“From a technical perspective, the recession is very likely over at this point,” Fed Chairman Ben Bernanke assured Americans. But since his speech back in September 2009 at the Brookings Institution in Washington, the results of the recession — tight credit, slammed jobs and slowed sales — are still felt hard throughout the country.

Banks continue to be embroiled in the middle of it all. From Bank of America to Citigroup, every major lender has shouldered its share of the blame both financially and in the public perception — and America’s biggest financial institutions continue on an uphill battle toward becoming salient businesses once again…

But while the big-name banks wean themselves from Uncle Sam’s till, the seedy side of the finance world is seeing significant growth.

Payday loans are one of the most controversial topics in banking. With APRs that start around 600% and maximum loans of $500 as standard, it’s no surprise that payday lenders are decried as the worst financial predators.

If you’re not familiar with payday loans, typically, they work like this: Someone in need of cash goes to a payday lender’s office to take out a small short-term loan of $100 to hold him over until his next payday. To do that, the borrower cuts a postdated check for $126.40 (the principal, plus $26.40 in fees, a 688.29% APR) made out to the lending company. Finally, the payday lending company cashes the check on the date the loan is due, 14 days later.

I’ll admit, it’s easy to succumb to the emotional argument against payday lenders…but digging a little big deeper into the numbers yields a somewhat different story.

Understanding Interest Rates

In the U.S., we’ve become accustomed to the mind-set that the difference between our credit card APRs and the prime rate (the lowest reference rate used by banks) was some sort of punishment levied upon us by our financial institutions of choice. That’s not a shocking concept when you consider the fact that lenders “punish” borrowers who default by hiking up their interest rates: Make a payment three days late? Well, now you have to pay us 30% each year!

Consumer punishment through APRs is the very reason behind the credit card reform that took hold back in February. The problem was that banks were hiking rates to beef up their bottom lines. Changing interest rates isn’t designed to be a profit center — it’s supposed to mitigate risk for the lenders…

If a customer has a history of making late payments — or blowing off his creditors entirely — charging him a higher interest rate is the bank’s way of making up for the fact that a higher percentage of that client base will default. As with small-cap investments, risk entitles investors to potentially higher profits; in this case, the investor is his bank.

But it’s not about greed. Over the long run, random risks even out — in other words, a random portfolio of higher risks at higher interest rates should yield the same as a random portfolio of lower risks at lower rates.

So what does that mean in the world of payday loans?

Simply put, payday lenders provide a necessary service for customers with no other options. If someone with awful credit doesn’t have the cash to pay the power bill this month, their options are to turn to a payday lender or to let the power get shut off.

And while the public is duped into thinking that payday lenders are gouging their clients with exorbitant fees, the truth is that triple-digit APRs are a necessary evil for an industry that sees several times more uncollectable debt than a prime-lending bank. But although profitability for payday lenders and cash advance companies isn’t necessarily any better or worse than investors would see at a regional bank, organic growth and misinformation are making this industry an attractive buy right now.

The Path to Payday Profits

While the credit market ground to a halt back in 2008, it was a completely different story in the payday loan industry — since payday lenders already dealt with the worst tranche of borrowing risks, they were mostly able to continue business as usual during the crunch. One thing that did change was their customer base.

With credit nonexistent at traditional lenders, better credit risks were actually pushed to payday lenders to keep their finances afloat. That’s meant payday loan operators have had larger numbers of more reliable clients in the last couple of years. But because of the stigma attached to payday loans, they’ve been eschewed by investors not willing to actually look past public perception.

That’s left some of these consumer lenders trading at a significant discount right now.

A couple of payday lenders worth looking at include First Cash Financial Services (NASDAQ: FCFS) and Dollar Financial Corp. (NASDAQ: DLLR) – two companies that Penny Stock Fortunes readers booked double-digit gains on in the past.

Sincerely,
Jonas Elmerraji
Managing Editor, Penny Sleuth

June 23, 2010

Jonas Elmerraji

A big-four public accounting alum, Jonas Elmerraji brings his readers extensive expertise in small-cap stocks and broad market moves. Elmerraji’s interest in the market started with an investing course in elementary school – today he holds a degree in financial economics from UMBC and specializes in blending fundamental and technical analysis. Elmerraji has contributed to Forbes, TheStreet.com, and Investors Business Daily among others. He is managing editor of the Penny Momentum Trader, and a co-editor of Penny Stock Fortunes.

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