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).
The debt trap critique against payday lenders seems based on three facts: payday loans are expensive (“usurious”), payday lenders locate near their customers (“targeting”), and most payday customers are repeat (“trapped”) borrowers. After documenting that the typical customer borrows 8 to 12 times per year, the CRL (Center for Responsible Lending) concluded:
- …borrowers are forced to pay high fees every two weeks just to keep an existing loan outstanding that they cannot afford to pay off. This …”debt trap” locks borrowers into revolving high priced short term credit instead of …reasonably priced longer-term credit (Ernst, Farris, and King 2003, p. 2)
The CRL study went on to estimate that 5 million trapped American familie were paying $3.4 billion annually to “predatory” payday lenders.
The debt trap critique has influenced lawmakers at every level to restrict payday credit or ban it outright. Oakland and San Francisco limit the number and location of payday stores. Oregon and Pennsylvania recently joined Georgia and North Carolina in banning payday loans. New York, New Jersey, and most New England states have never granted entry. By contrast, some western states (Washington, Idaho, Utah, and until recently New Mexico) have maintained relatively laissez faire policies toward payday lending. That patchwork regulation means that millions of people use payday credit repeatedly in some states, while their counterparts in other states go without. However one sees payday credit as helpful or harmful the uneven regulations means millions of households are potentially being wronged.
We test the debt trap hypothesis by investigating whether Georgia and North Carolina households had fewer financial problems, relative to households in other states, after payday credit was banned. The study we depart from is Stegman and Faris (2003). They find that “pre-existing” debt problems bounced checks or contact by debt collectors were the most significant predictors of payday credit demand by lower income households in North Carolina. We follow up by researching whether problems go down when payday credit gets banned. Is payday credit part of the problem, or part of the solution?.
We study patterns of returned (bounced) checks at Federal Reserve check processing centers, complaints against lenders and debt collectors filed by households with the FTC (Federal Trade Commission), and federal bankruptcy filings. The monthly complaints data are new to this study; we obtained them from the FTC under the Freedom of Information Act. We use changes in complaints within a state to identify changes in household welfare (well being), a distinct advantage compared to the ambiguous measures (interest rates and repeat borrowing) emphasized by critics of payday lending. How do we know when credit is so expensive or burdensome that households are better off without it? The real test is whether household welfare is higher with or without payday credit, and complaints are a measure of welfare.
Most of our findings contradict the debt trap hypothesis. Relative to other states, households in Georgia bounced more checks after the ban, complained more about lenders and debt collectors, and were more likely to file for bankruptcy under Chapter 7. The changes are substantial. On average, the Federal Reserve check processing center in Atlanta returned 1.2 million more checks per year after the ban. At $30 per item, depositors paid an extra $36 million per year in bounced check fees after the ban. Complaints against debt collectors by Georgians, the state with the highest rate of complaints to begin with, rose 64 percent compared to before the ban, relative to other states. Preliminary results for North Carolina are very similar. Ancillary tests suggest that the extra problems associated with payday credit bans are not just temporary “withdrawal” effects; Hawaiians’ debt problems declined, and become less chronic, after Hawaii doubled the maximum legal “dose” of payday credit in 2003.
Our findings will come as no surprise to observers who have noticed that payday credit, as expensive as it is, is still cheaper than a close substitute: bounced check “protection” sold by credit unions and banks (Stegman 2007). Bounce protection spares check writers the embarrassment of having a check returned from a merchant, and any associated merchant fees, but the protection can be quite expensive. The Woodstock Institute survey of overdraft protection plans at eight large Chicago banks estimated the (implicit) APR for bounced check “protection” averaged 2400 percent (Westrich and Bush 2004). Sheila Bair (2005), now head of the Federal Deposit Insurance Corp.,observed that the “enormous” fees earned on bounced protection programs discouraged credit unions and banks from offering payday loans. She warned that customers were “catching on” and turning to payday credit for their “cheaper product.”
Our findings reinforce and extend other recent research on the consumer benefits payday credit. Morgan (2007) finds that households with risky income (and hence, high demand for credit) are less likely to miss debt payments if their state allows unlimited payday loans. That study looked at variation in credit supply between states; this study looks within states. Morse (2006) finds that California households weather floods, fires and other natural disasters with less suffering (foreclosures, illness, and death) if they happen to live closer to the types of places where payday lenders tend to congregate. Her findings show that payday credit can be profoundly beneficial, even lifesaving, in extraordinary events. Our findings show it helps avoid more quotidian disasters, like bouncing a mess of checks, or getting hassled at work by debt collectors.
Our findings may not be consistent with Skiba and Tobacman (2006). Using data from a single large payday lender in Texas, they find “suggestive but inconclusive evidence” (p. 1) that payday loan applicants who are denied loans are less likely than applicants granted loans to file for rescheduling of their debts under Chapter 13 of the bankruptcy Act. By contrast, filings under Chapter 7 were not affected. We too find lower Chapter 13 filings after payday loans are banned (denial at the state level) but we find higher Chapter 7 filings. Now recall that rescheduling under Chapter 13 is for filers with substantial assets to protect, while Chapter 7 (“no assets”) is for everyone else, including, as seems likely, most payday borrowers. Combined with our findings of more bounced checks and more problems with debt collectors, we take our results as evidence of a slipping down in the lives of would be payday borrowers: fewer bother to reschedule debts under Chapter 13, more file for Chapter 7, and more simply default without filing for bankruptcy.
Section II describes the payday credit market and the debt trap critique that led Georgia and North Carolina to close the market in those states. Section III illustrates how higher interest rates might push households from a sustainable debt path to an unsustainable path with accumulating debt and problems. Section IV introduces the debt problems we study and documents how national events have influenced their trends. Section V presents the main results: most problems increased in Georgia and North Carolina, relative to the national average, after those states banned payday credit. Ancillary tests show that Hawaiians’ debt problems (complaints) declined and became less chronic after the payday loan limit was doubled. Section VI concludes.
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