This week I want to discuss a far more immediate problem than saving for retirement or for college.
Here’s the question posed by the Federal Reserve to nearly 6,000 consumers in “The Report on Economic Well-Being of U.S. Households”: Suppose that you have an emergency expense that costs $400. Based on your current financial situation, how would you pay for this expense? Anyone with a car, washing machine, or air conditioner has been presented with an unexpected bill of $400 or more on many occasions. Forty-seven percent of respondents told the Federal Reserve that they either could not cover an emergency expense, or would cover it by selling something or borrowing money. Two-thirds of the respondents in households making less than $40,000 could not cover the unexpected expense.
Even though we’re into the second full year of the Affordable Care Act, 31 percent of the respondents were forced to forgo some form of medical care because they could not afford it. And just under one quarter of the respondents indicated that at least one member of their family experienced a financial hardship at some point in the last year.
I don’t want you to think that the economy isn’t improving or that the average American hasn’t seen some improvement in their prospects. The survey indicated that 65 percent of the respondents are doing okay or living comfortably, and this figure rose from 62 percent in 2013. In addition, 29 percent of the respondents expect their incomes to rise in the next 12 months, compared to 21 percent in the previous survey.
I want return to the question about the unexpected $400 expense. If you can’t cover that type of expense, you are actually very valuable to Wall Street, institutional investors and many wealthy folks looking for high yield investments. And if you need to borrow money to buy a used car or go to a for-profit school, you are also an important contributor to the returns of public pension plans and hedge funds.
When an unexpected emergency arises, the personal loan industry is only too happy to offer a high interest solution. As I wrote last November, North Carolina and other states have helped to generate a great deal of new high yield debt by loosening the restrictions and increasing the interest rates on consumer loans that target indigent borrowers. The maximum loan amount was increased from $10,000 to $15,000, the term of these loans was extended from seven to eight years, and the interest rate cap jumped from 19.2 percent to 22.8 percent. The consumer finance industry argued that they needed these changes in the law even though their borrowing costs have been extremely low thanks to the Federal Reserve.
In the current session of North Carolina’s General Assembly, the consumer finance industry came back looking for more ways to “help” consumers meet a $400 emergency. They were using the same arguments to push a new type of consumer loan. The industry argues that they need this new type of loan to better serve consumers. Fortunately, the new consumer loan proposal called the “alternative rate installment loan” failed to clear the General Assembly during this past session. I am sure that the proposal will reappear in 2016.
Under the proposal, a consumer could borrow between $300 and $1,500 for a period of six to eighteen months. From my perspective, this looks like a clever way to undermine North Carolina’s restrictions on payday loans. Moreover, this new kind of loan can be piled on top of one of those $15,000 loans issued under the Consumer Finance Act.
The proposal tries to appear consumer-friendly by claiming to prohibit the charging of interest on these loans. However, the proposed legislation allows the lender to charge a 10 percent nonrefundable investigation fee, plus an installment fee of 5 percent per month on balances below $500 and 4 percent on balances above $500. To be clear, the investigation and installment fees are nothing more than interest payments. Do you really think there’s much to investigate when someone with a poor credit score asks for one of these loans? While the bill’s sponsors want us to believe the lenders are going to conduct all sorts of due diligence and incur all sorts of expenses administering the loans, the reality is that these new loans will be marketed as an easy way to get quick credit. Lenders are going to charge 40 percent to 60 percent interest on these loans, which will work out to an annualized rate that will be much higher.
In my last column, I talked about the credit strategies being pursued by North Carolina’s public pension plan. Like dozens of other pension plans and hundreds of endowments, North Carolina is hiring alternative money managers to purchase high yield debt that often consists of consumer loans, used car loans, and student debt. In a low interest rate environment, hedge funds can borrow money at very low rates of interest in order to invest in the high yield debt of hard-pressed consumers. Consumer debt has such a high rate of interest that everybody from finance companies to hedge funds and even pension plans can make money off of a consumer’s inability to come up with $400 to meet an emergency.
What happens if hard-pressed consumers begin to default on these loans? Money management has a solution to this problem, known as distressed debt hedge funds. Institutional investors are clamoring to invest with hedge funds that specialize in squeezing profit out of consumer loans that have gone bad. Moreover, legislatures across the country, including our own General Assembly, have proposals pending that would make it easier to collect these debts and garnish wages.
Wall Street and money management executives continue to push Congress and state legislatures to chip away at various social programs aimed at helping the working poor. This is not merely an ideological view about the role of the government. Rather, it’s a sound business strategy. As wages stagnate and social programs shrink, more and more folks will have to turn to debt to meet one or more life emergencies. The growing mountain of consumer debt piling up on the working poor and lower middle class is an opportunity for investors of all sorts to pile into hedge funds that feed off these high interest loans.
There’s a sad irony in this investment food chain. Last time I checked, the average public servant in North Carolina made about $42,000 per year, which means there’s a high likelihood that she doesn’t have the financial wherewithal to fund a $400 emergency. If she takes out a loan, there’s some chance that her financial misfortune may become one tiny piece of a high yield asset managed by one of her pension’s hedge fund managers.
Invariably, Wall Street has a solution for everything and the power to sell it. Regrettably, most of their solutions are short-term fixes that offer money managers and institutional investors quick profits at the expense of consumers and then saddle the rest of us with long-term problems.
Andrew Silton’s Meditations on Money columns can be found twice a month in The N&O’s Work&Money section. He is a retired money manager living in Chapel Hill. He was CIO for the North Carolina Retirement System from 2002-2005. He writes the blog http://meditationonmoneymanagement.blogspot.com/