2013 Theses Doctoral

Essays in Alternative Financial Services

Czerwonko Pupi, Alejo Eduardo

"Alternative financial services" is a term often used to describe the array of financial services offered by providers that operate outside of federally insured banks. More than one in four households in the United States are either unbanked or underbanked, a number that has been growing steadily since 2009, according to the FDIC. These households conduct some or all of their financial transactions outside of the mainstream banking system. Many rely on alternative financial services providers. Rent-to-own stores, pawn shops, and payday lenders are the largest providers of credit within the alternative financial services world. This dissertation studies the rent-to-own industry. The rent-to-own agreement provides consumers immediate access to durable goods without a credit check or down payment. In a typical transaction, an agreement is written for a period of 12 to 24 months. The item is delivered immediately and rental payments are made monthly. At the end of each month, a consumer can continue to rent by paying for an additional period, or can return the good to the store without further obligation. Consumers obtain ownership of the good by renting to term or through early payment of a pre-specified cash price. What makes the study of rent-to-own contracts interesting is the unique nature of the agreement. Neither a credit sale nor a pure lease, this contract is the cornerstone of an industry that serves more than six million Americans each year, operates 9,800 storefronts in all 50 U.S. states and Canada, generates over US$ 8.5 billion in revenues a year, and employs more than 50,000 individuals. The industry has drawn attention from regulators and consumer advocacy groups. At the heart of the debate is the ostensibly high price of the transaction, and the allegedly overwhelming profitability of the firms in the industry. The first chapter of this dissertation introduces and motivates my dissertation research. It is followed by a chapter containing an overview of the different literatures my works builds on. I contribute to these literatures in several ways. To begin with, I develop the most detailed and comprehensive analysis of the rent-to-own contract, the industry's institutional details and its regulatory framework. It is also the first fully independent study of rent-to-own using micro-level data. To the best of my knowledge, there is no other study based on transaction-level data that has not been commissioned by the industry. This dissertation also contains the first piece of work on the rent-to-own industry to employ structural estimation techniques, and therefore the first to credibly analyze the consequences of contract changes, regulatory changes and other counterfactual exercises on social welfare. Chapter 3 analyzes the characteristics of rent-to-own contracts and key components of the industry. Some of the questions I answer along the way are: What is rent-to-own? What makes the contract unique? Is rent-to-own expensive to consumers? Who are the main market participants? What do customers look like and how do they behave? What do firms look like and how do they perform? A proper understanding of the rent-to-own market is essential to assess the value of the transaction to consumers and firms, as well as to design sensible regulatory frameworks. I find that while rent-to-own looks expensive compared to cash retail and credit sale transactions, it does not when benchmarked against pure leases. And those unbanked or underbanked U.S. households wanting to access durable goods may have nowhere else to turn to. There is no evidence that the rent-to-own activity is overwhelmingly profitable. The industry seems to be competitive and the performance of rent-to-own firms stands roughly in the median of the distribution of profitability across industries in the U.S. In chapter 4 I use proprietary micro-level data from a medium-sized rent-to-own chain in Ohio to analyze the behavior of consumers and the transaction-level performance of firms. The reduced-form analysis carried out in this chapter helps us understand contract use in the context of rent-to-own. I address the controversy regarding the proportion of rent-to-own customers that rent items to term. Consumer advocates say the great majority of them do; the industry association states 75% return the rented item within the first four months of the contract. The analysis of micro-level data shows that the truth lies somewhere in the middle. The data also reveal that consumers respond to the incentives and trade-offs presented to them by the contract. During the first half of the rent-to-own agreement, consumers mostly make rental payments or return the item. During the second half, as the early purchase option becomes more affordable, an increasing amount of consumers exercise it. Many of them just stop making payments and do not return the item. Delinquency is a serious problem in the industry that significantly affects the performance of rent-to-own firms. Furniture items and appliances, items that suffer the least from delinquency, are the most profitable product categories. The data description chapter motivates the development of a dynamic structural model of consumer behavior and firm performance. Chapter 5 presents the model, describes the estimation procedure and lists the challenges I had to be overcome along the way. I present the results of estimating the model using transaction-level data of rent-to-own contracts, as well as a series of robustness tests in chapter 6. The model does a very good job at fitting observed consumer behavior and the procedure and results. I use these demand estimates to analyze contract design, that is, how the different dimensions of the rent-to-own contract affect consumer satisfaction and firm performance. The counterfactual exercises suggest there exist potential changes to the contract terms that can make both consumers and firms better off. I find that reducing the flexibility of the rent-to-own contract in terms of the return option, while simultaneously decreasing the monthly rental rate, yields higher social welfare. Also, if regulation restricting the shape of the early purchase option schedule was lifted, the rent-to-own firm could alter the schedule in such a way as to make both consumers and the firm better off. This would entail a higher early purchase option price at the beginning of the rent-to-own contract, but this price would decrease faster over time than what the current regulation dictates. Finally, I show that better theft prevention measures could improve the performance of rent-to-own firms significantly. Rent-to-own operators could then transfer part of their increased revenue to consumers in the form of lower monthly rental rates.robustness tests yield favorable results, which increases my confidence in the estimation.