|Shares Out. (in M):||14||P/E||9.2x||8.2x|
|Market Cap (in $M):||1,067||P/FCF||0.0x||0.0x|
|Net Debt (in $M):||0||EBIT||0||0|
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I am recommending a short position in the predatory lender WRLD based on a new angle: credit insurance. The CFPB is cracking down on credit insurance right now and I believe ~60% of WRLD’s net income comes from selling credit insurance. I also believe that the CFPB could consider banning “loan flipping” (i.e. frequent intentional refinancing) which is essential to WRLD’s business. Several other U.S. financial regulators ban this practice, and the objective of the CFPB is to close loopholes. The writing is on the wall that WRLD is in the crosshairs of a potential regulatory showdown that could result in the equity being worth zero. With WRLD trading at 9x earnings and 2.7x book, the equity market is ignoring this risk. Apparently management agrees because they have been selling stock at a rapid clip – about $3mm per quarter.
The short thesis on WRLD has been around for a while: basically, WRLD’s business model is a house of cards built on several predatory lending practices, and it is screaming to have the CFPB shut it down. The short thesis to date has not focused on the risk from credit insurance, but this is a serious new risk. The CFPB has acknowledged that credit insurance is a dirty product. Based on the CFPB’s recent enforcement action against Capital One, WRLD could lose ~60% of its earnings.
The CFPB’s first two enforcement actions have been over payment protection products (aka credit insurance). In July, the CFPB slapped Capital One for a variety of deceptive sales practices for payment protection products and forced Capital One to cease selling these products until it submits an acceptable compliance plan. Capital One responded that it would simply stop selling payment protection products. Also, earlier this year Discover disclosed that it is facing an enforcement action from the CFPB for the same issue. If the same scenario played out at WRLD, expect the effects to be devastating.
The CFPB implied in its Capital One press release that more enforcement actions over payment protection products are forthcoming. The CFPB also released a compliance bulletin over so called “add-on” products on July 18. I have been told by people with knowledge of the CFPB’s thinking that the CFPB thinks credit insurance is a “dirty product” that it can use to rack-up quick enforcement victories in order to justify its existence in the face of political opposition.
Overview of WRLD
WRLD is the subject of an excellent write-up by Casper719 in December 2010 and Citron Research did a damning expose in 2009 (http://www.citronresearch.com/index.php/2009/05/07/world-acceptance-corp-nasdaqwrld-their-business-model-is-a-borderline-legal-ponzi-scheme-whose-day-of-reckoning-has-finally-come/).
WRLD’s main business is offering sub-prime installment loans – typically $1,000 loans with a one-year term and a 64% interest rate – through 1,000+ branches to customers who are too sub-prime even for a credit card. Yes, the average interest rate is 64% for a one year loan – WRLD operates in the last handful of states that have not adopted a 36% usury cap.
WRLD has been perhaps the most phenomenal growth story in all of financial services in the last 5-10 years, and also one of the biggest sub-prime predators that has not already been shut down, growing loans 15-20% per year and remaining highly profitable during the downturn. Loan losses only increased from 15% in 2006 to a peak of 17% in 2009 (by comparison losses for most credit card lenders tripled from 4% to 12% during this period). How is this possible? Because 75% of its loans are re-financings of existing loans. This staggering statistic from WRLD’s own 10K filing shows that customers almost never repay, they just keep flipping their loans. This shell game allows WRLD to keep collecting its huge interest charges and to defer recognizing losses until it inevitably crumbles.
WRLD also uses an arcane method called the “Rule of 78” for inflating interest charges which is banned in many states.
Casper719’s write-up does an excellent job analyzing these factors, so I will quote him (her?) here: “The real insidious part of this loan structure is how it is used to juice returns and create a cycle of debt many customers get locked into (without any understanding). WRLD aggressively markets refinancing of loans before maturity. Once a customer has paid a few months of the loan (which was mostly interest), the customer is eligible for another loan. Due to the Rule of 78, the loan structure and new origination fees dramatically increase the effective APR well beyond what would have been if the loan was simply paid off in due time.”
To quote further: “Over 70% of originations have been refinancings over the past 3 years. This enables the company, in my belief, to garner excess returns by the Rule of 78. Further, I believe the credit quality of the portfolio is not nearly as good as credit metrics contend, given the fact that the company literally extends and pretends on many of the loans.”
It is remarkable that WRLD trades at 2.7x book value when in all likelihood it would be unable to collect many of its loans if it did not keep “extending and pretending.” WRLD’s book value is highly theoretical.
The Credit Insurance Scam:
Credit insurance is the consumer finance equivalent of the extended warranty that Best Buy tries to sell you when you buy a TV – it is the very high margin add-on that you don’t really need – only in WRLD’s case, it is much more predatory. Credit insurance is supposed to cover your loan if you die or are disabled, or if you lose your job. But, it is a scam for several reasons which regulators and consumer advocates are picking up on.
While technically optional, it is bundled with the loan, so desperate borrowers don’t really know they are buying it (see below for a link to an actual loan contract). We talked to a former branch manager who said that they are encouraged to push it because it is so profitable, the disclosures that credit insurance is optional are not explained, and most borrowers don’t understand what they are signing up for. We believe the majority of loans are sold with credit insurance (branch managers and private competitors have told us 80%) although this is a statistic WRLD is reluctant to disclose.
When WRLD’s smaller competitor Regional Management (NYSE: RM) marketed its initial public offering this year, the CEO said that one of its growth strategies is to increase the “uptake rate” of credit insurance products by marketing them more heavily. He said, “The likelihood of the customer asking for it [credit insurance] is nil,” and “It is a product that has to be marketed to be sold.” The CEO said that branch managers are paid based on overall profitability and are cognizant that credit insurance is a high margin product. He also said, “We are mindful that if the uptake rate at any branch is too high then it looks fishy.”
One of the primary business purposes of selling credit insurance is to use it as an “APR enhancer” in states with where the maximum APR is capped by state law. Accordingly, we believe there is a strong incentive to “push” credit insurance in order to meet profit targets that would not be achievable solely from the interest rate on the loan. For example, World does not sell credit insurance in Wisconsin, Illinois and Missouri because these states have no APR caps, and World can meet its profit targets by simply by charging high APRs. However, World does sell credit insurance in order to meet its profit targets in states such as Kentucky, Oklahoma and Alabama where the maximum APR’s are capped at 41%, 30% and 20% respectively.
WRLD actually lends to the customer an extra amount to pay for the insurance premium, and WRLD lends it at the same usurious rate they charge for the underlying loan. I strongly encourage you to scrutinize this copy of an actual loan contract (http://www.scribd.com/doc/105852806/WRLD-Loan?secret_password=9y71r6mdyspez1su8ek). It shows that the customer refi’d a $757 loan, borrowed another $532, and then borrowed another $280 just to pay for five (!) types of credit insurance. So, 22% of the underlying loan balance is used to fund the payment for credit insurance premiums. The borrower is paying a 43.2% interest rate, including on the portion of the loan that is funding the payment of the insurance premium. (By the way, if you have access to PACER you can pull up hundreds of these loan contracts in creditor claims filed by WRLD. It provides you a truly heart-breaking window into the lives of its customers – many of whom have claims from hospitals, radiology clinics, and ambulance services.)
The majority of this insurance premium gets paid as a kickback to WRLD from the insurance company, although WRLD tries to hide this fact. Conveniently, WRLD works exclusively with the publicly traded insurance company Fortegra (ticker: FRF) d/b/a Life of the South. So, we can see from the insurer’s financial statements how this cozy relationship works. Have a look at FRF’s 2011 10K pg 47 which is the income statement for FRF’s Payment Protection segment. FRF has $115m in premium revenue, and pays $74m in commissions and $38m in insured losses. So, for every $1 that WRLD lends to the customer to buy insurance, 32c goes to paying actual losses, and 64c gets kicked back to WRLD as a commission – yes, that’s right, 64% of all the insurance premiums flow back to WRLD as pure profit. I believe that if this were understood by regulators and investors, it would cause a scandal. More on that below.
Credit insurance is the most expensive type of insurance by far as evidenced by its extremely low loss ratios (i.e. the ratio of insured losses relative to premiums), so customers are being massively overcharged versus other types of insurance like auto, health, life and homeowners. In fact, the loss ratio on credit insurance is in the 30%-range, which is below even the minimum guideline of 50% set by the National Association of Insurance Commissioners. A consortium of consumer advocacy groups has been lobbying for more aggressive federal oversight through the CFPB to crack down on credit insurance, estimating that Americans have been overcharged by $17.5bn since 2004 for credit insurance. See: http://www.consumerfed.org/elements/www.consumerfed.org/file/CFPA%20Moore%20credit%20insurance%20amendment%20letter(2).pdf
Putting it all together, WRLD is “double dipping” by collecting both ~64% of the insurance premium in the form of a kickback, and usurious interest income from financing the premium... and the customer does not understand what they are buying. I estimate this is accounts for 60% of WRLDs net income. Here are my assumptions:
Link to Force-Place Homeowners Insurance Scandal
One of the reasons I think credit insurance is so scandalous is that a related product, force-placed homeowners insurance, has actually erupted into a full blown scandal recently. Force-placed homeowners insurance is a product that your mortgage lender buys for you if you don’t prove that you have homeowners insurance. It is a “sister product” to credit insurance at World because they are both forms of “lender-placed insurance.” They are both sold by some of the same insurance companies (e.g. AIZ), they are both over-priced and have low loss ratios, and importantly, they both pay large kickbacks to the lenders for placing the insurance.
Here is a quick overview of the force-placed insurance scandal. The NYTs has been writing for a while about what a scam it is. Then the 49 State Attorneys’ General included force-placed insurance in their $25bn settlement with mortgage lenders in February. They said that force-placed insurance has to be purchased for “a commercially reasonable price” and banks cannot “accept referral fees from third parties.” Coincidentally, that same month, a Federal judge granted class action status to a suit against Wells Fargo involving the same issue: “inflating the cost of such coverage by secretly paying themselves unearned commissions.” In June, the NY Dept of Insurance held heated hearings on topic, and the CA Department of Insurance forced insurers to dramatically lower its rates for force placed insurance. In August, the National Association of Insurance Commissioners held hearings, and Florida demanded a 30% rate cut for force-placed insurance.
For whatever reason, no one seems to have noticed that WRLD is doing the exact same thing.
Here is a smattering of quotes from recent articles in the NYTs and the WSJ. You could take the words “force-placed” out of the quotes below and insert “credit insurance at World” and all the quotes would still apply.
June 12: “New York Regulator Orders Price Cut For `Forced' Home Insurance.” “At the hearings, Mr. Lawsky said the business has been highly profitable for the banks and insurers. He said his office found that insurers were paying out less than 25 cents in claims for each $1 of premium collected, compared with the approximately 55 cents they had estimated in their last rate submissions.” http://professional.wsj.com/article/TPDJON000020120612e86c00090.html
May 21: “The state Department of Financial Services is looking into whether the insurance firms effectively bought their dominant positions by paying kickbacks to banks disguised as commissions or other business, according to the department’s superintendent, Benjamin M. Lawsky.”
“Consumer advocates told the regulators the force-placed insurance business appeared fraught with sweetheart deals: A mortgage lender would take out the coverage with its own handpicked insurer; the insurer, in turn, would recycle much of the money back to the lender.” http://www.nytimes.com/2012/05/22/business/new-york-investigates-home-insurer-payments-to-banks.html?_r=1&ref=business
April 4: NY State is: “demanding justification for how their rates and loss ratios were calculated.” Regarding loss ratios: “Mr. Lawsky and investigators believe those payouts are as little as 20 cents on the dollar, compared with estimates to regulators of 55 cents.” “Critics say that rates are often exorbitant, partly because of close ties between insurers, agents, mortgage servicers and brokers. Mr. Lawsky's investigation also is scrutinizing those relationships, these people said.” “So far, investigators for Mr. Lawsky have found that 15% to 35% of premiums collected by force-placed insurers flows to brokers in the form of commissions, according to people familiar with the situation.” http://professional.wsj.com/article/SB10001424052702304072004577324110340811358.html?mod=WSJ_hp_LEFTWhatsNewsCollection
Credit insurance is far from the only risk that WRLD faces. For starters, how many public companies can you name whose business practices are outlawed in more half the states in the union? The long arc of regulation bends toward WRLD’s demise. For example, JUST IN AUGUST two remarkable things happened: 1) Senator Durbin proposed a bill that would cap consumer interest rates at 36% nationwide. This would put WRLD out of business. Unfortunately, it is not expected to pass. 2) WRLD put out an 8-K saying that a judge in Missouri has allowed a ballot initiative to move forward which would cap interest rates at 36%. WRLD said this could put them out of business in Missouri, which is 7% of net income. Unfortunately, the installment lending industry put up a large legal fight and got the ballot initiative dropped a few days ago.
I think it is highly likely that the CFPB will ban frequent loan refinancing. Why? Because several other financial regulators in the US ban the practice. The whole point of the CFPB is to close the regulatory loopholes that let predatory lenders operate. For example:
The FDIC’s Affordable Small-Dollar Loan Guidelines state, “[C]redit should be provided in a manner that offers borrowers a meaningful opportunity to repay based on their circumstances… [E]xcessive renewals of a closed-end product, or the prolonged failure to reduce the outstanding balance on an open-end loan, are signs that the product is not meeting the borrower's credit needs.” (Source: http://www.fdic.gov/news/news/press/2007/pr07052a.html)
The OCC discourages national banks from: “Loan ‘flipping’ – frequent refinancings that result in little or no economic benefit to the borrower and are undertaken with the primary or sole objective of generating additional loan fees, prepayment penalties, and fees from the financing of credit-related products.” (Source: http://www.occ.gov/static/news-issuances/memos-advisory-letters/2003/advisory-letter-2003-2.pdf)
The National Credit Union Administration, in October 2010, allowed members to offer a high rate installment loan product as an alternative to pay-day loans. However, it specifically prohibited roll-overs in order to achieve a “balance of providing borrowers with sufficient access to credit while helping borrowers transition from a reliance on repetitive borrowings.” (Source: http://www.federalregister.gov/articles/2010/09/24/2010-23610/short-term-small-amount-loans#p-25)
Timing: Status of CPFB
The timing for this short to play out is over the intermediate term. The CFPB is still in the process of defining the “large market participants” which it will supervise. For quick background, Dodd Frank mandates the CFPB to regulate mortgages, credit cards, student lending and payday, and the CFPB has discretion to select other areas to supervise. For example, the CFPB recently announced that it will supervise 150 debt collectors, most of which are smaller than WRLD.
All indications are that the CFPB will regulate installment lenders, of which WRLD is the largest. The CFPB says, “Under the new law, our nonbank supervision program will be able to look at companies of all sizes in the mortgage, payday lending, and private student lending markets. But for all other markets—like consumer installment loans [my emphasis], money transmitting, and debt collection—the CFPB generally can supervise only larger participants. Before we can do that, however, we need to define through a rule, no later than July 21, 2012, who is a “larger participant” in these markets.” Note, the CFPB has missed the July 21 deadline which was not a surprise. The CFPB is expected to make an announcement in the next six months.
Realistically, I think it could take up to three years for the CFPB to research, draft, submit for comment, and finally enforce regulations that will put WRLD out of business. But I think the stock will crater well in advance of this process.
For example, to date, nobody has focused on the credit insurance issue at WRLD. If someone were to shine the light here, as they have done for force placed home-owners insurance, this has the potential to become a public scandal. I think we are in the first inning of this playing out. For the first time ever, in just the last month or so, the sell-side analysts have started to mention the credit insurance risk at WRLD. Of course, most are completely dismissive, but if you talk to some of them personally they will share their concerns based on conversations with the CFPB. Also, for the first time ever, WRLD received four questions about credit insurance on its earnings call last week. I expect WRLD to receive more and more scrutiny from the market over this issue, and perhaps also the press.
Here is how I could see the news flow catalysts playing out:
At some point in this timeframe, WRLD’s valuation will drop significantly as the market prices in the inevitable risk of WRLD being shutdown.
WRLD trades at 9x forward earnings and 2.7x book value. For the last 10 years it has traded at an average forward P/E of 10x, and in the last year it has been at 9x forward, so I think there is little risk of multiple expansion. I think the main risk to being short is that WRLD continues to show EPS growth in the mid-teens range (despite EPS being highly manufactured), the P/E stays the same, and the stock price moves up with earnings.
***This posting is solely for the evaluation of VIC members and is not a recommendation to buy or sell this stock. This writing reflects the views of the individual author and should not be attributed to any affiliated investment firm, which may or may not hold positions consistent with the views expressed herein and may buy or sell shares at any time.***
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