Most Americans don’t have enough money saved to cover their expenses for three months if they were to suddenly lose their job or get injured, and 40% don’t think they could come up with $2000 suddenly if the need arose, report Princeton University professor Atif Mian and University of Chicago professor Amir Sufi on their blog The House of Debt, based on data collected in FINRA’s 2012 National Financial Capability Study.

“Excessive household debt was crucial in explaining the severity of the Great Recession,” write Mian and Sufi. “Households are extremely vulnerable to shocks, and many have too much debt. Are these two patterns related? The answer is unequivocally yes.”

houseofdebt_20140407_12 Financial Shock

houseofdebt_20140407_21 Financial Shock

Even with the economy improving, many of the households living more or less paycheck to paycheck will have to face sudden shocks, raising the question, how do people with precarious incomes get short term credit?

Financial shock: Payday loans replaced with bad checks

“One method that many households use to meet their financial needs is to bounce checks,” writes Rafferty Capital Markets LLC VP of equity research Richard X. Bove in an April 9 report. “A study by a company named Moebs Services finds that the average household will bounce 7.1 checks per year. This is up from 4, the last time I did am analysis of the sector in 2000. This is a relatively expensive method of raising funds.”

Bove argues that simply shutting down payday loans isn’t an effective way to help the working poor get by because they don’t have better options. Bouncing checks, late payments, utility reconnection fees, and overdraft fees are all more expensive forms of credit. The reason payday loans existed in the first place is because so many people don’t have access to more affordable forms of credit because they are seen as a credit risk.

Banning payday loans doesn’t create new financial products

This isn’t a popular point of view, but Bove certainly isn’t the first person to reach the conclusion that payday loans exist because they meet a specific need. When Federal Reserve Bank of New York researchers Donald P. Morgan and Michael R. Strain studied the impact that statewide payday loan bans had on Georgia and North Carolina, they didn’t find much support for the law.

“Georgians and North Carolinians do not seem better off since their states outlawed payday credit: they have bounced more checks, complained more about lenders and debt collectors, and have filed for Chapter 7 (“no asset”) bankruptcy at a higher rate,” they wrote in a 2007 report. “Million per year, as the [Center for Responsible Lending] projected, it cost them millions per year in returned check fees.”

Bove sees this as an investment opportunity, though he hasn’t yet explained how he thinks investors should make the most of it (saving that for a future letter), but it does raise a difficult point. Simply banning exorbitant interest rates doesn’t give the 40%+ Americans who have no buffer a way to absorb financial shocks, it just forces them to rely on informal credit in the form of fees and penalties at a higher overall cost.

“Progressives may call for something better than either payday credit and bounce protection,” write Morgan and Strain, “We’re all for that, but banning payday loans is not the way to motivate competitors to lower prices or invent new products.”