Investing in equities inevitably involves taking risks. Every company lists a number of risk factors in its annual reports, and there is arguably no risk factor more concerning than regulatory risk. That is the risk that a regulatory agency will create new rules that significantly affect a company’s business model or industry, possibly in an irrevocable way.
For that reason, when a large regulatory agency announces that it is cracking down on a particular industry, investors run for the exits. That’s exactly what is happening right now in the payday lending industry. Under severe pressure from new rules, payday lending is facing a structural crisis. As a result, investors should avoid the industry entirely.
Regulators Target Payday Lending
The payday lending business model is based on making short-term loans, typically of smaller dollar amounts, to individuals in need of quick cash. These loans are typically due when a person receives his or her next paycheck.
On the surface, there doesn’t seem to be anything wrong with this. And, there could be an argument that this model of lending can be a service to a particular demographic that is under-served by traditional banks and financial institutions.
However, the major red flag is that the payday lending industry is subject to predatory practices. Payday loans often have annualized interest rates in excess of 300%, or even higher in some cases.
And, in recent years, the payday lending has offered consumers online-based loans, which are now under scrutiny. Opening up payday loans online gives can sometimes give the lender the ability to close borrowers’ checking accounts if their balances are too low to cover the outstanding balance.
These practices have gotten the attention of the federal government, specifically the Consumer Financial Protection Bureau.
On June 2, the CFPB announced new regulations cracking down on this activity. New rules include placing limits on when and how lenders can gain access to consumers’ bank accounts. This specific issue is an increasing concern, as according to the CFPB, online payday lending activity makes up half of the small-dollar loan industry.
In an 18-month study the CFPB conducted with approximately 20,000 consumer accounts, half incurred overdraft fees or other penalties from their banks because their balances received payment requests from the payday lenders.
As a result, it is not entirely surprising to see the federal government taking action designed to more closely regulate, and limit the scope of the industry.
The Lending Club Case
One of the high-profile payday lenders is Lending Club (NYSE: LC), and it is a prime example of what can happen when an industry comes under the regulatory microscope. Shares of Lending Club have collapsed 56% just since the beginning of 2016, and are down 72% in the past one year amid a series of missteps by the company’s management.
The stock’s extremely poor performance was driven by accusations that the company’s loans were far riskier than originally intended. Making matters worse, Lending Club employees had falsified information about certain loans sold to an investment fund.
Upon finishing an internal investigation, the board of directors found that it was not sufficiently made aware that one of its funds was investing more heavily in five-year loans than the company’s policy. It turns out 60% of loans for the fund in question, LC Advisors, were comprised 60% of five-year loans, versus a stated maximum of 42%.
In addition, many of the loans being made did not meet the company’s risk profile. A recent letter from the company’s CFO to investors acknowledged that a valuation adjustment on these loans were driving Lending Club’s poor performance.
After having its lending practices questioned, Lending Club ousted its CEO Renaud Laplanche in May. The company then postponed its June shareholders meeting.
The key takeaway is that regulatory intervention is often a symptom of bigger issues within an industry. With such a high level of risk going forward, there is simply no reason to gamble on payday lending companies.
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