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.
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?
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