What Can Pawn Shops Teach Banks (and Us) About Risk Management?

pawn shop

When you hear the phrase “pawn shop”, what immediately comes to mind? For me it’s a shady store-front with metal bars protecting the windows. It’s dark and shadowy inside, and it certainly doesn’t feel like a shinging example of good financial management. But an interesting recent piece on Planet Money got me thinking a little bit differently.

The piece talked about the effect that falling gold prices was having on pawn shops, who rely heavily on gold as collateral for loans. There was a lot in the piece, some of it very troubling when viewed from the perspective of people putting themselves in debt over and over again. But there was one aspect in particular that stood out to me as having some valuable lessons for our banking system and for us as individuals.

How pawn shops work like banks

According to the piece, gold is heavily used in pawn shops as collateral for loans. People in need of money will bring their gold (typically in the form of jewelry) to a pawn shop and take out a loan. The pawn shop will hold the gold until the loan is paid back, at which point the gold is returned to the individual. But if the individual fails to pay back the loan, the pawn shop can sell the gold to recoup the money lost on the loan.

This is very similar to how a bank issues mortgage loans. With a mortgage, there’s no physical transaction of property to the bank, but the house serves as collateral just as the gold does. If the mortgage holder fails to pay back the loan, the bank forecloses on the home and attempts to sell it to recoup the money lost on the loan.

In both cases, the price at which the collateral (gold or house) could be sold goes a long way towards determining the safety of the loan for the business. If the lender is confident that they can sell the collateral at a price near the loan amount, the loan is less risky because they have a good chance of being able to recoup any losses. The risk turns up when the price of the collateral drops, the borrower stops paying the loan, and the lender is left with property that is worth much less than what they lost on the loan.

How pawn shops are smarter than banks

That very risk has shown up in recent months for pawn shops. The price of gold was up to almost $1,800 per ounce back in October of 2012, but has dropped to just over $1,300 per ounce recently. That’s a 28% drop in price in just about 10 months. For a business relying on the ability to sell gold to fight losses on failed loans, this sounds like a recipe for disaster.

But, according to the Planet Money story, this disaster was averted because the pawn shops are smartly very conservative with their loans. While they don’t require credit checks, they also won’t lend out more than 70% of the value of the gold you bring to them. So if you bring them $1,000 worth of gold, you can expect no more than a $700 loan. So even if the individual fails to pay back the entire loan, the pawn shop can withstand a 30% drop in the price of gold before they lose money. That’s a pretty savvy business move.

Banks, on the other hand, decided that they didn’t need to go to such smart financial lengths with their loans. There are many reasons for the housing collapse, but one of the reasons it had such a negative impact on banks was that there were an abnormal amount of loans given out for close to the full price of the house. According to a study released in 2006 by the National Association of Realtors, 43% of first-time home buyers were able to purchase their homes without any down-payment. In other words, the banks were loaning out 100% of the value of the collateral. The median down-payment in 2005 on a $150,000 home was 2%.

So in a large number of cases, banks were issuing loans at 98-100% of the value of their collateral. That’s a far cry from the 70% that pawn shops are working with. Now, some of this was driven by Federal programs advocating affordable housing, but a decent amount was just risky business practice. And the effect was that banks were highly sensitive to housing prices and when prices started to decline, they had no built in cushion that allowed them to sustain the drops. People started defaulting on their loans, the banks couldn’t recoup the cost from selling, and so they failed.

Lessons learned

The first lesson here is that every investment comes with risk. The pawn shops apparently understand this concept and take measures that balance out this risk. The banks did not understand this, focusing too much on potential investment returns and not enough on the very real downside they were exposing themselves to. Don’t let yourself lose sight of the fact that the promise of investment returns ALWAYS comes at the cost of very real risk of loss.

The second lesson here, is that you should only take on as much risk as you can afford. Pawn shops implemented this practice by only lending out 70% of the value of the gold brought in. They could have tried to make more money by making bigger loans, but they decided that they couldn’t afford that risk. Banks were not as prudent and many of them ended up shutting down. For you personally, it’s important to understand how your investment strategy exposes you to risk and how much risk you’re willing to take. It’s also important to take measures to protect against risk, such as buying insurance. Both of these things will help you avert disaster by functioning more like a pawn shop and less like a bank.

Other articles I think you’ll like

Rick Ferri: An interesting comparison between Medieval medicine and active mutual fund management.

Cash Rebel: A great discussion on how to consider what’s next with your career. I like his proactive approach to actively seek out his ideal job rather than just waiting to see what comes to him.

The Chicago Financial Planner: Roger Wohlner provides a really interesting retirement planning calculator. It gives you more input than most without going overboard. I definitely think it’s worth checking out.

Mo’ Money Mo’ Houses: Good tips on how to handle yourself properly when quitting your job.

Living Rich Cheaply: Andrew talks about financial responsibility as a change in mindset. I couldn’t agree more. It often starts with one change, and then you realize you can do another, and another, and before long your life is much different, but happier and more stable. Great post here.

Pretired.org: Nick describes a perfect day spent with his son. I have to admit, it made me a little jealous.

Making Sense of Cents: We all have some bad financial habits. What are yours?

Thanks to these carnivals for including me along with some other great posts!

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Photo courtesy of Matthew Straubmuller

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  • Andrew August 2, 2013

    Thanks for the mention Matt. A very interesting comparison between Pawn shops and Banks..I’ve always been a bit ignorant as to how pawn shops works…thanks for the enlightenment. Not that I plan on using them though! So with the banks lending close 100% of the collateral value…does PMI help protect their interests?

    • Matt @ momanddadmoney August 4, 2013

      You’re absolutely right that PMI should help and it was honestly just an oversight on my part for not including it as part of the discussion here. I’ll need to look into the role PMI did or did not play in the recent bank failures.

  • Debt Blag August 2, 2013

    Nice. I heard that story as well. It’s easy for us, with our credit cards, HELOCs, and retirement accounts, to forget that for a lot of under-banked people out there, pawn shops — and similar businesses like payday lenders — are the only way to access credit.

    • Matt @ momanddadmoney August 4, 2013

      Yep, there’s a whole different world out there for sure. One of the pawn brokers they talked to said the best customers were the ones who pawned the same thing over and over again. That sounded so sad, but then I realized that it’s not really any different from turning to credit cards again and again. Just a different mechanism for the same thing.

  • DC @ Young Adult Money August 2, 2013

    This is really a great analogy, and it’s really cool that pawn shops have taken such a conservative approach. I would imagine most pawn brokers have been in business for a number of years and realize the volatility of gold, as well as the great benefit the receiver of the loan is receiving by not having a credit check. When I hear pawn shop I think of the awesome TV show Pawn Stars! Love that show.

    • Matt @ momanddadmoney August 4, 2013

      Haha, I haven’t watched much of that show, but it’s been interesting the few times I’ve seen it on. It seems that pawn shops, like any other good business, have learned both the characteristics of their clientele and the risks they can afford and have adapted accordingly. Certainly interesting to learn valuable financial lessons from such a stigmatized business.

  • Alexa Mason August 2, 2013

    I would agree that pawn shops are much smarter than banks. And that’s expected. People know that a pawn shops prerogative is to make money so anything they pawn or sell will be under market value because the shop has to make money.

    • Matt @ momanddadmoney August 4, 2013

      Sure, they’ve gone a good job trying to ensure a profit. But shouldn’t banks be doing the same thing?

  • Done by Forty August 2, 2013

    In the case of someone not putting 20% down, the banks do have PMI to protect themselves. But I agree that simply lending a percentage of the appraised value of the home (say, 80%) might be a better approach, as it would also encourage better financial habits on the part of the borrower (e.g. – learning how to track spending & live on less than you make to save a downpayment.)

    • Matt @ momanddadmoney August 4, 2013

      It’s a good point about PMI, one Andrew made as well. It was an oversight on my part not including it here. You’re definitely right about requiring a higher down payment being better for the borrower. That’s not necessarily the bank’s job, but it would be nice if they cared a little more about it.

      • Done by Forty August 4, 2013

        Just to play the other side, a member of my church told me about a new job he started. He worked for an insurance company going through banks’ claims on PMI, to ensure that the banks had adhered to the terms of the insurance agreement and, in a sense, looking to see if there was a way to not pay out the claim. I got the impression that PMI wouldn’t pay out as much as the banks might hope…they’re probably better off with the real protection of just lending out a percentage of the current appraised value, as a pawn shop might.

        • Matt @ momanddadmoney August 5, 2013

          Interesting. I’ll definitely have to do a little more research into it. I honestly done know a lot about how PMI works or its effectiveness. In any case, they’re probably at least better off with a combination of the two.

  • Edward - Entry Level Dilemma August 2, 2013

    Don’t you just love listening to NPR for blog post ideas? I actually didn’t even know until very recently that collateralized loans were pawn shops primary business. I had always thought that pawn shops were basically thrift stores where you could sell your stuff to the store as well as buy.

    • Matt @ momanddadmoney August 4, 2013

      NPR is a treasure-trove of ideas. I wasn’t completely aware of their loan business either and thought of them more like you did as well. But the loan business certainly seems to fit right in with the rest of what they do, so I have to say that it wasn’t too surprising.

  • cashRebel August 3, 2013

    I had no idea pawn shops were so conservative. It’s such an interesting business model that banks could learn from haha. Thanks for the mention!

  • This Healthy Budget August 3, 2013

    As much as I hate that the History Channel has become the Pawn Stars network, it’s a solid example of risk management. They rarely get in over their heads and their low-ball offers, which seem to perhaps be a ripoff to TV viewers, allow them to stay in business. After all, these sellers can go somewhere else if their not happy with the prices they’re quoted but they usually seem eager to take the cash now rather than get a better return later.

    • Matt @ momanddadmoney August 4, 2013

      It’s certainly not the best deal for the customer, but the pawn shops seem to have found a model that works for them. It is interesting what qualifies as “history” these days. My wife has gravitated more towards the “H2” channel these days, which I think is at least a little more oriented towards the channel’s original purpose.

  • Greg August 4, 2013

    So you mean I can learn lessons from the shady places that I only see when I am in the wrong part of town 🙂 ? I like to overview and how you apply it to managing your own finances. As others have mentioned, I agree that banks could probably learn a thing or two about being a bit more conservative.

  • Laurie @thefrugalfarmer August 5, 2013

    Fun post, Matt. Then again, it doesn’t take much to be smarter than most banking higher-ups these days. 🙂

  • roger56d October 24, 2013

    Pawn shops help in understanding risk management and this is a well-written blog post that presents the problem and is convincing in every way.

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