Are Fintechs Pennywise & Pound stupid?

When a consumer goes to borrow, whether it is a credit card or a loan, there is a basic assumption that the lender will be ready with funds. The application goes to a bank, credit union or fintech that specializes in lending money.

However, there is more than one licensed lender that has a marketing process. In the case of a credit card, the financial institution must be prepared to meet the borrower’s demand for the credit line and in the case of an installment loan, the financial institution must be ready to deliver the funds at closing.

For the financing process to work, financial institutions must have the funds in their balance sheets or have access to a warehouse credit line. If the funds come from the balance sheet, it will reduce a bank’s liquidity by transferring cash to an account that will increase as the funds consume the credit limit. If the financing comes from a warehouse credit line, the financial institution or fintech will use these funds to support lending.

These actions are transparent to the borrower, except when funds are limited. To manage loss reserves, financial institutions need to calibrate their loan receivables with their available cash to ensure that the lending operation is liquid. There is a lot more to the process than what a typical borrower expects.

What top institutions and many fintech lenders do is create loans, age loans to mature the account, and then package asset-based securities (ABS) loans. The ABS process allows the financial institution to transfer accounts from its balance sheet to a group of investors, which releases cash for additional lending. This way, lenders can continue to invest in new borrower accounts.

Lenders such as American Express, Bank of America, Barclaycard, Chase, Citi, Discover and Wells Fargo are examples of top lenders developing the ABS strategy. Everything is based on the use of the FICO Score as a measure of asset quality. Institutional investors, such as California Teacher Retirement Fundor portfolio managers, such as e.g. Vanguard will take positions in ABS bids to increase their returns beyond the level of government securities. Some basics make a difference when it comes to investing.

The ABS process works well for large lenders because investors require critical mass. The strategy is not effective for lenders with loan portfolios of less than $ 5 billion, because volumes are usually insufficient for the needs of institutional investors.

Some fintech lenders use an alternative rating and it seems that some new lenders are less strict about the FICO rating. Instead, fintech can use their exclusive rating, either throughout the process or just at the source. And that brings us to today’s story from the Wall Street Journal.

The headline reads, “Investors are wary of consumer debt” and explains how “demand for bonds backed by loans from more risky borrowers is declining.”

Bond buyers backed by high-risk car loans or credit cards are demanding higher premiums than benchmark interest rates from mid-2020. investors have been punished shares of certain financial technology companies that have helped increase consumer lending recently, such as Affirm Holdings and Upstart Holdings.

Clayton Triick, a portfolio manager at Atlanta-based Angel Oak Capital Advisors, said he was particularly wary of debts owed by people with low credit scores. Angel Oak is “eating to the limit” when he bought the so-called consumer asset-backed securities in 2022, he said, buying smaller amounts of new bonds.

Wall Street’s enthusiasm for consumer debt helped finance the rise in lending. Nearly $ 900 billion in home equity packages traded on bonds and sold to investors as bonds were outstanding last year, according to Moody’s, which holds record lending for homes, cars and even electronics. Household debt topped $ 15 trillion for the first time last year, according to the Federal Reserve Bank of New York.

For more information on fintech foreclosed lending volumes, see this recent Mercator report entitled Installment lending: Fintechs gains ground for $ 212 billion in loans.

This year, investors have sold bonds generally, by increasing yields, which increase when prices fall. But consumer debt returns are growing even faster, a sign that traders believe the relative risk is rising. According to her data JPMorgan Chase & Co., from 0.9 percentage points premium or spread, at the beginning of the year. Yields have also risen on bonds backed by credit card debt and other types of consumer debt.

But for fintechs, the market is not so rosy.

Rising bond market costs have prompted at least one consumer lender to cancel new financing in recent weeks: Affirm, which specializes in “Buy-now-pay-late” loans for online shoppingpulled out a $ 500 million loan-backed bond in March after a major investor demanded a higher interest rate on the deal, according to a hedge-fund manager.

“We have decided to stop issuing the refinancing transaction given the extreme price volatility due to increased macroeconomic uncertainty,” said an Affirm spokesman.

An Upstart spokesman declined to comment. Upstart Chief Financial Officer Sanjay Datta said in a call to analysts in February that the company did not expect significant problems from rising bankruptcies.

Oh, the downstream effect is costly.

Shares of Affirm and rival Upstart have lost about 75% each since November, when late payments began to rise, according to FactSet. The short-term interest rate as a percentage of shares outstanding has tripled for Upstart to around 15% and nearly doubled for Affirm to 6%, according to S&P Capital IQ.

Remember, the economy can feel good, but there are bumps ahead.

Delays in payments for various types of securitized consumer debt are increasing. In February, the share of subprime car loans overdue by more than 60 days was 4.77%, up from 3.74% a year earlier and the highest level since April 2020. Delays in credit card payments have also increased from the lows reached last year, albeit at a more modest pace.

And a portfolio manager from Lord Abed sums things up well:

“An ABS investor needs to be vigilant about where the underwriting standards go from here,” Mr Castle said.

There we believe that the FICO Score comes into play. Privileged strategies in proprietary rating can help open up the sales channel, but at the back end of the spectrum, where investors need a consistent measurement, the FICO Score provides a risk-based view of a wide variety of consumer lending, from car loans. up to credit cards, consumer loans, and even timers. The FICO Score 720 means something to the investor, as does the 600. A proprietary rating used in addition to booking a loan can be interesting, but when it comes to risk assessment, there are many variables that can create a vague environment for investors.

Overview by Brian RileyManager, Credit Advisory Service at Mercator Advisory Group

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