stronger housing market overall as well as a more restrictive regulatory environment. While the risks in Canada may not be as high, the exceptional growth in the sub-prime mortgage market in Canada means that the default risks may be also be rising. www.share.ca
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In addition to the above business risks, there are both immediate and longer-term legislative and regulatory risks that could emerge as a result of Bill C-26. If provinces choose to enforce the current 60% maximum annual effective rate on short-term loans payday lenders may face financial crisis, impacting not only the company, but also their financial backers. Proposed requirements in Manitoba‟s draft legislation would also pose risks to the feasibility of payday lenders in that province. These requirements include licensing and bonding, which would make market entry more difficult for smaller operations but would also entail costs for established payday lenders. Other requirements include clear warnings of the high-cost of the loans, restrictions on the signing over of wages as well as limits on the fees allowed for loan renewals. All of these requirements arguably pose serious risks to the business model of payday lenders. Increasing media coverage and interest from consumer protection agencies around predatory lending practices and the sub-prime lending industry has raised concerns among both legislators and the general public about these lending practices. There are significant risks, particularly for banks, of being associated with sub-prime lending activities leading to negative public perceptions and increased distrust of these financial institutions. Such reputational risks are particularly pertinent in light of the numerous class action lawsuits currently being filed against sub-prime lenders and the likelihood that the major financial backers may come into the limelight through the litigation process. In addition to regulatory and reputational risks, there are significant market risks that investors with a long-term horizon need to consider. If sub-prime lending practices contribute to a breakdown in an individuals‟ ability to build financial assets as a result of debt- and poverty-cycles then there are important threats both to individual companies as well as to the financial sector as a whole. On one hand, industry representatives argue that a growing pool of low-income earners unable to access mainstream credit products will fuel the growth of the sub-prime lending industry. However, if these loan products serve to weaken the financial condition of borrowers and communities, then the industry may be contributing more to the weakening of their future potential market over the long-term. 5
Investor Opportunities
An alternative active investor approach to the sub-prime lending industry is to focus on the opportunities that exist for innovation from the financial sector to generate greater access to capital among low-income and disadvantaged groups. There are numerous innovations from within Canada and internationally that could be more broadly applied to the Canadian context to deal with the impacts of predatory lending practices and ensure that low-income Canadians have access to secure and affordable credit. The recent establishment of the Community Financial Services Centre in Northern Winnipeg is an example of an alternative service model from the payday lenders and www.share.ca
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pond shops that currently characterize that neighbourhood. The new centre, supported by the Assiniboine Credit Union, aims to provide banking services and financial education to low-income residents in order to help them make the transition to mainstream banking. The Centre is using a number of innovations in order to compete with the payday lenders but also to better meet the needs of clients. These innovations include accessible debit cards, financial literacy and the use of social capital in place of identity and proof of address requirements to access bank accounts. Mainstream banks have also experimented with alternative services. In 2002, the Royal Bank of Canada initiated a concept in Toronto called Cash & Save in an attempt to meet the financial services needs of residents in lower-income and underserved areas where full bank branches had recently closed. Cash & Save allows customers to cash cheques, pay bills, purchase money orders and wire money at more reasonable rates than private cheque cashing stores. Although it does not yet provide credit services such as payday or short terms loans, it may provide an important foundation in which to build accessible and appropriate smallscale lending products as an alternative for consumers. International initiatives may also serve as interesting models for Canada‟s finance sector. For example, the second largest bank in India – ICICI Bank – also employed a broker model in response to government legislation requiring that 25% of new branches be opened in rural areas. While the other banks tried to fight the legislation, ICICI Bank saw this as an opportunity and developed a partnership model with not-for-profit microfinance lenders operating across rural India. This partnership model has been a tremendous success through its employment of appropriate technologies, financial literacy training and by building on the core competencies of each of the partner organizations. ICICI Bank is now not only the second largest bank in India in terms of asset size, but also the largest microfinancial service provider in rural India. South African banks have also embarked on an interesting innovation in response to the political and economic imperative of making financial services more accessible to the majority black population. Through a voluntary initiative, five of South Africa‟s major commercial banks cooperatively developed a low-cost product that they would collectively offer called the Mzansi Account. The key characteristics of this innovation are that the banks agreed to share their operational platforms, to create a national brand and to compete on additional services and functionality. While the Mzansi Account does not guarantee consumers access to credit, it does provide people with access to affordable financial services and financial literacy training, which are an important foundation for gaining access to credit. 6
Courses of Action for Investors
There are numerous entry points and courses of action for investors seeking to minimize the risks posed by sub-prime lending activities. Investors could approach banks in their portfolios and ask for more information on their securitization and www.share.ca
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underwriting policies; branch closure policies and data; disclosure on third-party lending activities. Investors could also ask banks to make tangible commitments to making financial services more accessible, particularly in low-income neighbourhoods etc. Another approach for socially responsible investors would be to support microfinance initiatives in the Canadian context through community investment funds. Developing viable community-based alternatives to predatory lending services is crucial for increasing competition and developing innovative institutional models that are responsive to the needs of those who do not have access to traditional financial services. In order for these innovations to be developed, however, they require capital and often, they require patient or long-term capital, which could be provided through community investment funds.
For further information contact: Shannon Rohan Programme Officer SHARE
[email protected] +1 604 408 2456
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