Sub-Prime Lending in Canada: Implications & Opportunities ...

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.

1 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-to-

own 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 individuals regular income ? is the fastest

1 Cheque cashing becomes a form of lending when a person doesnt 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 Canadas 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 companys total revenues.

Money Marts 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 CPLAs 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

2 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 . 5 To view the CPLA Code of Best Business Practices, see .

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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 Blocks 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 Canadas largest banks support predatory lending. Available on-line at . 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: . 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 Canadas 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

ACORNs 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. 10 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 Canadas 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 Canadas 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: .

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