Bankruptcy

Fringe Banking and Financial Distress

By Jim Hawkins

The answers to the question about the definition of financial distress track with my thinking too.  On the one hand, we could define financial distress loosely and almost everything counts (like forgetting your wallet and needing to pay for parking).  Stephen Ware once wrote that financial distress could mean having wants that exceed your ability to pay.  For me, such a loose conception of the term causes it to lose any meaning.  Wants exceeding needs could be the owner of the Yankees wanting to own a NBA team but not having enough money.  This expansive of a definition misses the heart of distress which seems to relate to not meeting basic needs or getting collection calls, etc.  

On the other hand, some definitions are so restrictive that they miss a large group of people we?d commonly think of as in distress.  If we define distress as declaring bankruptcy or even getting sued or called for collection, we miss all the people who are going without basic medications to pay their credit card bills or skipping meals to service other debt.  And, we miss all the people who do not declare bankruptcy but for whom it would be efficient to do so.

The two most common definitions that came up in law review articles were (1) having unmanageable debt; and (2) not being able to have your financial ends meet.  I think the first is a better definition because most measures of financial distress relate to debt (debt to income ratio; negative net worth; debt service ratio, etc).  But, because the concept is indeterminate and people accept both, I use both.

Using these two definitions, I started to think about whether fringe banking products cause financial distress.  Academics and policymakers often assert that they do.  And, the argument makes a lot of sense: Fringe borrowers are on the financial fringe already, and fringe banking products cost ridiculous amounts of money.  It seems likely that using fringe credit would cause distress.  But I don?t think so.

There are two key characteristics of fringe banking products that limit the likelihood borrowers will experience distress when using them.  First, the amounts of the loans are small.  At most, you can get a payday loans for a total of 1/26th of your annual salary.  The average payday loan is for $300.  The average pawn loan is around $70.  But, a single credit card company will give you a credit limit of 1/5th of your annual income.  With such a small amount of money owed, it is unlikely you?ll be taking on unmanageable debt.

Second, most fringe credit is structured to guarantee repayment regardless of whether the borrower can repay the loan.  Pawn loans and auto title loans are both self-liquidating.  If you don?t pay the loan, you don?t owe anything because the lender just keeps your property (and usually isn't entitled to any deficiency).  Similarly, if someone doesn?t make a rent-to-own payment, the person doesn?t owe any money, they just lose possession of the goods.

Anyway, the full argument is here.  This is a rough draft, so I?m very interested in any comments.  If you want to email me directly, my email is jrhawkins [at] uh.edu .
 

Full post as published by Credit Slips on February 19, 2010 (boomark / email).