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The Trouble With Payday Lenders

NEW YORK (TheStreet) -- In the last several years of economic uncertainty and tightened availability of consumer credit, payday lenders including Cash America (CSH), World Acceptance (WRLD) and First Cash (FCFS) have posted impressive growth.

As traditional lenders tightened underwriting standards, an unsaturated market for short-term, high-risk loans emerged, and payday lenders filled the gaps with great success. As the largest players grew and consolidated smaller pawnshop operations, investors shared in the bounty.

But there is trouble on the horizon from multiple directions.

A recent $19 million settlement between Cash America and the Consumer Financial Protection Bureau has exposed serious potential legal and regulatory risks inherent in the business model.

To understand how fragile the regulatory situation is, it's helpful to examine the $570 case that precipitated the federal investigations and subsequent $19 million settlement.

In May 2009 one of Cash America's subsidiaries filed a collections suit in Ohio against one Rodney Scott for an amount of $570.16, the balance due under his payday loan. The court ruled the loan, which the subsidiary offered under the Ohio Mortgage Loan Act ("OMLA"), was not authorized under OMLA, and should instead have been offered under a different statute (one that allows for significantly lower effective interest and fees).

As it turned out, Scott's case was not the extent of the company's paperwork troubles in Ohio. Shortly after the district court's decision, Cash America's Ohio division announced that it would forgive all debt collections dating back to the beginning of 2008, and reimburse some 14,000 Ohio customers. This decision, a spokesperson said, was due to "technical errors" that the company "discovered in [its] own due diligence."

As a result of the scrutiny surrounding the Ohio case, the CFPB began looking into the company at a federal level. It, in turn, uncovered evidence of illegal robo-signing practices and violations of a law limiting the interest charged on loans to military service members. The CFPB also alleged that the company instructed employees to erase relevant files and phone calls, and coached them in preparation for speaking to examiners.

It seems unlikely that this is the end of CFPB's interest in the industry as a whole. Regulators are keen on cracking down on lenders that charge very high rates, and it is likely that more state and federal laws and regulations will emerge to tighten around the industry in the future.

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