The loan rangers

Jason Fillion knows he isn't an ideal loan customer for a bank or any other old-school financial institution. Back in 2000, his computer store in Enderby, B.C., went belly up, leaving $48,000 in unpaid debts. That blot on his credit history means Fillion is classified as a "subprime" borrower. Now living in Calgary, the 35-year-old Fillion went shopping for a pickup truck in March. He wasn't surprised when two dealers turned him down for low-interest financing, but it rankled just the same. "They treated me like mud between their feet," he says.

Then a Chrysler dealer offered Fillion a 3% loan -- on the condition he put down $13,000. Fillion didn't have that kind of cash. Instead of turning him away, however, the dealer suggested that Fillion apply to VFC Inc., which specializes in car loans to subprime borrowers. The dealer e-mailed VFC an application, Fillion sent copies of some bank statements, and within hours he had a loan for $35,000. "I bought a 2006 Dodge Ram 1500 quad cab with a Hemi," he says. "Midnight blue -- love the colour."

Fillion has to pay nearly 13% annual interest, and his monthly payments will be $699. "The interest rate really doesn't bother me," he says. If he pays off the loan in six years -- or in two, as he hopes -- he'll have a robust new credit rating. "It's my doorway to getting credit cards and credit from other places," he says. But that doorway will be costly. If Fillion had been able to borrow the full purchase price from a bank, he would have paid about 8%, or $600 a month -- and a total of $6,300 less over the full term of the loan.

Fillion is far from unique. There are millions of Canadians with "bruised" credit ratings, or none at all, who are eager to borrow money to buy homes, cars and appliances. But they are automatically spit out as rejects by the computerized borrower assessment models used by Canada's big banks. This caste of customers includes the self-employed entrepreneur with an irregular income, the recent immigrant with no Canadian credit history, the single mother who missed a few mortgage payments during a messy divorce, and the labourer with a paycheque due next week who needs cash for a car repair or a night out, now.

Many of these borrowers live in the wrong part of town -- wrong for the big banks, that is. Since the early 1990s, the banks have closed dozens of branches in low-income areas of Toronto, Vancouver and other cities. Why allocate tiny portions of capital to marginal branches when big dollops of it could be deployed in booming lines of business such as investment dealing, corporate finance and high-net-worth individual banking?

Other lenders have streamed in to fill the void the banks left, building up a multibillion-dollar subprime market. The key to the lenders' profits: Screen the customers and charge them enough in interest and fees to cover the risk. Like Fillion, many of them are relieved to get a loan at all, and they're not too concerned about the interest rate.

At the riskiest, costliest and most controversial end of the subprime market are the inviting, brightly coloured branches of payday lenders such as Money Mart and CashMoney ("Are you a little short this month?"), which have sprouted like dandelions in rundown neighbourhoods. There are now about 1,350 payday loan outlets across the country, generating more than $1.5 billion in revenue a year.

Yet the business is still unregulated. Critics charge that the payday loan outfits are really loan-sharking operations that trap low-income borrowers in a cycle of debt: If customers are regularly short of cash before payday, they have to keep borrowing and paying brutally high interest rates and fees. Add up all the charges on a typical one- or two-week payday loan and annualize the total, and it can be several hundred per cent a year, far higher than the Criminal Code's usury threshold of 60% a year. "It's a ridiculously high-cost business, with a ridiculously high-cost product, operating in a Wild West environment," says John Young, who recently stepped down as executive director of the Canadian arm of the U.S. community activist group ACORN (Association of Community Organizations for Reform Now).

Payday loan contracts carefully specify an effective annualized interest rate below 60%. Money Mart charges 89 cents in interest per $100 per week, which is 46.44% a year. On a typical $250, 10-day loan, interest would be $3.18. That is the only charge if the loan is paid off in cash before the due date. But if the loan is paid off with a postdated cheque, typically on the borrower's payday, there are additional fees, and the total would be $41.45. Lenders say those extra fees reflect the high costs of doing business. They also deny that they systematically prey on the poor -- calling the charge absurd -- and add that their customers must have jobs or some other source of steady income. "You lend money to people who are going to give it back to you," says Michael Thompson, president of the Canadian Payday Loan Association.

More upscale than the payday outfits are the consumer finance divisions of foreign-owned banks like Wells Fargo, Citigroup and HSBC. Each has hundreds of branches that deal in personal loans, as well as mortgages and home equity loans. They also offer auto loans and financing for furniture and appliances, often through in-store credit cards or financing at retailers like The Brick. Another segment are the rapidly growing niche players such as mortgage specialists Xceed Mortgage Corp. and Home Capital Group Inc. An unsecured two-year personal loan from either sort of company can bear annual interest as high as 30%. Borrow $5,000 for three years from a bank at prime, and you'll pay $455 in interest. Borrow it from a subprime lender, and you'll shell out another $2,176.

Then there are the big banks. Impressed by the growth of the subprime sector, they're looking to claim some of the turf they have avoided or abandoned. In February, Toronto-Dominion Bank announced it would buy VFC for $326 million. That same month, Bank of Nova Scotia said it would buy Maple Trust, a mortgage company that deals primarily with independent mortgage brokers, for $233 million. And in April, Scotia launched The Mortgage Authority, which will accept broker referrals of borrowers with slightly lower credit scores than the bank has required previously. Charles Lambert, the bank's managing director of mortgages, calls it "the alternate A market." Finally, RBC Royal Bank has a cheque-cashing pilot project, Cash & Save.

There are no payday loans at Cash & Save -- the banks won't touch that business with a barge pole. Historically, banking has been a genteel business in Canada. The banks have been strictly regulated and protected from competition. In exchange for that protection, the banks were expected to provide basic banking services to all Canadians. The optics of going into the seamy-seeming business of payday lending just wouldn't be right.

There is no such quid pro quo with the unregulated payday lenders. Yet, until recently, provincial Attorneys General and police were uncertain they could make usury charges stick. A number of class-action lawsuits are before the courts, including three launched by Windsor-based lawyer Harvey Strosberg. One of his cases concerns Margaret Smith, a Windsor pensioner who, according to court documents, took out four payday loans from Money Mart in 2003, three of $330 and one of $300. Each one was an advance on a Canada Pension cheque, and she paid more than $30 in interest and fees on each. The annual interest rate works out to more than 300%, Strosberg says. Or, as the statement of claim puts it, "the aggregate of all the interest, charges and expenses relating to each of [Smith's]Fast Cash advances constitutes interest at a criminal rate."

In January, police in Winnipeg became the first in the country to charge a payday lender -- Paymax Canada Inc. -- with levying criminal interest rates. In March, Manitoba's NDP government introduced legislation to license payday loan providers, set fees and clamp down on abuses.

This will require help from Ottawa. In fact, in April, federal Justice Minister Vic Toews said he would revive proposals by the Martin government to exempt the industry from the 60% usury limit, which would clear the way for provincial regulation. Even the Canadian Payday Loan Association, which represents 30 companies with more than 850 outlets, including Money Mart and the other large providers, favours regulation, arguing that abuses tend to come from mom-and-pop operations.

Compared with the United States and the U.K., Canada's subprime market is still under-developed. Canadian bankers don't even like to say "subprime," studiously using terms like "non-prime," "near-prime," "non-traditional" or "specialized finance" instead. "People don't like to be sub-anything," jokes Ivan Wahl, chairman and CEO of Xceed Mortgage. Whatever you call the market, says Tim Hockey, head of TD Canada Trust's personal banking business, it accounts for more than 20% of all loans to individuals in the U.S. and Britain, versus just single digits in Canada.

In the U.S., the subprime sector grew exponentially in the early 1990s as a smitten Wall Street took more than two dozen new lenders public. Backing up the lenders were banks and other financial intermediaries that securitized the loans -- buying up millions of dollars worth of individual mortgage, car or other loans, bundling them and then selling them as packages to institutional investors. By 1997, however, many of the aggressive new lenders hit the skids.

Mainstream banks were nonetheless impressed by the growth of the sector, and it started to consolidate. Some banks, such as Wells Fargo, built up their own subprime operations. And, like many big banks, Wells Fargo also started financing and securitizing loans for other subprime lenders, including Dollar Financial Corp., Money Mart's parent. Indeed, Wells Fargo has become a lightning rod for criticism -- in part because of the payday connection, and in part thanks to allegations that its own subprime mortgage operation encourages poor borrowers to take out big mortgages, then charges excessively high interest rates, fees and late-payment penalties. A Wells Fargo spokesman recently said those charges "distort and misrepresent our business practices."

Other big international banks expanded their subprime operations by acquisition. Citigroup and HSBC both bought decades-old consumer finance companies that had extensive branch networks in the U.S. and Canada, then folded them into their own consumer finance divisions. In 2000, Citigroup took over the Associates, which itself had bought rivals Beneficial Finance in 1998 and Avco Financial Services in 1999. In 2003, HSBC bought Household Finance. The consolidation swept up hundreds of Canadian branches, which now operate under the CitiFinancial and HSBC Finance banners.

Just as the Canadian banks do, the foreign banks' consumer finance operations rely heavily on computerized borrower assessment models. But face-to-face contact in branches is also important. "We have a very decentralized, community-based approach to doing business," says Scott Wood, president of CitiFinancial Canada. "We want our employees to be, generally, living in the same communities where their customers are."

The human touch and street-level appeal are big factors in the rapid spread of the payday lenders as well. Money Mart was launched in Edmonton in 1982, by entrepreneurs Stephen Clark and Mark McDonald, mainly as a cheque-cashing service. They quickly won over customers willing to pay quite a stiff immediate fee of "two bucks on a hun" (later, three). The outlets were as unbankerly as that slogan: well lighted, staffed by friendly people (behind the bulletproof glass) and open long hours -- 24 hours, in some cases. Customers who tried the new service were typically deeply distrustful of banks. But there were logical reasons for cashing a cheque at Money Mart. Tradespeople working late on Friday, for example, faced waiting until Monday for a bank to release funds.

By the time Dollar Financial bought Money Mart in 1996, the chain had grown to 140 branches, yet payday lending still wasn't part of its business. Before 1996, when Money Mart started the practice, the term "payday lending" wasn't even in use in Canada. Money Mart now has more than 350 branches across the country. Dollar Financial doesn't break out Money Mart's financial results, but fees and interest from payday lending now generate about half of the parent's total revenue of about $300 million (U.S.).

Money Mart executives declined to be interviewed for this story, but the company provided background information and responses to questions. It rejects the "stereotype" that its customers are vulnerable, low-income Canadians. According to the company, its typical customer is 33 years old and has a job that pays an average or above-average salary. Roughly nine out of 10 of those customers have a bank account, but they prefer to use Money Mart occasionally because it's more convenient. "It's no different than someone going to a corner convenience store for a carton of milk and paying a premium," the company says. "In many respects, Money Mart is the 7-11 of financial services." A survey of 1,000 Canadians prepared last year for the Canadian Payday Loan Association found that the average household income of payday customers was $41,376 -- less than the $56,400 earned by the general population, but hardly destitution. There is, after all, a CashMoney in the complex that houses the Department of Finance in Ottawa.

Dollar Financial's 2004 annual report describes a much more desperate target borrower. "Our core customer group generally lacks sufficient income to accumulate assets or to build savings," it says. The report also says "significant opportunities for growth exist" for payday loan providers because of the "failure of commercial banks and other traditional financial service providers to address adequately the needs of lower- and middle-income individuals."

Clarissa Martin has been a member of that core customer group. She hasn't liked it one bit, but feels she had no other choices. The 29-year-old Toronto day care worker is a single mother of three. At a lunchtime demonstration by about two dozen ACORN activists at a Money Mart outlet in east Toronto, she explained why she started taking out payday loans, and why she had to keep doing it.

Martin, who was living in Jane-Finch several years ago, found herself short of cash for day-to-day living expenses. There were two banks and three payday loan outlets nearby. While she assumed she had no chance of borrowing from a bank, the payday loan outlets were friendly-looking and open late. Besides, all the "regular working people" in the neighbourhood used them. Although she's aware of the cost now, at the time she didn't calculate the full, annualized interest charges and fees. They seemed manageable at the time -- just a few dollars.

She used Money Mart, which won't allow customers to borrow more than 50% of the value of an upcoming cheque. But after Martin received enough money to pay off one loan, she often had to borrow again. "They go right into your bank account in the morning," she says. "They get first dibs." Employees at the loan outlet weren't high-pressure salespeople, but "every time you go to pay it back, they ask you, 'Do you want another?' It was easy to do, and it was easy to do more than once," she says. Indeed, Money Mart staffers are unfailingly polite. Even during the ACORN demonstration, employees continued to serve customers with a smile as protesters barged in, shouting "Loan sharks!"

Martin now lives in east Toronto, and she says she still used Money Mart on occasion up until last year, when she changed from part-time to full-time in her job at Toronto's George Brown College. Until then, she says, "My need outweighed the consequences."

Manitoba's proposed legislation takes aim at so-called rollovers of payday loans from paycheque to paycheque. Lenders wouldn't be allowed to charge additional fees to extend or renew loans unless authorized by the province. According to a 2004 Ernst & Young study prepared for the Canadian Payday Loan Association, each first-time borrower ultimately takes out an average of 15 rollover or rewrite loans. Even the association's voluntary best-practices code, which is posted in Money Mart locations, prohibits extra fees for those rollovers. Money Mart says it "does not and has never granted rollovers. A customer must repay their loan in full prior to being granted further credit."

ACORN would like much stronger measures, including the elimination of loans based on social assistance cheques and a mandatory cooling-off period between loans. But it's hard to see how payday lending could even exist without rollovers or repeat loans. Take the case of Edmonton-based Rentcash Inc., a provider of financing for The Cash Store, Instaloans and Insta-rent, which together have 419 outlets. Rentcash implemented a no-rollover policy in January, 2005. Loan defaults soared, and Rentcash's fourth-quarter profit plunged to $244,000 from $3.3 million in the previous quarter. The news instantly dropped the company's share price by more than half.

It's also hard to see how fees and interest charges will come down substantially, even with regulation. It costs a lot to provide small loans. According to the Ernst & Young study, the average payday loan in Canada is $279. The average cost to the lender per $100 loaned is $15.69, with three-quarters of that being operating costs, and only about 20% the result of bad debts.

Whether for payday loans or something bigger, there isn't much downward pressure on loan rates, either, because subprime borrowers aren't price-sensitive. Garry Denscombe, a 40-year-old sales rep in Calgary, is typical. Three years ago, he and his wife split up; he got custody of their two kids. He missed a couple of mortgage payments on the family's three-bedroom bungalow, driving down his credit score. His bank turned him down for a new mortgage. "It was devastating," he says. "Here I am thinking the worst: Oh, my God, am I going to have to sell my house? How am I going to live?"

But the bank referred Denscombe to Xceed. This is something the banks often do, hoping to hang on to their other business with the customer. He's now paying 6.05% on a five-year mortgage, compared with the 4.75% he paid when he was still married. "Don't get me wrong; I totally appreciate it," he says. "I would have had to sell my house, all because of divorce."

After years of fat profits, Canada's Big Six banks have about $10 billion of surplus capital to deploy, and not all of it will go toward the Holy Grail of U.S. acquisitions. TD's Tim Hockey expects his bank rivals to venture further into subprime waters. "There's something about our mentality that says, well, if one of us wants to do it, why shouldn't the rest of us do it?" he says.

The efficacy of the subprime sector's down-to-earth vibe is one reason TD plans to maintain VFC as a stand-alone subsidiary, rather than integrating it into a traditional bank bureaucracy. "Over the years, we've gone away, as an industry, from making those individual, across-the-table decisions," says Hockey. "We've moved to what's called model-based adjudication decisions."

Former ACORN head John Young would love it if the banks allocated even a smidgen of that $10-billion kitty to providing personal service in the low-income neighbourhoods where borrowers now trek to payday lenders. Competition from banks, he says, might "drive down price and drive out loan sharks." But that frontier still appears to be a long way off for the banks, even though it may be just down the street. The risks and the costs are just too daunting. In Toronto's downtrodden Regent Park, 10 bank branches have closed since 1980, leaving just two behind. Like any other company, banks aren't in business to lose money, and they carefully assess costs and returns in any potential market segment.

A Royal Bank pilot project in Toronto is instructive. After consulting with charities like Yonge Street Mission and St. Christopher House in 2001, Royal opened two Cash & Save outlets, one near Regent Park and one in hardscrabble Parkdale. The outlets look a lot like payday loan shops. But they don't offer loans -- just cheque cashing, bill payments, money orders and wire transfers. Their appearance prompted competing outlets nearby to drop their fees, which pleased the charities. But the fees still aren't cheap. Cash & Save charges a 99-cent processing fee, plus 1.99%, which works out to the proverbial three bucks on a hun, or $21 on a $1,000 cheque. But for the bank, this self-limiting venture is not a huge cash-spinner.

Established businesses tend to expand only on the margins of their specialty, and often only after upstarts take a leap first. In the case of subprime lending, a borrower like Jason Fillion, who has a job, a house and a vehicle, is pretty close to the banks' core-business comfort zone. Poorer Canadians who lack those things are still likely to be labelled rejects. For them, there's a friendly payday loan outlet nearby that's open late.

No down payment? No problem!

How downmarket lenders work the math so they don't get hosed

You can lend money to people whom the banks won't touch -- and still make a profit. Just ask Ivan Wahl.

Xceed Mortgage CEO Wahl has twice carved out profitable niches in mortgages. In 1985, he founded FirstLine Trust, the first Canadian company to specialize in mortgage-backed securities. FirstLine dealt exclusively through independent mortgage brokers, which Wahl says was considered "quite a risky business" because the borrowers were thought to be lower quality than bank customers. "We demonstrated, over the next 10 years, that that was an urban myth."

By 1995, FirstLine had a $7-billion home mortgage portfolio. That year, Canadian Imperial Bank of Commerce bought the firm. Wahl stayed with CIBC for five years, "failed badly" at retirement, and then got back in the game. In 2002, he led a group of investors that bought 90% of Xceed, which had been in Canada since 1997, originally as a subsidiary of a large U.S. subprime lender. Since it went public in 2004, Xceed's share price has climbed from $5 to more than $9, and it now has a $2-billion portfolio. Wahl figures the Canadian subprime mortgage market could eventually be worth $60 billion.

Xceed deals with two types of customers: "credit-challenged" borrowers (the recent immigrants, divorcees, former bankrupts, etc.), and "high-ratio" ones who want to borrow up to 100% of the purchase price of a home. Wahl says many of the borrowers in the second group actually have good credit ratings, but they're "people with lifestyle junkie habits" -- cars, European vacations and so on -- or entrepreneurs who put any money coming in back into their own businesses.

Each of the banks has its own detailed number-crunching system, yet they all rely heavily on credit-agency scores like those under Equifax's widely used Beacon system. The banks will usually turn down borrowers with a Beacon score of less than 620 (scores are based largely on bill payment and credit-card histories, and range from about 300 to 900). Xceed will go below 620 if other aspects of the applicant's finances look good.

Traditional mortgage lenders know that Canada Mortgage and Housing Corp. will insure them against losses on loans to homebuyers who put at least 25% down. Buyers who can only put down between 5% and 25% must have insurance from CMHC or Genworth Financial Canada. But neither will insure anyone with less than a 5% down payment, nor anyone who faces paying more than 40% of their pretax income on their mortgage.

Xceed, however, will provide uninsured mortgages to borrowers with no down payment, and is more open-minded about the income threshold. How can it afford to do that? Xceed simply checks each borrower's financial history thoroughly and appraises every house and neighbourhood. (CMHC might appraise one property in 100, relying on actuarial tables to estimate possible losses on the rest.)

Result? Last year, a very good one for real estate, Xceed's losses totalled just eight basis points (0.08%) of the total value of its portfolio. Wahl says more typical annual losses might be 20 basis points, which is probably about four times the credit losses of a typical bank.

Wahl says Xceed typically charges most borrowers between one and two percentage points a year more in interest than banks do. This more than offsets the default risk and the commissions Xceed pays to mortgage brokers, which are richer than what the banks pay. "As a businessman, I'd make that trade-off all day long," he says.

Of course, lending against a home is less risky than lending against the value of a car, which will depreciate the moment it's driven off the lot. But it can be done, as car-loan specialist VFC has shown. Its loan portfolio has grown to more than $430 million from $25 million in 1998. Even though VFC will lend up to 100% of the value of a car or truck to subprime borrowers, its annualized loan loss rate was just 6% last year.

As VFC chief executive officer Erik de Witte explains, the borrower selection process and follow-up is rigorous. Auto dealers have a prospective buyer fill out a one-page application, which the dealer sends electronically to VFC. About two-thirds of applicants are rejected within minutes. For those that proceed, the company verifies all the information. By the time that's done, the applicants have been reduced by another two-thirds -- either because they drop the application or are rejected. So, in the end, only about 1 in 10 applicants gets a loan.

VFC then gives borrowers a risk rating from "five key" to "one key." The five-key borrowers will get a loan for as little as 9.9%; the five-key ones will pay as much as 29.9%. If things don't work out, VFC has about two dozen employees in the collections department at its Toronto headquarters. "Our customers need some handholding," says de Witte. "You don't hear any yelling, do you? It's all very professional."