Companies profit from lending to the little guy


New York--Money lending is a class-oriented business, and in the classical hierarchy, sovereign governments and major corporations are at the top. Middle- to low-income people are at the bottom.

A re-evaluation may be in order, though. Those at the top are battering the economic underpinnings of marble-columned banks, while those at the bottom are bringing profits to storefront lenders.

"Rarely," said Samuel Liss, an analyst at Salomon Brothers, "has a U.S. economic slowdown caused such a clear dichotomy between consumer and commercial finance."

Losses on consumer loans have increased, and demand for new credit has suffered -- and it could get worse. But, for the moment at least, the high rates charged on loans to the little guys have allowed major consumer finance companies to post inordinately healthy results.

Primerica's Baltimore-based subsidiary, Commercial Credit, had record earnings last year and expects a record again this year.

That's also the case with the ubiquitous Household Finance Corp. offices that serve as the consumer finance arm of Household International. Beneficial Corp., more hesitant about making any forecast, merely emphasizes that its earnings have increased for 18 consecutive quarters.

And the share prices of these companies are up sharply, along with gains by MBNA Corp., the former credit-card subsidiary of MNC Financial Corp., which is essentially in the same business.

"Consumer finance companies are experiencing a flattening, not decline, in earnings," Mr. Liss said. -- a cheerful appraisal given the reality for many other financial firms.

Certainly they have avoided great disaster. Unfettered by legislation limiting them to a single geographic region -- a restriction faced by banks -- major consumer finance companies have offices throughout the country. That meant the Southwest bust in the mid-1980s could be offset by strength on the two coasts -- or the reverse, as is occurring today.

Their segment of the market also has been spared the worst of the current economic contraction: New office towers may be vacant and "junk" bond issuers in bankruptcy, but unemployment remains relatively low, and credit appears to have acquired an enduring attraction.

"There are still a lot of people working and borrowing," said Robert Willumstad, president of Commercial Credit.

That doesn't mean everyone wants to deal with these people. Typically, customers of consumer finance companies have lower middle incomes, hate paperwork and have a greater tendency to default. Often, they have been rejected by banks in the past. Nevertheless, they are willing to pay a lot for the privilege of borrowing, particularly if the red tape is reduced.

The result: Consumer finance companies do quite well.

While banks assume money is a commodity and clobber themselves to attract customers by shaving fractions of a point off interest rates, consumer finance companies treat money as a refined product. They charge astronomical rates, provide personalized service and develop loyal customers. David Farris, Beneficial Corp.'s chief operating officer, said his company is even used for education loans -- a category of credit where the government has provided alternatives with extremely low rates.

"They probably could get a cheaper loan, but they are sold on the fact that Beneficial will always be there," Mr. Farris said.

How much cheaper is truly dramatic.

Government-guaranteed student loans currently are offered for

about 8.5 percent. Some banks are offering home mortgages for less than 10 percent. Spot checks of several consumer finance company branch offices suggest that home equity loans, one of their two major credit lines, are now offered at more than 15 percent. Unsecured personal lines of credit, the companies' other major line, can cost as much as 25 percent in annual interest.

Too high? Who is to say, if people are willing to pay? Credit cards, Mr. Farris notes, charge similarly high rates and successfully market cash advances.

charge more because we take more risks," Mr. Willumstad adds.

The numbers back his claim. During 1990, his company wrote of almost 3 percent of its loans -- an amount that over time would devastate a bank. On personal unsecured loans, the ones that carry the highest rates, defaults have approached 5 percent.

Still, the higher risk doesn't overwhelm the reward.

Even after the write-offs for bad loans, consumer finance companies still typically generate returns on assets of more than 1 percent, the goal for banks.

In 1990, Commercial Credit returned 2.7 percent on assets, and 2.4 percent the year before.

Typically, said Stephen Shippie, an analyst at Moody's, a bank will receive 3.5 percent to 5 percent more to lend money than it pays to borrow. Consumer finance companies maintain much greater margins. At the moment, the gap is a much as 15 percentage points.

That is because the recession has lowered interest rates in the markets where the large consumer finance companies borrow, while the consumer finance companies themselves have largely resisted lowering their own rates to customers.

That may be prudent. Defaults and delinquent payments on cars, mobile homes, credit cards and most other categories of debt are all rising.

As bankruptcy loses its social stigma, it's a good bet that repayment risk, as it is known in the trade, will increase.

Defaults, of course, could ultimately bury any lender. And consumer finance companies face another problem: Consumers are becoming more prudent themselves. In May, consumer credit, which prior to the recession had been growing at about 10 percent a year, actually contracted. Less business and more losses make a poor combination for any company.

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